The Importance of Bilateral Investment Treaties (BITs) When Investing in Emerging Markets

Posted on March 19, 2014 by - Uncategorized

Tax planning forms a natural part of any decision-making process regarding the optimal structure of foreign investments. Strangely enough, until recently, BIT-planning (i.e., planning to protect the investor’s interests against unfair treatment by the host country’s government via bilateral investment treaties), rarely received a seat at the table. Venezuela’s actions in the oil and gas industry have emphasized, however, that the value of bilateral investment treaties cannot be overestimated. The decision by Mobil Corporation and ConocoPhilips to structure (or restructure) their investments in the Orinoco Oil Belt projects in Venezuela through a company incorporated under Netherlands law will probably save them billions of dollars. These investors invoked the protection of the Bilateral Investment Treaty entered into between the Kingdom of the Netherlands and Venezuela after the expropriation of their investments, and are currently involved in multibillion dollar arbitrations with Venezuela. 

Foreign investors, especially those investing in emerging markets, are well advised to analyze not only the tax efficiency of a particular investment vehicle, but also the existence and substance of BITs to which the host country is a signatory. Sometimes the tax and BIT analyses point to the same optimal investment vehicle. If not, the solution may be to use two investment vehicle layers so that optimal tax planning is combined with the best protection under BITs. 

This article discusses what BITs are, how investors can enforce claims under BITs, and why using a Dutch or Curaçao entity and the associated extensive BIT treaty network of the Netherlands and Curaçao may prove useful when investing in countries that are perceived to be politically unstable. Finally, this article will also briefly address BIT developments in the EU. 

What are BITS?

BITs are agreements between two countries protecting investments made by investors from one contracting state in the territory of the other contracting state. The purpose of BITs is to stimulate foreign investments by reducing political risk. The number of BITs entered into has increased exponentially over the last two decades. The first BIT was entered into between Germany and Pakistan in 1959. At the end of the 1980s, there were approximately 385 BITs, whereas currently the number approaches 3,000. Most BITs include the following substantive obligations that each country undertakes toward investors from the other country, with only narrow exceptions: 

  • Treating foreign investors’ investments fairly and equitably, i.e., not taking unreasonable or discriminatory measures and treating investments of foreign investors at least as favorably as investments from its own nationals and nationals of third states;
  • Not nationalizing or expropriating investments from foreign investors, unless the measures taken are non-discriminatory, taken in the public interest, and while observing due process, are taken against payment of prompt, adequate, and fair compensation. Importantly, regulations substantially negatively affecting the value of an investment can qualify as an expropriation for these purposes; and
  • Allowing funds relating to investments to be freely transferred by foreign investors without delay, which includes protection against foreign exchange restrictions. This protection was invoked several times under BITs entered into by Argentina. 

In this article we only address bilateral investment treaties. Please note that there are a few multinational treaties that also offer investment protection, the most important ones of which are NAFTA and the Energy Charter. 

Enforcement of BITs

BITs are quite unique in that they provide a basis for claims by an individual person or company against a state. In an effort to avoid the need to turn to the national courts for a judicial remedy, BITs usually contain an arbitration clause submitting disputes to a neutral arbitration tribunal, normally the International Centre for Settlement of Investment Disputes (ICSID), the most frequently used alternative being arbitration under the rules of the United Nations Commission on International Trade Law (UNCITRAL). Awards rendered by the ICSID are binding on parties and not subject to any court or other appeal, provided that an award can be annulled by a second ICSID panel, but only on grounds that are significantly narrower than the grounds that can be found in the New York Arbitration Convention. The ICSID was established under the Convention on the Settlement of Investment Disputes between States and Nationals of other States on March 18, 1965 (the “Washington Convention”), as an initiative of the World Bank. The Washington Convention entered into force on October 14, 1966, after having been ratified by 20 countries. Under Article 54 of the Washington Convention, each of the current 150 states that have ratified it must recognize an award rendered pursuant to the Washington Convention as binding and must enforce the monetary obligations imposed by that award as if it were a final judgment of a court of that state. However, it should be noted that local law of the country in which enforcement is sought will ultimately determine whether particular sovereign assets can be seized. 

There are currently 183 cases pending before the ICSID, including the $7 billion case Mobil Corporation, Venezuela Holdings B.V. and others v. Venezuela and the $30 billion case ConocoPhillips Petrozuata B.V. and others v. Venezuela, both based on the BIT entered into between the Kingdom of the Netherlands and Venezuela. In the Mobil case, the arbitration panel confirmed, in accordance with existing case law from ICSID panels, that the fact that a Dutch intermediary holding company was added to the structure years after the original investment and probably with a view to the political environment in Venezuela, did not negatively affect the rights of Mobil to seek protection under the Dutch BIT. In the ConocoPhillips case, the arbitral tribunal ruled on September 3, 2013, that Venezuela has unlawfully expropriated the investments of ConocoPhillips in three oil projects in Venezuela by failing to offer just compensation for the taking of ConocoPhillips assets in the oil projects. The arbitration will continue to determine the level of compensation. Venezuela (27) and Argentina (24) head the list of countries against which the most ICSID cases are pending. 

BIT Due Diligence

Not all BITs are created equal. If a host country has entered into multiple BITs, it is worthwhile to review the contents of those BITs in order to determine which BIT provides the best protection for a specific investment. Some BITs are worded more investor-friendly than others. We’ll explore below some of the issues to look for when doing due diligence on BITs: 

  • Which investments are protected? Each BIT will have a definition of “Investments.” Some of these definitions are worded broadly, but it may also be the case that BIT protection is only awarded to a narrow category of investments, or that certain investments are expressly excluded. It may, for example, be limited to protection of equity interests.
  • When does the BIT apply? It will be important to see whether BIT protection is only granted to citizens of, and companies incorporated under the laws of, or having their head quarters in, the contracting state, or whether for example, companies in third countries owned and/or controlled by such citizens or corporations also qualify for protection.
  • Term of BIT protection. BITs are entered into for a specific term and may, or may not, be extended for a certain period after a termination notice has been given. In addition, it may be important to check whether the protection is also afforded to investments made before the BIT becomes effective. 

Use of Dutch or Curaçao Investment Vehicles

Dutch or Curaçao investment vehicles are already often used for tax reasons. Dutch policy aims at removing international double taxation, and the Netherlands has therefore entered into nearly 100 international tax treaties. In addition, Dutch tax law does not provide for withholding tax on outbound interest and royalties. Lastly, profits received by a Dutch parent company from a foreign subsidiary or made through a permanent establishment situated abroad are exempt from taxation in the Netherlands (often referred to as the “participation exemption”). The extensive BIT treaty network of the Netherlands and Curaçao provides another strong argument for using a Dutch or Curaçao investment vehicle when making foreign investments in countries which are perceived to be politically risky. 

The Kingdom of the Netherlands entered into 97 BITs of which 89 are currently in effect. These BITs generally apply to The Netherlands, Curaçao, St. Maarten, and Aruba. Curaçao is probably the only well-known off-shore jurisdiction that provides the benefit of such an extensive BIT treaty network. The model treaty on which most are based is considered to be very investor-friendly. The issues referred to above are dealt with as follows: 

Which investments are protected? In virtually all BITs entered into by the Kingdom of the Netherlands, the definition of “investments” is worded broadly and is open-ended. The definition generally covers any kind of asset, including, but not limited to: (1) movable and immovable property and security rights in relation thereto; (2) rights derived from shares, bonds, and other interests in corporations and joint ventures; (3) monetary claims; (4) intellectual property rights; and (5) rights to explore, extract, and win natural resources and other rights granted under public law. 

To which investors does the BIT apply? The Dutch Kingdom’s BITs typically not only apply to citizens and corporations of the Netherlands, Aruba, Curaçao, and St. Maarten, but also to foreign corporations that are directly or indirectly controlled by such citizens or corporations. A significant number of BITs of other countries require qualifying investors to be both established in the contracting country and to have their head office there. These other BITs would therefore not provide protection on the basis of intermediary holding companies located in the state that entered into the BIT with the host country. The Dutch Kingdom’s approach gives a lot of flexibility to structure investments in a tax efficient manner, while allowing the investor at the same time to benefit from the rights granted to investors under the relevant BIT, since it is possible to use multiple layers of investment vehicles. Almost all Dutch Kingdom BITs provide protection as long as there is a Dutch or Dutch Caribbean vehicle in the corporate structure. 

Term of BIT protection. The BITs of the Dutch Kingdom are in most cases valid for an initial period of 15 years. They usually also apply to investments that have been made before the date of entry into force. Unless a six-month advance termination notice has been given by one of the contracting states before its expiry date, they will automatically be extended for 10 years. Importantly, in the case of a termination, the provisions of the BIT generally survive for a further period of 15 years for investments that were made before its termination. Consequently, the Dutch Kingdom-Venezuela BIT that has been terminated upon Venezuela’s request as of November 1, 2008, will for example, remain in force until November 1, 2023, for investments made before November 1, 2008. 

BITS in Effect

Netherlands       89

Curaçao             89

Brazil                   0

China               100 (not including U.S.)

India                  65 (not including U.S.)

U.S.                   40

Cayman Islands  0

Bermuda             5

Canada              27

BITs and BRICs

Below, we will briefly describe the BIT situation in the BRIC (Brazil, Russia, India and China) countries and provide, if applicable, some details of the BITs entered into by the BRICs with the Kingdom of the Netherlands, which are among the most investor-friendly BITs entered into by the relevant countries. 

Brazil 

Brazil executed 14 BITs, including one with the Kingdom of the Netherlands, but apparently had a change of heart and has not ratified any of them. It is not a party to the Washington Convention. 

Russian Federation 

The Russian Federation is a signatory to 44 BITs. The Russian Federation, or rather its predecessor, the Soviet Union, entered into a BIT with the United States in 1992, but never ratified it, so it is not effective. The BIT with the Kingdom of the Netherlands became effective in 1991. Russia has executed the Washington Convention, but has not ratified it. 

The Dutch-Russian BIT has the following features: 

  • The definition of investments is very broad and includes, for example, intellectual property rights and concessions to explore natural resources.
  • It offers protection for the benefit of intermediary holding companies.
  • It offers direct access to ad hoc arbitration with arbiters to be appointed by the president of the chamber of commerce in Stockholm. 

India 

India has 65 BITs in effect, with a few pending. There is no BIT with the United States. The BIT between India and the Kingdom of the Netherlands has the following main features:

  • The definition of investments is very broad and includes for example intellectual property rights and concessions.
  • It offers protection for the benefit of intermediary holding companies.
  • It offers access to ICSID or UNCITRAL arbitration. 

China 

China entered into about 100 BITs. The list does not include the United States. When investing in China, U.S. investors could therefore benefit from interposing an intermediary holding company from a jurisdiction with an investor-friendly China BIT. Obviously, interposing the intermediary holding company should not result in the payment of additional taxes, so the choice of jurisdiction will also depend on a thorough tax analysis. Interposing a Dutch intermediary holding company may fit the bill. 

The Dutch-China BIT has the following features:

  • The definition of investments is very broad and includes, for example, intellectual property rights.
  • It also offers protection for the benefit of intermediary holding companies.
  • It offers direct access to ICSID or UNCITRAL arbitration (contrary to many other China BITs). 

In the case of China, it is especially interesting that the BIT offers protection for the benefit of intermediary holding companies. Given that the Dutch-China Tax Treaty provides for a 10 percent dividend withholding tax, whereas, for example, an investment by a Hong Kong entity would only trigger a 5 percent withholding tax burden, the investment should not be directly made through a Dutch subsidiary. To add BIT protection, the Dutch subsidiary should be interposed above, for example, such Hong Kong entity. Interposing the Dutch entity will not lead to additional taxes, given the Dutch participation exemption for subsidiaries (income derived though qualifying subsidiaries are not subject to corporate income tax) and the fact that dividends paid by the Dutch entity to a U.S. parent can be made without dividend withholding tax, either by using the U.S.-Dutch Tax Treaty, or by structuring the Dutch entity as a “cooperative.” 

Developments in the EU

As of December 1, 2009, the EU became exclusively authorized to enter into new BITs on behalf of its member states. However, existing BITs entered into by an EU member state remain effective, unless and until the EU enters into a new BIT with the relevant other state. 

Conclusion

When contemplating foreign direct investments, especially in emerging markets, BIT due diligence should be part of the work undertaken. Basing the decision on which investment vehicle to use solely on tax considerations may prove costly if a host government takes hostile action. 

Using a Dutch or Curaçao entity may not only make sense from a tax perspective, but also because of the extensive BIT network of the Netherlands and Curaçao.

Unauthorized Practice of Law and the Transplanted In-House Counsel

Posted on March 19, 2014 by - Uncategorized

 

George, an in-house lawyer employed by Acme Corporation, is licensed to practice law in New York. Fifteen years ago, George moved to Acme’s headquarters in Chicago, where he has worked ever since. He is not a member of the Illinois bar. Is George engaged in the unauthorized practice of law (UPL), and if so, what might be the consequences? 

In-House Lawyers and Unauthorized Practice

Lawyers move – including, frequently, both across state lines and from private law firm practice to in-house legal departments. For decades prior to the adoption of Rule 5.5(d) of the American Bar Association’s Model Rules of Professional Conduct, an in-house lawyer licensed only in a state other than where he or she worked rarely attracted scrutiny with respect to UPL, from bar authorities or otherwise. To the extent that issues arose, it was often when the lawyer left the in-house position to return to private firm practice and applied for local bar admission; at that point some state bar regulators might pose pointed questions about what the lawyer did during his or her in-house tenure. 

The Model Rule 5.5(d)-(e) Safe Harbor for In-House Lawyers

Model Rule 5.5(d)-(e), adopted by the ABA House of Delegates in 2002, was meant to create a safe harbor for in-house lawyers admitted in a U.S. jurisdiction, but not where they work. This was one of several multijurisdictional practice safe harbors added to Rule 5.5. In general, it is relatively easy for an in-house lawyer to comply with subsections (d) and (e) of Model Rule 5.5, which reflect a policy judgment that such an in-house role “does not create an unreasonable risk to the client and others because the employer is well situated to assess the lawyer’s qualifications and the qualities of the lawyer’s work.” Model Rule 5.5, Comment 16. 

New In-House Registration and Limited Admission Rules

Illinois adopted a modified version of Model Rule 5.5(d). If that had been the only step taken on this topic in Illinois and elsewhere, George and other in-house lawyers licensed only in other states would have little to worry about with respect to UPL (as long as they kept their licenses current and confined their practices to representation of their employers). In tandem with the adoption of versions of Model Rule 5.5(d)-(e), however, many states (including Illinois, where George works) also adopted rules requiring in-house lawyers who are only admitted elsewhere in the United States to register with or obtain limited admission from the state bar regulatory authority. While the safe harbor in Illinois Rule of Professional Conduct 5.5(d) covers George, Comment 17 to the Illinois rule (based on Comment 17 to Model Rule 5.5) also contains a cross-reference to another Illinois rule on limited admission of in-house counsel in George’s position. The 2014 edition of the Comprehensive Guide to Bar Admission Requirements, compiled by the National Conference of Bar Examiners and the American Bar Association Section of Legal Education and Admission to the Bar, states that 33 states now have license, registration, or certification requirements for corporate counsel not otherwise admitted in-state, with application fees ranging from zero to $1,300. 

The ABA has adopted a Model Rule for Registration of In-House Counsel, but state rules on this topic vary on a number of subjects, including whether: 

  • The rule is framed in terms of “registration” or “limited admission” of in-house lawyers;
  • Representation is also permitted of organization personnel on matters relating to their organizational roles;
  • Court appearances on behalf of the organization are allowed;
  • Pro bono work for clients other than the organizational employer is authorized;
  • Time worked under the rule can later be used to “waive in” for general bar admission purposes;
  • The in-house lawyer must satisfy continuing legal education requirements; and
  • A one-time fee, annual payments, or both are required. 

Some states have no such in-house counsel rules. For that matter, not all states have yet even adopted a version of Model Rule 5.5(d)-(e); a number of states simply retain a vague prohibition on engaging in or assisting the unauthorized practice of law. 

A New Risk Spectrum

Whereas UPL by in-house lawyers was once a relatively low-risk subject nationwide, if only because of a relative lack of scrutiny, the UPL risk spectrum for in-house lawyers has broadened considerably. At one end of the spectrum, jurisdictions in which versions of Model Rule 5.5(d)-(e) have been adopted without any supplemental rules relating to registration of out-of-state in-house lawyers are even lower-risk from a UPL perspective than they once were. On the other hand, lawyers like George working in jurisdictions that have adopted registration or limited admission rules for in-house lawyers who are only licensed elsewhere now face greater risks than they did before Model Rule 5.5(d)-(e) – at least if they fail to comply. An initiative that was intended to help house counsel like George who are not locally admitted seems to have focused added local bar attention on in-house lawyers. 

Privilege Loss?

Another possible issue, on which there does not yet seem to be any case law, is whether George’s failure to comply with the Illinois house counsel rule could be used as a basis for claiming that Acme’s communications with George are not covered by the attorney-client privilege. A similar argument in analogous circumstances was rejected in Gucci America, Inc. v. Guess?, Inc., 2011 U.S. Dist. LEXIS 15 (S.D.N.Y. January 3, 2011). In that case, the in-house lawyer had been admitted in a state other than where he worked in-house, but had then gone on inactive status. The court concluded that a lawyer on inactive status was nonetheless a lawyer for purposes of the attorney-client privilege, and that the corporate employer was not under any obligation to check on the active bar status of its in-house lawyer. The case, however, did not address any in-house lawyer admission or registration rules, and it is unclear whether courts would take the Gucci approach in cases involving such rules. 

Illinois Amnesty

Responding to a perception that a significant number of in-house lawyers who are subject to the Illinois rule on this subject may not yet have obtained the required limited in-house licenses, the Illinois Supreme Court declared an amnesty for lawyers who apply for such licenses during 2014. In addition to the $1,250 registration fee provided for under the Illinois rules, an in-house lawyer taking advantage of the amnesty must also pay an additional $1,250 penalty, but is not expected to make up back payments or continuing legal education requirements. The court stated that the prior failure of such lawyers to apply under the rule would not be a basis for prosecution for having engaged in the unauthorized practice of law, that it would not be grounds for denying a license or discipline, and that such applicants would not be investigated by the Illinois Attorney Registration and Disciplinary Commission. Presumably implicit in those statements is the possibility that a lawyer such as George who is covered by the house counsel rule (Illinois Supreme Court Rule 716) and who does not take advantage of the amnesty could be subject to those actions thereafter. 

Conclusion

If unauthorized practice rules exist primarily to protect clients and others against unqualified lawyers, it is difficult to find many situations in which such problems have been experienced by corporations or other organizations employing in-house lawyers. To some, state rules regarding registration or limited admission of in-house lawyers like George are solutions in search of a problem. As a practical matter, these rules are probably designed, not to solve systemic problems relating to the performance quality of George or other in-house lawyers, but rather to (a) require such in-house lawyers to contribute financially to funding the state bar, and (b) ensure that such in-house lawyers are subject to local state bar jurisdiction. In-house lawyers such as George who have not complied with such rules should consider addressing the situation, and Acme and other employers of such lawyers may want to help or require them to do so.

Rule 5.5(d)-(e) of the Model Rules of Professional Conduct

(d) A lawyer admitted in another United States jurisdiction or in a foreign jurisdiction, and not disbarred or suspended from practice in any jurisdiction or the equivalent thereof, may provide legal services through an office or other systematic and continuous presence in this jurisdiction that:

(1) are provided to the lawyer’s employer or its organizational affiliates; are not services for which the forum requires pro hac vice admission; and, when performed by a foreign lawyer and requires advice on the law of this or another U.S. jurisdiction or of the United States, such advice shall be based upon the advice of a lawyer who is duly licensed and authorized by the jurisdiction to provide such advice; or

(2) are services that the lawyer is authorized by federal or other law or rule to provide in this jurisdiction.

(e) For purposes of paragraph (d), the foreign lawyer must be a member in good standing of a recognized legal profession in a foreign jurisdiction, the members of which are admitted to practice as lawyers or counselors at law or the equivalent, and are subject to effective regulation and discipline by a duly constituted professional body or a public authority.

Observations on Captive Insurance Companies: 10 Worst and 10 Best Things

Posted on February 18, 2014 by - Uncategorized

A captive insurance company (commonly referred to in short as a “captive”) is an insurance subsidiary that is set up by the parent company to underwrite the insurance needs of the other subsidiaries. For example, British Petroleum wisely set up a captive insurance company (Jupiter Insurance Ltd.) to provide environmental insurance to its operating units, and the moneys from its captive were used to fund in substantial part the Gulf cleanup. 

The vast majority of Fortune 500 companies now have captive subsidiaries (and many companies have several captives, including those for employee benefits), and captives are now also routinely used by small companies for the same purpose. Over 30 states now have captive-enabling legislation, most recently North Carolina and Texas, in addition to states such as Delaware, Kentucky, Missouri, Nevada, Utah, and Vermont, which are very active in marketing their states as premier jurisdictions for the formation of captives. 

A captive can be a wonderful risk management tool when used correctly; but therein lies the rub, many are not. The difference between a poorly-run captive and a well-run captive is often difficult for novices to discern. So, in reverse order, here are 10 bad practices involving captive insurance companies, followed by 10 good ones. 

Dangers of a Bad Captive Arrangement

10. Bogus Risk Pools

A lot of businesses with valid needs for insurance don’t have enough subsidiaries to pass what is known as the “multiple insured” test for risk distribution, and so they instead participate in what is known as a “risk pool” to obtain risk-distribution. 

In a nutshell, a “risk pool” is an insurance arrangement involving multiple, usually unrelated captive owners who share certain risks through their individual captives. Risk pools are usually set up by captive managers to facilitate the needs of certain of their captive clients. In various guidance, the IRS has validated the concept of the risk pool when run correctly. 

The difficulty is with the “when run correctly” part. The problem with most risk pools is that there is in fact very little sharing of risks, and thus, the large premiums being charged by the pool are neither actuarially sound nor bear anything but a coincidental relationship to reality. The IRS refers to these as “notional risk pools” – there is a notion of a risk, but not much beyond the mere notion. 

Many of these pools have been operated for years with few or no claims, which calls into serious question whether the large premiums they charge are realistic (the answer is that they are not). Maybe in the first year when the pool has no loss history, it can be aggressive in how it prices the premiums paid. By the fifth year, however, a run of large premiums with few or no losses probably indicates that the premiums were mispriced. 

By like token, if there is true risk-sharing in a pool, that means that the participants are subject to actual risk of loss – including the total loss of their premiums paid by their operating businesses into the pool. This is where the wink-wink, nod-nod of “That will never happen; actually you’ll never lose anything significant” usually shows up, which is another way of saying the risk pool is just a vehicle to facilitate the appearance of risk-shifting, without actual risk-shifting, i.e., tax fraud. 

While the saying around my office is “Pools are for fools!,” the truth is that some clients (including some of mine) cannot meet the test for risk distribution in any other way, and therefore make an informed business decision to participate in a risk pool. However, for these clients my advice is usually, “Do whatever reorganization of your business is necessary to get out of the risk pool as quickly as you can.” If a client is still in a risk pool after a few years just because they need the risk-distribution for tax purposes, there has been a serious failure in business planning by someone. 

9. Failure to Make Feasibility Study Prior to Formation

Before the decision to form the captive is even made, a feasibility study should be conducted that looks at all aspects of the captive and validates its viability and economics, as well as whether the captive will meet critical tests for risk-shifting and risk-distribution. 

If for no other reason, a feasibility study that carefully documents the non-tax purposes of the captive (to distinguish it from a tax shelter masquerading as a captive) should be done, since the IRS on audits of captives routinely asks for such documents as part of its evaluation. A good captive feasibility study will go a long way in showing the IRS that the captive is founded on solid business economics and does not exist merely to try to save some bucks in taxes. 

8. Ignoring State Tax Issues

There is a misconception that if the underlying business is doing business in State A, and the captive is formed in State B, then by virtue of that alone, State A cannot tax the captive. 

Not true. Actually, whether State A can tax the captive depends on a variety of factors. If business decisions regarding the captive are made in State A, for example (probably the most common way to blow this), then State A can probably tax the captive. 

Captive owners must be very careful to not let the captive “touch” State A in any way, unless of course the captive is formed in State A (and then it doesn’t matter, which is often the easiest and most sensible approach). This is usually accomplished by using a captive management firm (“captive manager”) to perform all the functions of the captive in State B; but just having a captive manager in State B isn’t enough – diligence is required not to blow this. 

7. Single-Line Myopia

Too often, captives are formed to underwrite one single risk of the organization, without looking at the myriad other risks of the enterprise. This happens the most when the captive is promoted by an insurance broker who is only focusing on helping the client with that one line of business, usually workers compensation, and it misses a lot of benefits for the client. 

In a sense, a captive is a lot like a casino – the more games in a casino, the better the risk distribution of the casino. The same is true with a captive having different types of policies; there is more risk distribution. Also, since the costs of a captive are often fixed or not dependent on how much insurance the captive underwrites, the more insurance that it underwrites, the better the economics of the captive. Which is to say that captives are usually the most efficient when they are underwriting all possible lines of coverage for the organization, not just a single line. 

Often, when a captive is being evaluated solely for a single line, the conclusion is reached that the captive will not be economical as to that single line only, when it might be very economical if it takes on other risks. It is difficult to understand why those involved with captives would not look to all the possible coverages the captive might underwrite for a particular client, but such myopia occurs very frequently. Frankly, there is a lot of “If I don’t sell it, I’m not going to worry about it” going on with the insurance brokers, but that attitude doesn’t serve their clients well. Good insurance brokers who assist their clients with captives will look at the entirety of the clients’ books of insurance business, as well as where the clients have chosen not to purchase third-party insurance because it is too costly. 

Take caution, however, that the IRS now apparently tests for “line-item homogeneity,” meaning it takes the position that each line of coverage must meet the tests for risk distribution separately, i.e., without regard to other lines of coverage being underwritten by the captive. Many captive tax professionals believe the IRS is flat wrong on that point and will lose a challenge on appeal to a U.S. Court of Appeals, but who wants to pay for that fight? 

6. Poorly-Drafted Policies

The policies underwritten by a captive should not be substantially different in their form than policies underwritten by any other insurance company. A good captive manager will use modified standard industry forms to draft policies. By contrast, bad captive managers will draft simplistic policies that often omit key insurance contract terms or else unnecessarily expose the captive to lawsuits by third-party claimants. 

There is a reason why there is so much boilerplate in typical insurance contracts – it works. But also, one of the biggest benefits to a client is the ability to custom-tailor coverage to more closely fit their needs by modifying the standard industry forms. Too many captive managers just slap out some basic policies and call it a day; what a shame for their clients to lose a wonderful opportunity. 

5. Bogus Insurance Contracts

I’ve actually sat in on meetings where some other adviser has told their prospective client something to the effect that, “You’ll pay premiums, but you don’t have to make claims!” (wink-wink, nod-nod). Then, I’ve had to inform the client that, “If you don’t make and pay valid claims under the policies, then you don’t have a captive, but instead, you just have a tax fraud.” 

The U.S. Supreme Court has defined “insurance” as including an “insurance contract.” If there is no valid, binding contract, which is fully honored between the captive and the operating subsidiaries, then there is no insurance. What you have then is simply a sham. 

4. Inadequate Capital

About once a month, somebody will call me to inquire about a captive, and say that they have already decided to put the captive in X jurisdiction. When I ask why, they say that it is because X jurisdiction only requires $25,000 in capital or some other small number. 

The problem here is that while a small amount of capital may be all that is required by local regulatory law, the minimum capital requirements of a captive for tax purposes is usually much higher, and must be set by an actuary. It is very rare that a captive will take in more than five times the amount of its capital in the first year, and more than three times the amount of capital in succeeding years. 

The idea is that the captive needs to have some “skin in the game” other than the premiums that it receives from insureds. In fact, the more capital that a captive has, the safer the arrangement will be from a tax standpoint. 

Note that this is primarily a first-year problem, since after the first-year’s policies expire, the reserves that back those policies then go into surplus and are available as capital for future underwriting. However, the problem can materialize in later years if there are excessive claims or the captive’s owners distribute too much of profits to themselves, leaving the captive’s capital cupboard bare. 

3. Highly Questionable Risks

A big problem with captives that are just disguised tax shelters is that their policies reflect the underwriting of longshot risks. Like, a really big longshot, as in a “10,000,000,000 to 1, an-asteroid-is-likely-to-hit-the-Earth-first” longshot. Think, hurricane insurance for a business whose operations are in Lincoln, Nebraska, or terrorism insurance for a business in Little Rock, Arkansas. 

Maybe it is possible that a really huge hurricane could make its way to Lincoln, or Al Qaeda someday decides to take out a firm in Little Rock, but what is the real risk of that happening? And even if one could say with a straight fact that it might happen, what is the correct amount of premiums for such a policy? $1 per $100,000,000 in coverage? It is sure not $500,000 for $2,000,000 in coverage, which is how the promoters of sham captives will often write it. 

Where a captive is formed as a tax shelter, sometimes the risks that are underwritten are already covered by insurance; such as where a doctor sets up a captive for tax reasons and tries to underwrite his or her malpractice liability risks, but then keeps an existing malpractice policy in place so that there is in actuality nothing being covered by the policy (since he or she doesn’t want the captive to actually have to pay a claim!). 

2. Premiums Not Bearing Any Relationship to Reality

There is an old joke in the captive insurance world, which is that “You don’t go to the bathroom without first getting an actuary to sign off on it.” That is not too far from the truth. Premiums must be set by a qualified actuary, or else they are probably not defensible in tax court. Unfortunately, what happens too often is that a tax attorney and the insurance manager meet with the client and ask, “How much do you want to save in taxes?” They then pull some premium numbers out of the sky to get the client to the desired target. 

Sorry, but it doesn’t work that way. The premiums of a captive have to be determined like any other insurance company; setting the premiums as would be done in an arm’s length transaction, which is by, among many other things, assessing the true risks of the operating subsidiaries, their needs for the particular insurance, and the minimum and maximum coverage required. 

Going back to the hurricane insurance for the business in Lincoln or the terrorism insurance for the company in Little Rock: what is the correct amount of premiums? It is going to be really low, as in dig-the-loose-change-out-of-your-couch low. It is not going to be $500,000 or even $100,000, yet such goofy premium calculations are common with captives that are merely a facade for a tax shelter. 

Note that having an actuary sign off on premium calculations is not always going to save you, as those premiums have to be reasonable too. Just like there are real estate appraisers whose first question is “What number do you want?,” there are corrupt actuaries who will give you either a $1 or $10,000,000 premium number for the exact same policy and risk. But remember: if the premium calculation is not reasonable, it will not survive a challenge no matter how lengthy the actuary’s credentials. 

1. Captive Insurance Companies Sold as Tax Shelters

The primary use of a captive must be for bona fide risk management purposes, and not to save taxes. Unfortunately, many of the same promoters of tax shelters who a few years ago were selling Son of Boss, CARDS, BLIPS, and other flavor-of-the-day tax shelters, are now selling captives as a way to save taxes, with only the barest lip-service being paid to the risk management function. 

Hale Stewart, an author of a book on captive insurance company taxation, told me recently, “Captives sold as a tax mitigation tool and not as a bona fide risk reduction, are not really captives at all. But I keep running into them.” So do I, mostly (but not all) so-called 831(b) captive insurance companies, i.e., captives that have made an election to be taxed as a small insurance company under IRS Code Section 831(b). While the vast majority of 831(b) captives are quite legitimate, there is still probably much more abuse going on with these companies than with non-831(b) companies. 

These “tax shelter captives” usually suffer from significant flaws, including inadequate capital, grossly overpriced premiums, insuring non-existent risks, lack of true risk distribution, or as a scheme to buy life insurance with pre-tax dollars. It is probably only a matter of time before these companies, and their owners, come to grief on any number of theories the IRS could assert. 

Avoiding the Hazards of a Bad Captive Arrangement

Like any other complex legal and financial structure, the money that one spends on a second opinion from truly independent counsel will be some of the best money they will ever spend. In this context, “truly independent” means somebody that a client finds themselves and is not related to or recommended by whoever is pitching them the captive. 

A lot of people in the captive world have gotten away for years with some really bad practices only because the IRS has not spent much time or effort looking in to the practices of captive insurance companies. But as the captive market has dramatically expanded, it is unrealistic to think that the IRS’s lack of attention will last much longer. 

So, either do a captive right, or don’t do it at all. Now, on to the good things about captive insurance, also presented in reverse order: 

10. Create a Giant War Chest for the Business

Like any insurance company, captives tend to accumulate a considerable amount of assets in reserves and surplus. While these assets back the policies issued by the insurance company, a portion of those assets may be available to the business owner in a worst-case scenario where the business owner needs the funds to cover a larger catastrophe. 

While there may be significant tax ramifications to “cashing out the captive” to meet some emergency not covered by a policy, at least the business owner has the option of so doing, and can then weigh the cost/benefit analysis at the time the money is needed. Certainly, getting money out of a captive is easier and more expedient than obtaining a business loan from a bank at a time when the business is in deep distress. 

During the 2008 crash, more than a few business owners did exactly that. And while their captives became empty shells for a while, they were able to use the money to save their businesses. While one who is setting up a captive certainly hopes their business never will have such a need, it is nice to know that safety net is there. 

9. Retain Key Employees

Occasionally, business owners will award a key employee or two by giving them equity in the captive as part of an overall strategy to retain those employees for the benefit of the business. Giving key employees stock in the captive is sometimes less messy and troublesome than giving them equity in the business itself, and can avoid the animosity that can sometimes materialize when other employees are not given a stake in the business. 

While this situation is rare, it works swimmingly. While ownership in the operating business is difficult to conceal, particularly for businesses with significant accounting staffs, often no one in the business except the owners knows what is going on with the captive, allowing great flexibility in creating key employee arrangements. 

8. Enterprise Asset Protection

A collateral benefit to a captive is that each dollar paid by the operating business to the captive reduces the assets of the operating business by that same dollar. Accordingly, if something goes dreadfully wrong for the business, those dollars are no longer available to creditors of the business. 

Indeed, captive insurance must rank as one of the best enterprise asset protection strategies ever created. Note that it would be very difficult for creditors of a business to prove that payments to a captive for bona fide insurance coverage would be a fraudulent transfer, since the business received back a substantial economic benefit in the insurance coverage from the captive. Also, the captive may (and usually is) structured to be remote from the underlying business for purposes of bankruptcy, so even if the operating business is forced into bankruptcy, the odds are low that the captive will be swept into the bankruptcy vortex. 

7. Cover Risks Otherwise Exposed

Businesses are often forced to effectively self-insure risks (whether they realize it or not) because either the risk is so unusual that insurance cannot be purchased for it at any price, or because the insurance to cover the risk is exorbitantly expensive. These are ideal risks to be covered by a captive, and indeed, this is one of the primary purposes of captive insurance. 

Moreover, even where a business has insurance against certain types of risks, the business will still be exposed to deductibles and exclusions. While in the past, general liability insurance (known in the industry as “GL”) covered a very broad range of risks, typical modern exclusions give such a policy more holes than Swiss cheese. These days, the typical GL policy may have exclusions for things like employment practices liability, which exposes the business to claims of sexual harassment, age discrimination, wage and hourly claims, and the like. The insurance provided by captives can fill these gaps. 

6. Draft Your Own Policies

Captives can (and should) draft carefully custom-tailored policies to fit the exact needs of the business. This not only means covering areas of exposure and eliminating exclusions, but also drafting the policy in ways that make it nearly impossible for a third-party claimant against the business to assert a claim directly against the policy (unlike most commercial policies). 

Because policies can be custom-tailored, they can be much more efficient. With commercial policies, a business might be stuck with $2 million in coverage of some risk, even though as to that particular risk, the business might only need a more precisely-calculated $1.45 million in coverage – so the business need not pay for what it doesn’t need, and instead allot those same premium dollars to other risks for which the business is exposed. 

5. Choose Your Own Counsel

When you buy insurance from a commercial carrier, they typically retain the right to hire an attorney for you. Theoretically, the attorney that your insurance company hires will be your attorney and only look out for your interests even to the detriment of the insurance company – but will he or she really do so? 

Insurance defense counsel may be assigned 200 cases from a particular insurance company in a year, only one of which is yours. Who do you think they will really owe their loyalty to? Additionally, insurance companies are notoriously cheap when it comes to hiring counsel – you may get someone whose primary qualification to handle your defense is that he or she bid lower than any other insurance defense attorney for the work. 

My advice has long been that if you are ever sued and your insurance company appoints counsel for you, get your own counsel to ride herd on your insurance company’s lawyers; i.e., make sure that they competently represent your interests first and foremost, and if possible, settle the claim within policy limits. 

With a captive, a business doesn’t have these problems at all. Since the business owners control the captive, they can select the counsel of their choice to handle particular claims. They have the option of not opting for the cheapest insurance defense counsel, but the best. Or, on the flipside, they can retain a good insurance defense attorney to handle most matters at a discount. All this usually has the effect of a better defense at a lower cost to the business. 

4. Administer Claims on Your Own Terms

A problem with commercial carriers is that they can allow a small claim to fester, either by not taking care of the claim early or by allowing it to drag on without resolution. Or, the insurance company may settle a frivolous claim just to save defense costs, thus encouraging more such frivolous claims against the business. 

With a captive, the business owners can administer their own claims on their own terms, and get on top of claims quickly before they spin into something much larger. The business owners can also choose to not settle frivolous claims, forcing the plaintiff’s attorneys to incur time and expense litigating the claims before dismissal, and by doing so, deter future lawsuits. 

A captive’s ability to draft its own policies, choose its own attorneys, and administer its own claims are all important cost-saving benefits of a captive. 

3. Save Money on Insurance

The primary purpose of a captive is to save money on insurance, and in this, captives have no equal. There are three main aspects to this: 

First, by underwriting the insurance needs of the business, the captive can capture and retain the underwriting profits that would ordinarily be lost to the commercial carrier. Additionally, considering that commercial carriers have enormous costs that must be priced into their policies, such as the expense of compensating agents, marketing and advertising expenses, and high executive compensation, there is a great deal of fluff having nothing to do with true risk in commercial policies that can be saved through the use of a captive. 

Second, even where the business decides to keep commercial insurance in place against particular risks, the captive can be used to reduce costs by raising deductibles, lowering coverage limits, or increasing exclusions – the idea being for the business to find the sweet spot where the commercial insurance is most economical, and then use the captive to insure around that area. Since the greatest expense of most insurance policies is the “first dollar” expense, simply increasing deductibles can result in dramatic premium decreases with commercial policies. 

Third, the mere existence of the captive and its ability to underwrite risks can save money even if the captive is never used for that purpose at all. This is because the insurance broker knows that if the premium prices offered to the operating business for insurance are not efficient, the operating business may decide to cover them in the captive instead – and once that particular book of business is lost, it may be forever lost to the broker. Thus, the threat of a captive can be used to significantly barter down the commercial carrier into offering insurance to the operating business at rock-bottom prices. 

The combination of all three of these factors can result in very substantial savings to the business enterprise, but the benefits of a captive can extend well beyond the immediate savings of insurance dollars. 

2. Forces the Business to Focus on Risk Management

When a business is buying insurance from a commercial carrier, the concept of claims is only loosely attached to the economic cost to the business in terms of increased premiums. But when claims are being paid from a captive – effectively, from the business owner’s pocket – the focus on claims can become intense, and consequently, the business becomes focused (often for the first time) on enterprise risk management. 

The benefits of enterprise risk management, while sometimes hard to exactly quantify, are enormous. The focus shifts to analyzing the business so as to spot potential risks. Claims are thus prevented instead of administered. In the end, the business owner gains a better understanding of the business and its limitations, and that is priceless. 

1. Create a New Business

Many business owners who form captives think of it for what it does, but they don’t realize that they have just created a new business – an insurance company – and thereby cast themselves into the business of insurance. The captive thus acts not just as an enterprise risk management tool, but also as a segue into a whole new business opportunity. 

An existing captive with sufficient capital can be converted to a full insurance company that offers insurance to the general public by changing its license and business plan, and meeting certain other state requirements. This usually doesn’t mean that the new insurance company owner will throw open the doors to the general public, but instead often limits business to the same business that the owner is familiar with – offering insurance to similar businesses where the insurance company owner can get a good feel as to their claims exposure, and accordingly, price premiums appropriately. 

The business of insurance can be a great business, and more than a few business owners find insurance an even better business than the successful business they are already in. I’ve had more than a dozen clients go from their captive being just another affiliate in their overall business organization, to running an insurance company and conducting the business of insurance as their primary business. 

A Final Note

Note that I haven’t mentioned tax savings as one of my favorite benefits of captives. While captives can offer certain tax advantages to business owners, my tendency is to view a proposed captive arrangement as tax-neutral and make sure that it works without any regard to any tax benefits. This is because to the extent that a captive offers tax benefits, those are the icing on the cake – the cake is the numerous other non-tax advantages of captives, and the cake by itself is pretty good.

 

 

Current Tax Issues with Captive Insurance Companies

Posted on February 18, 2014 by - Uncategorized

Large U.S. companies have been forming captive insurance companies (wholly owned insurance subsidiaries) since the 1950s. In general, such large captives are formed for one of three main reasons. First, some companies are unable to obtain necessary insurance coverage. For example, certain nuclear power companies formed a captive named Nuclear Electric Insurance Limited, because they could find no other insurance coverage. Second, some companies seek to obtain cheaper insurance. For example, the trucking market is currently “hardening” (premiums are increasing), leading to trucking companies forming captives. Third, some companies seek to gain more control over their current insurance program. 

The insurance code offers a small insurance company a strategic advantage: Internal Revenue Code (IRC) § 831(b) allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income. As a simple example, suppose a small insurance company had $500,000 in income but earned 5 percent on its total portfolio earning $25,000 for the year. The company would use the $25,000 figure as their gross income figure for the year. 

A captive can also be formed offshore and still be deemed a U.S. captive, provided it makes an IRC § 953(d) election agreeing to be taxed as a domestic company. For many large captives, forming offshore may provide a great deal of flexibility not found onshore. However, it should be noted that the Internal Revenue Service (IRS) is currently spending a great deal of time focused on offshore tax enforcement. Recently, the IRS refused to issue a positive private letter ruling to a number of foreign captives seeking 831(b) status, which may be an indication of tougher IRS scrutiny in this area. Thus, while a compliant captive should ultimately have nothing to fear from operating internationally, there is at least some chance that doing so may result in some additional compliance costs if it gets caught up in the IRS dragnet. 

This article will: (1) provide a brief history of captive insurance companies; (2) outline key requirements for captive insurance including insurance risks, risk shifting, risk distribution, and reinsurance; and (3) discuss certain IRS enforcement areas in captives, including excessive premiums and IRC § 831(b) tax shelter issues.

A Short History of Captive Insurance Companies

The IRS defines a captive insurance company as a “wholly owned insurance subsidiary.” According to the case law of that time, companies started forming captives in the 1950s because they couldn’t find insurance, could only find very expensive insurance, or simply decided that forming their own insurance company made more sense. The taxpayers in both United States v. Weber Paper Co., 320 F.2d 199 (8th Cir. Mo. 1963) and Consumer’s Oil Corp. of Trenton, NJ v. United States, 188 F. Supp. 796 (NJ 1960) owned property for which they could not procure flood insurance, leading both to form an insurance company. While the taxpayer in Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. Kan. 1986) did have an insurance policy, its carrier had complete control of its attorneys during litigation. When Beech was sued under a products liability claim in the early 1970s, it filed a motion to remove its insurer-appointed counsel several weeks before trial. The court denied this motion and Beech lost the case. Subsequently, Beech formed a captive to write its own insurance policy. Other cases provide similar examples. 

The IRS was concerned by the rise of captive insurance for two inter-related reasons. Their first concern was that the “captive insurer” was in fact a reserve account, defined as “an estimate of a definite liability of indefinite or uncertain amount.” While there is a certain amount of conceptual overlap between a reserve account and insurance (in both, a party is attempting to financially prepare for an anticipated contingency), contributions to a reserve account are non-deductible while premium payments are deductible. This leads to the IRS’ second concern – the rather uncertain nature of the legal definition of insurance. While the Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (U.S. 1941) defined insurance in 1943 as being comprised of both risk shifting and risk distribution, it provided no further guidance for either term. Hence, the IRS could legitimately argue that the captive insurance company was not in fact a bona fide insurance company but instead a reserve account, allowing the IRS to deny the deduction claimed by the parent company for the premium paid to the captive. 

Captive litigation can be broken down into pre- and post-Humana v. Commissioner, 88 T.C. 197 (1987). From the late 1970s to the late 1980s (pre-Humana) the IRS won a majority of their cases due to better preparation, weak taxpayer defenses, and a judiciary unaccustomed to dealing with the technical requirements of insurance. The Humana decision changed this, as the structure was well set-up and expertly defended and explained by counsel, leading to a partial taxpayer victory. Between Humana in the late 1980s and United Parcel Service of America v. Commissioner, 254 F.3d 1014 (11th Circuit 2001) in the early 2000s, the IRS lost most of its cases as taxpayers established better structures, these structures were better defended, and several states passed captive insurance-enabling legislation. The death knell for this initial wave of IRS captive litigation was the UPS decision, which the IRS won at trial based on an assignment of income argument, but which the appeals court disagreed with in a tersely worded decision, in which it reversed the tax court’s ruling and remanded for further action. Following the UPS case, the IRS largely ended its initial quest of litigating to prove the invalidity of captive insurance.&nbsp

Insurance Risks, Risk Shifting, and Risk Distribution

Counsel interested in recommending a captive to a client needs to be aware of several basic concepts, the first of which is derived from The Harper Group v. Commiss’r, 96 T.C. 45, 47 (1991), which states that all captives must comply with the following three factors: (1) the arrangement involves the existence of an “insurance risk”; (2) there is both risk shifting and risk distribution; and (3) the arrangement is for “insurance” in its commonly accepted sense. Points one and three can be reworded to simply say all captives must function as insurance companies; the insured must demonstrate it will be materially harmed (usually through financial loss derived from an ownership interest), and that the harm is “fortuitous” – one which is random and cannot be prevented. 

Risk shifting and risk distribution are a bit more complicated. Risk shifting is seen from the insured’s perspective and requires the risk of loss to “shift” from the insured to a third party. This is accomplished via an insurance policy (whose formation and terms are interpreted under basic contract law principles). Risk distribution is seen from the insurer’s perspective, and requires the insurer to pool risk from a sufficient number of resources such that losses smooth out over time. Non-compliance with either of these factors comprised the “economic family argument,” the IRS’ primary anti-captive weapon. 

Reinsurance or Safe Harbor IRS Revenue Rulings

One of the largest benefits of a captive is the ability to access the reinsurance market. Reinsurance is often called “insurance for insurance companies” as it allows insurers to spread out the risk of their own portfolios. For example, suppose an insurer was exposed to $5 million of potential claims for the year. The insurer could purchase reinsurance, thereby lowering its risk exposure. In our example, the insurer could purchase reinsurance that covered risks of about $2,000,000. Therefore, if the parent company had losses over $2,000,000, the reinsurer would be liable. 

The IRS has provided two safe harbors for captive insurance companies that decide not to use traditional reinsurance. All captives that wish to take advantage of a safe harbor must comply with one of two fact patterns outlined in specific IRS Revenue Rulings. In Rev. Rul. 2002-89, the captive insurer must derive at least 50 percent of its revenue and risk from a non-parent. For smaller captives, this is usually accomplished through the use of “risk pools” wherein a group of captives shares a portion of their risk with other captives, usually managed by the same captive management company. Participation is usually accomplished through a quota treaty retrocessional reinsurance arrangement. In Rev. Rul. 2002-90, a captive must underwrite risk for at least 12 different subsidiaries, with none comprising less that 5 percent nor more than 15 percent of the total risk underwritten by the captives. 

Excessive Premiums

One area that is currently being litigated by the IRS is excessive premium payments beyond what is reasonable for the claimed insurance risks. The IRS has a few cases in the U.S. Tax Court pipeline that address this issue, so it would not be unexpected that more such cases will follow. The IRS is concerned with transactions in which the tax deduction claimed is actually the reason for the existence of the policy. Treasury Regulation § 1.801-3(a) provides that an insurance company is “a company whose primary and predominant business activity . . . is the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies.” When the captive charges commercially unreasonable or non-arm’s length premiums, it may not be treated as bona fide insurance company. Thus, if the true purpose of an insurance company is to provide tax deductions, then the company may not qualify as an “insurance company” under the IRC. 

In the area of small captives, the existence of a $1.2 million maximum premium payment makes this type of analysis particularly relevant. The IRS requires that a captive operate as an actual insurance company in order for it to receive the economic benefit allowed under IRC § 831(b). It is important to remember that the $1.2 million can purchase a large amount of commercial insurance, so any small captive claiming policy premiums of that size may come under IRS scrutiny unless it has a very significant amount of provable potential claims.

IRC § 831(b) Tax Shelter Issues

The IRS is aware of certain questionable tax shelter practices in the captive world, especially in connection with small IRC § 831(b) captive insurance companies. While these arrangements are certainly a minority of the larger pool of compliant captives, it is worth noting some of the more prevalent IRS tax shelter issues here. 

Some IRC § 831(b) captive policies insure risks that are unrealistic with respect to the insured business. Specifically, certain insurance risk pools centered on terrorism are currently attracting increased IRS attention. The concern arises here because so few businesses may actually have the need for insuring against a terrorist act, making this coverage appear to be too remote to be justified for most insureds. While there are certainly business operations that involve terrorism risk, there are also many businesses that do not have this risk. 

The IRS has also become aware of the use of life insurance in IRC § 831(b) captives as a pre-ordained investment. Since life insurance is not generally a deductible business expense, the concern here is that the IRS may see a pre-planned use of an IRC § 831(b) captive as a conduit for life insurance as both undermining the business purpose of the captive, as well as a device for taking a deduction that the business could not otherwise take directly. The judicial doctrines and codified economic substance doctrine could be applicable here. 

Since an IRC § 831(b) captive may result in the deferral of realization of ordinary income, over a long period of time, this type of captive may accumulate a very large amount of retained resources. Because a captive is taxed as a C corporation, this type of large reserve could be subject to the Accumulated Earnings Tax (AET). The AET is a 15 percent penalty tax designed to prevent corporations from unreasonably retaining after-tax earnings and profits in lieu of paying current dividends to shareholders. Accumulated taxable income is reduced by a credit for an accumulation amount sufficient to satisfy reasonable current and future anticipated business needs. 

Conclusion

Captive insurance companies have been around since the 1950s and are currently a popular alternative vehicle for insuring risks associated with businesses. There are several key requirements that must be met for captive insurance to be deemed proper by the IRS. These include insuring real risks, shifting the risk from the insured business to the insuring captive, and the captive distributing the shifted risk among several other captive insurance companies. The IRS has raised specific tax issues that are currently the subject of IRS enforcement actions. These include the payment of excessive insurance premiums, as well as several IRC § 831(b) tax shelter issues. Overall, captive insurance may be an excellent insurance option for midsize and large businesses, provided that the professionals structuring the arrangements comply with IRS requirements in connection with the formation and maintenance of the captive insurance company.

 

 

 

 

Choice of Domicile in Captive Insurance Planning

Posted on February 18, 2014 by - Uncategorized

A captive insurance company in its most typical form is essentially a new subsidiary that is created by a parent company to underwrite the insurance needs of its operating subsidiaries. The basic idea of a captive is to bring in-house the purchasing of insurance that was previously done from unrelated commercial insurance companies, and retain the underwriting profits for the benefit of shareholders. But even beyond that, captive insurance companies fulfill a large role in making the entire enterprise focus on the management of its various risks of loss and incurring liabilities. 

The factors that go into the decision to form a captive insurance company, and the steps to do so, are beyond the scope of this article and are well-treated elsewhere. This article will focus upon a critical inquiry that is inherent in the captive creation process, which is the choice of the jurisdiction where the captive will be formed and domiciled. 

Captive insurance companies were originally formed outside the United States, usually in well-known debtors’ havens such as Bermuda, the Cayman Islands, and the British Virgin Islands. This is because of a perception that there were certain potential local tax benefits to being formed in those domiciles, but much more importantly, because the U.S. states did not have captive legislation, and instead treated captives like normal commercial carriers. Doing so made little practical sense, insofar as normal commercial carriers are subject to a wide swath of laws designed to protect the general public, such as requiring large amounts of capital and reserves, public filing of policies, and making premium rate requests. These requirements were, of course, nonsensical in the captive context where there is little need to protect the operating subsidiaries from the captive insurance company ultimately owned by the same parent. 

Vermont cracked open the door to captives in 1981, and through sheer persistence and aggressively changing its laws to match or exceed those of the offshore havens in favorability, was able to hold its own and grow its captive business against the likes of Bermuda. The IRS kicked the door wide open in 2002, following its landmark loss in United Parcel Service v. C.I.R., 254 F.3d 1014 (11th Cir. 2001), by issuing Revenue Rulings 2002-89, 2002-90, and 2002-91, that not only recognized the fundamental legitimacy of a properly structured and operated captive insurance arrangement, but also created safe-harbors in the confused area of risk distribution. Numerous states then flooded the captive marketplace – 37 states as of this writing – by passing captive insurance enabling legislation. 

It should be noted that for most tax purposes, there is little difference between an offshore captive (one formed outside the United States) or a domestic one, since the vast bulk of captives make the election under Tax Code § 953(d) to be treated as a domestic company. These days, the reasons for a captive to “go offshore” most often relate to those relatively few captives that for tax reasons do not make the § 953(d) election (captives owned by charitable organizations, for instance, have tax reasons for wanting to be taxed as a controlled foreign corporation instead), or captives where financial privacy or practical immunity to the enforcement of a domestic judgment is at a premium. 

The analysis and planning that goes into the formation of a captive insurance arrangement may be likened to the solving of a Rubic’s cube, where decisions must be made that will affect several or all sides, and some key issues must be resolved at once as if some juridical algebra problem. Most often, the question of where the captive should be domiciled is one of the last – not first – issues to be resolved. This is because the resolution of other issues, such as availability of capital, specialty lines of insurance to be written, and particular needs for flexibility in the investment of the captive’s assets, quite often lead to the choice of a particular domicile. There is rarely a need for prospective captive owner to choose the domicile as a first step, and indeed to do so can lead to missed opportunities if the captive arrangement could have been more efficient if formed elsewhere. 

But even beyond that, the issue of state taxation of premiums now most often resolves the issue – particularly if the captive owner is headquartered in one of the ever-increasing number of captive-friendly states. In the past, states paid little attention to their fiscal losses occasioned by captive insurance, mainly for the reasons that the very concept of captive insurance was little known to the state tax authorities, and payments to captives (as opposed to ordinary commercial insurance carriers) are inherently difficult for state field auditors to pick up. While some states have long been aggressive in taxing the premiums paid to captives (Texas is probably the best example of this), it has only been recently that other states have taken note of their own fiscal losses and have grown more aggressive in taxing the premiums paid to captives. Yet, at the same time, when a state passes new captive insurance legislation, in order to make that state’s laws more attractive to new captive formations, the state will usually exempt or substantially limit the taxes on premiums paid to its in-state captives. This creates a very powerful incentive for new captive owners to choose their own state (if it is friendly to captives) to form their captive, and puts pressure on existing captive owners to bring their captives back home. 

So, the default rule might be well be – if it isn’t already – the best domicile to form your captive is the one you are in. This disregards, however, that some states such as California and Washington do not yet have captive enabling legislation, while other states have either done little or nothing to implement their legislation, or have implemented it very poorly. The upshot of this is that many prospective captive owners will have to look beyond their state’s borders for a place to land their new insurance company. It is for these owners and their advisers that the factors discussed below will be of the most importance. 

It would be easy enough at this point to dive into a discussion of the technical nuances of the laws of various jurisdictions. That would not do the subject proper justice. Long experience has shown that the single most important factor in choice of domicile for a captive is not any specific statute or regulation, but that of the amenability of the insurance regulators in the domicile to working with captive owners to make the arrangement a success. Laws and regulations are only so good, or bad, as they are interpreted by their regulators, and in the case of captives this typically means the insurance commissioner’s office or equivalent. 

Very simply, a bad insurance commissioner’s office can make hash out of the best captive laws and regulations with the result that the captive owner becomes quite miserable. A good insurance commissioner’s office can, by contrast, work through mediocre laws and regulations to make captives in the state a happy success. Of course, no chart could adequately spell out the differences in how these regulators treat captives, and any such chart would be obsolete as quickly as the personnel changes occurred in the insurance commissioner’s office, which they do with some regularity. Suffice it to say that the best information about regulators must be obtained anecdotally from captive managers and other captive professionals who have done business in the state, while noting that the regulators of some states have a long and consistent history of favorable treatment of captives, while other states have undergone uncomfortable fluctuations dependent upon whomever is in charge at a given time. 

With that caveat firmly in mind, we turn to an examination of the statutory and regulatory factors that go into domicile selection for captives. What we will see is that the specific requirements of each jurisdiction are very similar. There is a good reason for that, which may be accurately expressed in a single word: competition. To vie for business, the various domiciles must offer regulations that are as, or more, favorable than that of competing jurisdictions. One may attribute Vermont’s long run of success to the fact that its state legislature, mindful that the captive sector is its second largest industry, has demonstrated a willingness to quickly consider and pass cutting-edge legislation so as to keep Vermont’s captive laws competitive with those of other jurisdictions. 

Minimum capitalization, i.e., how much cash the captive will need to qualify and stay qualified for its insurance license, is a significant factor of consideration in choosing a domicile. Obviously, the less money that a captive owner has to tie up in the captive, which moneys may be deployed to greater returns elsewhere, the more efficient the captive arrangement will be. Thus, captive domiciles compete for business by lowering their capital requirements to certain minimum amounts. 

It is here that our Rubic’s cube reappears, where we have to solve more than just one side of the puzzle at once. Although captive owners naturally desire to place as little capital as possible in their captive, the requirements of tax law must be taken into consideration. For tax purposes, one of the elements to establish the existence of an insurance contract is the requirement of “risk shifting,” which posits that the captive must have more risk of loss than simply the premium that it takes in from its insured. The captive must have, the slang goes, enough of its “own skin in the game” such that it can satisfy claims against a policy over and above the premium received. 

Thus, there are both actuarial and tax variables in the minimum capitalization equation. From the actuarial side, the limits on the maximum potential losses that the captive may underwrite – and thus policy limits – are limited by some combination of the total premiums to be received by the captive, loss expectancy, existing reserves, and capitalization. Plus, while the IRS has provided painfully little guidance on what constitutes minimum capital for tax purposes, it seems (largely anecdotally) that the captive’s capital should not be less than one-third of the premiums received in any given year, i.e., as it is usually articulated, premiums should not exceed capital by a ratio of greater than 3:1. 

There seems to be an accepted exception to this ratio for the first year of a captive’s existence, when the ratio of premiums to capitalization should not exceed 5:1, and which takes into consideration that relatively few claims are likely to have matured to where they will require payment in the first year. It is this 5:1 ratio that has worked to set the standard for minimum capitalization in most captive domiciles. The vast majority of captives start out as companies that make the Tax Code § 831(b) election, which means that the captive will not be taxed on its premium income so long as its premiums received do not exceed $1.2 million during the year. Applying the 5:1 ratio to $1.2 million results in a minimum capitalization requirement for tax purposes of $240,000 (which has been rounded up for statutory purposes to $250,000), which represents by far the most common minimum capitalization requirement of domestic domiciles. The states that have higher statutory minimum capital requirements are usually avoided by captive owners. 

However, not all new captives will take in the maximum amount of $1.2 million in premiums the first year, and this is where regulatory flexibility to lower the minimum capital for the first year only can be a very significant advantage for a captive domicile. These exceptions are created by the very practical recognition that by the second year, the premiums paid in the first year for the first year’s policies which have not expired, will be available to apply toward the statutory minimum. 

Offshore domiciles often have much lower minimum capital requirements (Nevis only requires $10,000 in capital for a single-owner captive) in consideration that many of the captives they form will not be subject to the minimum capitalization requirements for U.S. tax purposes, as their owners will often have little or no connection to the United States. But again, the statutory minimum capital requirements are but one side of the captive Rubic’s cube for U.S. taxpayers. 

Investment flexibility, i.e., the particular domicile’s rules about how the captive’s assets may be deployed, is a very significant factor in choosing a captive domicile – some might suggest the single most important factor. Non-captive commercial insurance companies are usually subject to “permitted asset” rules, which are an exhaustive list of the things that such insurance companies may invest in, so as to help protect the financial health of those companies from speculative investments (and also the state insurance fund from having to take over the liabilities of an insolvent carrier). The investment rules relating to captives can be much more flexible, and it is here that the domiciles have an opportunity to really compete against each other. 

Prior to the 2008 crash, which resulted in the liquidation of not just a few captives whose investments had failed, the investment rules relating to captives were typically very lax. The typical statement was that an investment was appropriate, “so long as it does not threaten the minimum liquidity of the company.” In application, this had an “almost anything goes” air, and led to captives making all sorts of creative, speculative, but often ill-advised investments, of their assets. 

After the 2008 market crash, many regulators started to the take back the reins over captive investments. This has been most commonly seen in how regulators view a large, single investment that comprises a large percentage of the captive’s overall assets, say over 30 percent – regulators now often cringe when so many of the captive’s eggs are be placed in one basket, and may either refuse to approve the investment or require additional capital to be infused into the company. But it is also seen in regulators occasionally requiring that certain captives abide by the very regimented investment restrictions for non-captive commercial carriers. 

As with so many things in the captive sector, the best information regarding a domicile’s investment flexibility is not necessarily found in its laws or regulations, so much as learned anecdotally from conversations with captive managers and owners of existing captives in that state. It should also be noted that investment flexibility in a particular domicile has the potential to change literally overnight as personnel changes in the insurance commissioner’s office bring different attitudes about how captives should be safely investing their assets. This issue can be a moving target, and more than a few captives have left particular domiciles and migrated elsewhere when they felt that investment restrictions had become too strict. 

Infrastructure support, i.e., the ability of the insurance commissioner’s office to effectively handle captives, is also a very important consideration. Newer domiciles in particular are often unwilling to extend adequate funding to the captive division within the insurance commissioner’s office until the economic benefits of captives within the state have been established. Indeed, while 37 states have passed captive enabling legislation, probably a third or so of these states could be said to have adequately funded their insurance commissioners to allocate resources for separate captive regulators; this is why captive development is stillborn in those states. 

On the other hand, the legislatures of the handful of states that lead the sector in the number of captives domiciled have seen the economic benefits of captives and have well-funded their insurance commissioners’ offices to properly administer them. These states have independent “captive deputy commissioners,” full time staffs, and quality financial analysts and examiners who are highly experienced with captives and their peculiar needs. 

But infrastructure support is not just limited to the insurance commissioner’s office. The best domiciles will have many quality captive managers who have been at least minimally vetted by the commissioner, and a cadre of other professionals such as accountants and attorneys who are likewise familiar with captives in that state. The availability of numerous of these captive service providers and professionals gives captive owners both the ability to choose between numerous competent providers and professionals, and the benefits of competition between them to drive down the pricing of their services.

In summary, there is quite a bit of analysis that goes into the selection of the domicile for a captive insurance company, and much of that analysis will be based on anecdotal information obtained from others who have practical experience in particular domiciles. The resolution of other considerations in the planning of the captive will quite often require the elimination from consideration of certain (if not many) domiciles, and make the choice of domicile in the end that much easier. But even if the grass appears greener on the other side of the fence, strong consideration to forming the captive in the state where the operating business is located now should always be made, even if that state’s captive laws and regulations are not the best.

 

Revisiting MAE MAC Clauses in M&A after Cooper T

Posted on February 18, 2014 by - Uncategorized

In what is now a familiar scenario, a megamerger unravels after post-signing events make the target less attractive to the acquirer, the acquirer develops considerable buyer’s remorse, and the target accuses the acquirer of delaying the deal.  If the acquirer has failed to negotiate a termination right triggered by the unforeseen events and also possesses an obligation to close, then the target may have a viable claim for breach of the merger agreement arising from the acquirer’s intentional delay. 

This fact pattern unfolded after Cooper Tire & Rubber Company announced a proposed $2.5 billion sale of the company to Apollo Tyres Limited (Apollo Tyres) in June 2013. The United Steelworkers (USW) asserted that the proposed merger required a renegotiation of the union’s contract with Cooper. After Apollo Tyres conditioned its participation in negotiations with the USW on Cooper accepting a $9 reduction in the deal price of $36, Cooper filed an action in Delaware. Cooper argued that Apollo Tyres breached a covenant to use its “reasonable best efforts” to obtain approvals required for closing. In Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd., C.A. No. 8980-VCG (Del. Ch. Nov. 8, 2013), the Delaware Court of Chancery rejected Cooper’s claims that Apollo Tyres breached the merger agreement, but cautioned Apollo Tyres against continuing to use the union issues to renegotiate the deal price. Cooper terminated the merger agreement in December 2013. 

The Cooper fact pattern was reminiscent of the events that unfolded after Hexion Specialty Chemicals, Inc., and its parent, Apollo Global Management, LLC (Apollo), agreed to acquire Huntsman Corp. in 2007. During the period between signing and closing, Huntsman reported disappointing earnings, and Hexion attempted to extricate itself from the transaction by claiming that Huntsman had suffered a material adverse effect and would be insolvent post-closing. In subsequent litigation, the Delaware Court of Chancery found that the changes in Huntsman’s financial performance did not constitute an MAE. Apollo Global Management, LLC v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008). 

More recently, the Delaware Court of Chancery found that short-term changes in financial results could conceivably constitute a material adverse effect under an acquisition agreement for purposes of a motion to dismiss against a backdrop of allegations of fraudulently misconduct by the sellers of a privately-held business. Osram Sylvania, Inc. v. Townsend Ventures, LLC, C.A. No. 8123-VCP (Del. Ch. Nov. 19, 2013). 

The acquirer’s typical protection against undesirable risks from significant changes in the target’s business between signing and closing is the material adverse effect or “MAE” clause. As more fully outlined below, these cases suggest that short-term, forward-looking elements of the MAE definition in merger agreements merit more attention by deal practitioners. 

Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd.

Background

This case arose after labor issues in both the United States and China threatened to unravel Apollo Tyres’ proposed $2.5 billion buyout of Cooper. Workers seized Cooper’s largest Chinese facility in July 2013, rendering it unlikely that Cooper could deliver timely, interim financial statements to Apollo Tyres. In addition, the USW filed an arbitration proceeding in Tennessee, alleging that the merger agreement violated the union’s collective bargaining agreements with Cooper. Thereafter, an arbitrator issued an order, preventing Cooper from consummating the merger absent renegotiation of its agreements with the USW. As a result, Apollo Tyres and Cooper agreed not to close the merger until the union contracts had been renegotiated. Subsequently, Cooper lowered its forecasted profits for 2013 by one-third, largely as a result of the labor issues. Thereafter, Apollo Tyres made some attempts to renegotiate the USW contracts (without Cooper’s input), but eventually halted negotiations because Cooper would not agree to a reduction in the merger price. Cooper estimated the cost of the USW developments to be about $10 million over six years, while Apollo Tyres argued that the economic effects would be more severe, warranting a $9 per share decrease in the merger consideration. 

In October 2013, Cooper initiated this action, alleging that Apollo Tyres breached Section 6.12 of the parties’ merger agreement by failing to use its “reasonable best efforts” to renegotiate the USW contracts. Cooper focused on Apollo Tyres’ decision to condition its participation in negotiations with the USW on a reduction in the merger price despite the parties’ exclusion of the impact of the announcement of the merger on Cooper’s relationship with its labor unions from the events that would constitute a material adverse effect. Cooper also had listed the possible renegotiation of the USW contracts on its disclosure schedules. 

The Court’s Decision 

Although the court found that Apollo Tyres did try to use the developments with the USW, the events at Cooper’s Chinese facility, and Cooper’s disappointing interim financials to reduce the merger consideration, it found no breach of Section 6.12. The court reasoned that Apollo Tyres possessed a good-faith but erroneous belief that the developments with the USW might constitute a material adverse effect under the merger agreement. The court also found no evidence that Apollo Tyres otherwise dragged its heels in violation of the reasonable best efforts covenant. Specifically, the court found persuasive evidence that Apollo Tyres’ executives and its hired experts immediately travelled to Tennessee to meet with the USW after learning of the arbitrator’s order and held meetings over the next several weeks with the USW. The court also found convincing the testimony of the experts hired by Apollo Tyres on the issue of whether Apollo Tyres had used its “reasonable best efforts” to reach the required agreement with the USW. 

However, in dicta, the court found unavailing Apollo Tyres’ position that it could continue to use the USW developments to renegotiate the deal price without breaching the reasonable best efforts provision given the parties specifically carved out union developments from the definition of an MAE. Subsequently, Apollo Tyres notified Cooper that financing was unavailable, and Cooper terminated the merger agreement. 

Apollo Global Management, LLC v. Huntsman Corp.

Background 

In July 2007, Hexion agreed to acquire all outstanding shares of Huntsman for $10.6 billion. Because Hexion had been eager to be the winner of a competitive bidding process, the merger agreement contained no financing contingency, and Hexion agreed to use its “reasonable best efforts” to consummate the financing, which was being provided by Credit Suisse and Deutsche Bank. In addition, the merger agreement entitled Huntsman to uncapped damages if Hexion “knowingly and intentionally breached” its covenants under the merger agreement. An MAE/MAC clause permitted Hexion to terminate the merger agreement upon the “occurrence, condition, change, event or effect that is materially adverse to the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole.” 

During the period between signing and closing, Huntsman reported several disappointing quarterly results, missing the numbers it projected at the time the deal was signed. Huntsman’s first-half 2008 EBITDA was down 19.9 percent year-over-year from its first-half 2007 EBITDA, and its second-half 2007 EBITDA was 22 percent below the projections Huntsman presented to bidders in June 2007 for the rest of the year. After receiving these financials, Hexion and Apollo began exploring options for extricating Hexion from the transaction. Initially, Hexion focused on arguing that Huntsman had suffered a material adverse effect. Subsequently, Hexion explored ways to disrupt the financing. Hexion (through Apollo) sought a written opinion of Duff and Phelps of the likely insolvency of the combined companies post-closing. After obtaining such an opinion, without any input from, or the knowledge, of Huntsman’s management, Hexion forwarded it to Credit Suisse and attached the opinion to the complaint that the company filed in Delaware. Plaintiffs sought a declaration that: (1) Hexion possessed no obligation to consummate the merger if the combined companies were insolvent, and (2) Huntsman had suffered a material adverse effect. Huntsman counterclaimed and sought, among other things, specific performance of the merger agreement. After the filing of the Delaware litigation, Credit Suisse and Deutsche Bank pulled their financing. 

The Court’s Decision 

In reviewing the parties’ claims, the court began with Hexion’s argument that its obligation to close was excused as a result of Huntsman suffering a material adverse effect. As quoted above, the definition of a “material adverse effect” did not specifically cover changes in short-term prospects. Accordingly, under Delaware law, the court was required to presume that Hexion was purchasing Huntsman as part of a long-term strategy. While Huntsman’s interim performance may have been “disappointing,” the court was unable to conclude that a change “consequential to the company’s long-term earnings over a period of years” had occurred. According to the court, at best, Hexion’s projections predicated Huntsman’s 2009 EBITDA to be 3.6 percent lower than expected at the time of the execution of the merger agreement. 

The court found that Hexion intentionally breached its covenant to use its “reasonable best efforts” to consummate the financing for the following reasons. First, the court found the mere fact that Hexion failed to approach Huntsman about the possible insolvency of the combined entity before engaging Duff and Phelps to render an insolvency opinion constituted an intentional breach of the merger agreement. Second, the court found Hexion intentionally breached the merger agreement by publishing the solvency opinion (both by filing it with a complaint and by sending it to Credit Suisse). The court also confirmed that the solvency of the combined entity was not a condition precedent to any of Hexion’s obligations under the merger agreement. However, the court found that it could not order Hexion to close. The merger agreement provided that, in circumstances where Hexion was obligated to consummate the merger, but had not: “Huntsman shall not be entitled to enforce specifically the obligations of [Hexion] to consummate the Merger.” The court therefore ordered Hexion to perform its obligations under the merger agreement, other than the obligation to close. 

In December 2008, Apollo and Hexion agreed to pay Huntsman $425 million to settle the litigation, in addition to a $325 million breakup fee. 

Osram Sylvania, Inc. v. Townsend Ventures, LLC

Background 

In September 2011, plaintiff Osram Sylvania Inc. (OSI), a preferred stockholder of Encelium Holdings, Inc. (Encelium), agreed to purchase all of Encelium’s common stock from Townsend Ventures, LLC, and members of Encelium’s management (Townsend) for $47 million pursuant to a stock purchase agreement (the SPA). In the months leading up to the execution of the SPA, Townsend provided OSI with a management presentation which included Encelium’s historical financials and some forecasts. The management presentation revealed that Encelium had a negative EBITDA for calendar year 2010, but projected sales for the calendar year 2011 of approximately $18 million. The management presentation also disclosed that two of Encelium’s employees were responsible for approximately 32 percent of the forecasted sales for 2011. In early July 2011, Townsend reported to OSI that Encelium’s actual sales for the second quarter of 2011 were consistent with the forecasted sales numbers contained in the management presentation. Further, Townsend forecasted sales of approximately $4 million for the third quarter of 2011. In October 2011, the stock sale closed. 

After the closing, OSI learned that Encelium’s sales for the third quarter of 2011 were only $2 million, or approximately one-half of defendants’ estimates. According to OSI, Townsend knew Encelium’s actual sales results for this period prior to closing, but concealed the company’s underperformance. OSI also alleged that defendants manipulated the second quarter 2011 numbers to conceal underperformance. Specifically, OSI contended that defendants: (1) held invoices for payment, (2) billed and shipping excess product to create reportable revenue (without disclosing the credits to be applied), and (3) failed to disclose discount policies to inflate revenues. Encelium also allegedly failed to disclose that its top two salespeople resigned during the summer of 2011. OSI supported its allegations with an Encelium internal e-mail, in which one of the defendants stated: “[G]iven where sales are going the distraction with senior management is far too great to keep up any charade on the chance that a deal does happen.” 

Based on the foregoing, OSI contended that Townsend breached numerous provisions of the SPA, including representations relating to the accuracy of Encelium’s financial statements and the absence of a material adverse effect or change. OSI also claimed that Townsend breached Section 6.4 of the SPA, which required defendants to notify OSI of any fact or circumstance that occurred during the period between signing and closing, which had or would reasonably be expected to have, individually or in the aggregate, a material adverse effect. OSI also included counts of fraud in its complaint. 

The Court’s Decision 

In reviewing OSI’s claims, the court found that OSI adequately pleaded breaches of a number of Townsend’s representations and warranties under the SPA, including Sections 3.5(c) (warranting that the company had been run in the ordinary course of business and that there had been no MAC/MAE since the end of the second quarter of 2011), Section 3.7 (warranting that there had been no event or change since December 31, 2010, that resulted in, or would reasonably be expected to result in an MAC/MAE), and 3.5(b) (warranting the accuracy of the financial statements from 2008 through the second quarter of 2011). 

The SPA defined an MAE/MAC as “any effect or change . . . that would be materially adverse to the Business, assets, condition (financial or otherwise), results or operations of [Encelium].” Here, the court found that it was reasonably conceivable that certain of Encelium’s business practices, such as the billing and shipping of excess product during the months preceding the signing of the SPA, could have a material adverse effect on the company’s “long-term performance.” Furthermore, the court found it reasonably conceivable that Encelium’s achievement of only one-half of projected revenues for the third quarter of 2011, constituted an MAC or MAE, requiring notification under Section 6.4 of the SPA. The court also found that OSI stated a claim for fraud by alleging that defendants misrepresented the financial condition of the company to induce OSI to purchase Encelium’s common stock at an inflated price. 

Looking Forward: Lessons from Recent MAE/MAC Decisions

The lessons from Osram, Cooper Tire, and its predecessors are clear: the definition of an “MAE” in any merger agreement deserves a second look. In public company agreements, the failure of a target to meet earnings or revenue projections is commonly excluded from the list of events than could constitute a MAE, as are developments which result from the announcement of the merger. Further, changes in “prospects” are rarely included in the MAE clause as an event that could constitute an MAE. The elimination or retooling of these exceptions to the MAE definition, coupled with the introduction of more short-term, forward-looking features may give acquirers greater flexibility in responding to events that occur during signing and closing. While the introduction of these definitional elements may not be appropriate or realistically obtainable in most deals, the foregoing decisions make the case for their consideration. 

On the other hand, targets should focus on whether they have the ability to force a buyer to close upon the satisfaction of all conditions precedent to closing and/or to pay a significant reverse termination fee. As the foregoing cases show, targets may enter into agreements with the expectation that they have the ability to force the acquirer to close if all closing conditions are met, but are later disappointed. 

Privacy and Social Media

Posted on January 23, 2014 by - Uncategorized

From every angle, social media is anathema to privacy. The very founding concept of paleolithic AOL chatrooms and Usenet newsgroups, and later Facebook, MySpace, and the earliest blogging sites was to provide a forum for people to share with each other. People shared ideas, humor, emotions, preferences, prejudices, priorities, and often misguided attempts at profundity. Newer sites simply broadened and deepened the sharing – Twitter users share commute times and coffee temperatures, Tumblers share memes galore, and Instagramites share a wealth of doctored photographs. 

We learned things about the people in our world, and they about us. Thanks to social media, we now know that if our nearest coworker were a tree, she would be a willow, and the celebrity she believes that she most resembles is Angelina Jolie. We also know that Shirley’s kids are honor students and that Tom’s brother was just released from prison (early, for good behavior), that Jeffrey lives and dies with his Eagles and that Sandra is so, so, so sad at the plight of shelter animals. Importantly, we know when people are leaving town and how long they will be gone. We know if they come into money. We learn about their families and their vulnerabilities. We learn about drinking and drug use, sexual promiscuity, and even crimes like DWI or hit and run. We see pictures of their kids, their cars, their vacations, and their homes. 

All of this sharing may help create communities, but it also destroys privacy. The bikini-clad body that is perfectly appropriate on the beach at St. John or Captiva may undermine the respect an employee has worked hard to earn from superiors, subordinates, and peers at the office who may view the vacation pictures on Facebook. The same may be true for pictures of a drinking party among friends. Too much published information can and will present obstacles when circumstances change and a spouse sues for divorce, or a rival is seeking an edge for a promotion at work. We all know that kids can be the cruel, and your insistence on wearing mouse ears at a Disney theme park may reach the attention of your children’s classmates, and their parents. Criminals trawl social media constantly, looking for vulnerabilities and vacations, pinpointing easy targets. 

Operators of various social media outlets are well aware that their profits may increase as we expand our willingness to share personal information about ourselves, and much of the business model development for social media sites is designed to coerce, cajole, trick, taunt, or tease us into revealing more information about our lives and our thoughts and opinions. Who are your friends? What discounts interest you? You “liked” the last Vin Diesel movie, will you like the next one? What is your relationship status? Who do you write to? Who do you poke? Won’t you download the mobile app so we can see where you are when you access our site? Your friends have downloaded our app. Why won’t you? We will ask you again in two hours. 

Every bit of information we disclose is another databite to be mined and measured, sorted and sold. Online transactions provide even more opportunities, because a purchase through a social media site hits the trifecta for the site owner. With a purchase, the site registers our activity, our expenditure, our degree of interest in a good or service and an entire category of goods or services (opening our wallet demonstrates significant interest), our bank, our credit card information, our shipping address, our online ID, and our passwords. In addition, the social media site may trumpet the sale to our friends attempting to induce additional transactions. And beyond this extraordinary information bounty, the social media site likely received a financial kickback from a sale made from its platform. Moreover, the data mining industry attempts to review every transaction and every posting in which we engage in order to be able to maximize the profit potential of every piece of information disclosed by that transaction or posting. 

For this reason, social media is not simply a collection of online places that allow private information to escape, but social media sites are organized to draw as much participation and information out of us as possible. Like casinos built without sunlight or clocks so as to encourage your further play, the social media sites and data mining industry study online behavior and build manipulation machines designed to entice you to remain engaged and to divulge information. A search engine site may not care whether you own a particular make or model of car or that you baked cookies last night, but it cares that you told them about your car and your cookies. They make money from aggregating car owners and cookie bakers and selling information to companies who can exploit that information. 

Until recently, there has been very little counterbalance to the siren’s call of revealing everything on social media or to the tricks and manipulations that the online media companies employ to make sharing easy, satisfying, and seemingly so necessary. Certainly there are authors writing jeremiads both in and out of the mainstream media who will despair about the morality of kids today, or about the solipsistic adults who believe that each workout or restaurant meal is worth recording for posterity and circulating to wide circle of “friends.” There seems to be an absence of concerted opposition to this kind of activity. Schools and workplaces do not appear to actively discourage sharing in social media, except to prevent a student from bullying another, or to caution workers not to release company trade secrets. Governmental restrictions are spotty at best, except for the intelligence services, judiciary, and some government agencies. 

In short, prior to 2013, legislatures and regulators in the United States appeared to be more concerned about the data they could glean from social media than protecting privacy of the average citizen in the online world. Much of the rest of the industrialized world has a very different viewpoint about personal information than that we experience in the United States. In Europe, Canada, and other countries across the world, protection of each citizen’s private information is considered to be a human right, secured by statute and enforced by government and private causes of action. In the United States, by contrast, only certain classes of information are protected under federal law – financial transactions, health care transactions, and information regarding children under the age of 13 – while nearly all other data is considered to be fair game for any business or government agency that chooses to collect, store, and use the information. 

The Federal Trade Commission (FTC) and state attorneys general have been the traditional protectors of online privacy for lightly-regulated industries like social media. But through much of the development of social media and socially-oriented Internet sites, these enforcement agencies have tended only to enforce the privacy policies that a site chose to publicize. If a social media site had claimed not to gather certain information, but it indeed gathered that information, then the FTC would assert claims upon that site. However, if the social media site had a vague privacy policy that never clearly disclosed all of the information it gathered, or if the site gathered and sold massive amounts of personal data from its users, and the site revealed its behavior in its privacy policy, then no enforcement action would be initiated because the site was not breaking any known laws. (The exception to this rule seemed to be the 2006 ruling against Choicepoint, costing the company $10 million in civil penalties for providing personal information to identity thieves.) In other words, for most personal data about people, their activities, and their transactions, it seems that a social media site would not be regulated for use or abuse of this data, only for misrepresenting what data was collected and how such data was used. Deep intrusions of privacy may be allowed, as long as the site doesn’t directly misrepresent what it is doing. 

The FTC has moved beyond this position during the past three years by using its powers to enforce privacy policies on social media sites to sue transgressors, and then to force the transgressive sites into settlements that include a long-term consent order permitting the FTC to have a tighter grip on the site’s policies. For example, in November 2011, the FTC claimed that Facebook had lied to consumers by repeatedly stating that personal information would be kept private, while repeatedly allowing that personal information to be shared and made public. In settling this claim, Facebook agreed to a 20-year consent order protecting its member’s privacy in more specific ways. That agreement mandates that Facebook receive explicit consent of its users before disclosing private information. Following up on this, in September 2013, the FTC announced an inquiry into whether Facebook’s proposed new privacy policies, disclosed in August 2013, violated the 20-year consent agreement. In its proposed new policies, Facebook was planning to use its members’ names and pictures in advertising products the members had “liked” or for which they had given a favorable comment, and the new policy provided that Facebook automatically assumed that the parents of teenage Facebook users had granted permission for their children’s names to be used in advertising. The original FTC claim relating to an allegedly misleading privacy policy has thereby enabled the FTC to exercise much greater influence into Facebook’s future treatment of consumer data. The FTC also has obtained similar 20-year consent orders in place with Twitter, MySpace, and Google. 

State breach notice laws affecting social media privacy have some relatively consistent elements and some experimental elements. These laws address the way that a social media company must behave after a breach of security relating to a site-user’s personal information. Over 45 U.S. jurisdictions have some sort of data breach notice law. While these statutes come in a variety of flavors – some include obligations triggered by simple exposure of personal data while others are not triggered until the exposed data is at risk of theft and misuse – their basic function is the same: if a company exposes/loses certain kinds of data relating to individuals, then the company must provide notice of the loss to the data subjects (and often to law enforcement and credit services). Nearly all of these laws would apply to companies collecting personal data about their users and failing to appropriately guard the data from unauthorized breach or disclosure. However, social media sites are considered to provide a special class of service where the essential purpose of the enterprise is to enable people to provide information about themselves to a larger public. The social media companies only facilitate this exercise. Therefore, in the regular course of using social media, people are exposing their own private data, even health-care data, financial information, and information about their children, and self-exposure will not trigger the state breach notice laws. It is, however, likely that a failure by a social media company to protect a user’s private data beyond that company’s privacy settings would trigger these laws. For example, if a Texas social media user had set her account to “friends only,” and the social media site exposed her account more broadly, then the site would be subject to state law breach notice requirements. 

A social media site might have trouble meeting its obligations with respect to breaches because for each user whose account was compromised, the site must determine if the exposure included private and legally protected subject matter as defined in each applicable statute. Rather than undertake this Herculean task, the site may determine simply to notify all its members about the mistake, whether or not such notice is mandated by a particular state law. Of course, as with other enterprises, social media companies that accept credit card payments or otherwise keep customer financial account data are expected to protect this data and are obligated to notify customers where financial data was compromised. 

As social media grows in importance in many American lives, states are tackling specific aspects of privacy intrusions that are raised in the news and that capture the imagination of legislatures and the public. For example, the concern about disclosure of personal information on social media sites has manifest in the field of worksite protections. In the past two years, a new wave of privacy laws has been sweeping state legislatures; at this writing, 12 states currently have laws specifically restricting employers from demanding access to their employees’ social media sites when those sites are not fully public. (The states that have passed these laws are Arkansas, California, Colorado, Illinois, Maryland, Michigan, New Jersey, New Mexico, Nevada, Oregon, Utah, and Washington.) Nearly all of these laws were passed in 2013, and other legislatures are currently considering legislating similar employer restrictions. One of the newest and broadest of these laws, passed in September 2013 and signed into law in New Jersey, prohibits employers from seeking access to “a person account,” such as a friends-only account at Facebook. Further, the law prohibits employers from “shoulder surfing” or making an employee access a personal account while management watches, from requiring an applicant or employee to change the privacy settings on a restricted account to a less-restrictive setting so that the employer can access it, or by forcing the employee to accept an employer’s “friend” request. The law also prohibits an employer from retaliating or discriminating against a job applicant or employee for refusing to provide log-in information to the employer, for reporting violations of this law to the New Jersey Commissioner of Labor, or from testifying or participating in an investigation into a violation of the law. 

The New Jersey law contains exceptions for financial service firms that are required by statute to monitor employees’ social media communications. Similarly, in September of 2013, Illinois amended its social media password law to exempt the financial services sector, because many companies in this sector – banking, securities sales, and insurance – are required to monitor certain employee’s correspondence of all types with customers or prospective customers. Most states with laws in this space have broad definitions of the type of sites protected. For example, the recently passed Nevada statute classifies a social media account as “any electronic service or account or electronic content, including, without limitation, videos, photographs, blogs, video blogs, podcasts, instant and text messages, electronic mail programs or service, online services or Internet website profiles.” The penalties for these laws vary widely, with California, Colorado, Illinois, New Jersey, and Oregon creating administrative remedies; Illinois, Maryland, Michigan, Oregon, Utah, and Washington providing a private right of action (some with penalty caps); and Arkansas, Nevada, and New Mexico not addressing remedies at all in their statutes. Other aspects of the laws vary by state. Oregon bans colleges from asking for social media passwords. Washington allows employers to be granted access to social media sites when making factual determinations in the course of conducting an investigation. New Mexico’s restrictions only apply to job applicants and not to employees. 

Despite these laws, employers are still allowed to review social media pages that are available to the general public, and employees may volunteer access to their social media accounts or may choose to “friend” work associates, including their superiors. Taking advantage of these voluntary actions does not violate any of the new social media forced access laws. However, because of the recent trend toward increasing the protection accorded to personal online accounts and communications, employers should document how they obtained any social media information regarding employees how they obtained access to it. The trend toward increased protection is not uniform, though, and highlights uncertainty in a number of jurisdictions as to the degree to which privacy in social media should be protected. Most states have not approved such protections, and those that have passed a password protection law are inconsistent with respect to penalties, definitions, and the scope of protections. 

California is taking steps to protect the privacy of some social media users from users’ own poor judgments. In autumn 2013, California enacted a law that would require social media sites to allow young registered users to erase their own comments from the sites. This is a first step in the United States toward the “right to be forgotten” that has been debated in Europe over the past decade. Teens who may have posted embarrassing statements will now have the right to clear those statements from the site’s memory banks. The mechanism for enforcement has not as yet been determined, but we do know some of the limitations of the law. The statute only covers the teen’s own posts and not posts made by others. A child can only erase his or her own statements, not the comments, “like” buttons, or other posts surrounding those statements. (A new case has ruled that use of the “like” button on social media is constitutionally protected speech. Bland v. Roberts, Case No. 12 – 1671, 4th Cir., September 18, 2013.) A teen cannot erase pictures of him or herself that others have posted, or statements about that teen that third parties posted, no matter how embarrassing or offensive those pictures or statements may be. The Library of Congress is currently archiving public tweets on Twitter, and other third-party sites archive social media data. These archive sites are not covered by the California law. And from a policy standpoint, is there a downside to permitting young bullies, racists, and fraudsters to eliminate the evidence of their statements? Although some of this speech may have legal implications and may be required in court proceedings, under the new California law these statements may be required to be deleted. 

In an equally bold move, in 2013 the California legislature also addressed the broad concern of consumers who are being silently tracked by software over the Internet. Tracking tools used by social media are one of the ways these sites derive revenues, capturing user’s behavior and then selling targeted advertising designed to match or appeal to the type of behavior a specific user exhibits. Many sites use persistent beacons, cookies, and other tools that follow a person’s web usage and send information about that user’s visits and habits to the site or other third parties. Some Internet browser programs are now including anti-tracking technology, permitting a user to attempt to reject these monitoring tools or at least to advise sites that use the tools that this user does not wish to be tracked in this way. California’s new law will not force sites to stop tracking consumers, and it will not even force those sites to acknowledge and follow “do not track” instructions received by consumer’s browser. Instead, the California law requires companies to disclose whether the sites will honor “do not track” instructions from their users. Presumably, it is thought that Internet surfers will avoid sites that do not honor such requests. It is also likely that the California attorney general’s office, which fought for this law, will be posting a “naughty and nice” list of companies which will and won’t respect their user’s wishes not to be tracked. This law follows several years of failure by Internet sites (including social media) and privacy advocates to agree on a method permitting people to opt-out of being tracked online. It is unlikely that the California law will itself cause major changes in social media company behavior, but this is the first statute to advance the conversation on tracking of private online movements, and it could lead to further action by legislatures across the country.

Led by the states, the United States is developing laws and regulations to protect certain aspects of people’s information on social media. As social media sites evolve to make the dissemination of information easier, our society is beginning to recognize the problems inherent in such dissemination, and the use and protections to which such information is entitled. Both the FTC and state legislatures are taking steps to protect the American public from inappropriate intrusions on their privacy through social media – even if they are only protecting us from our own poor judgment.

U.S. Supreme Court Reaffirms that Forum-Selection Clauses Are Presumptively Enforceable

Posted on January 22, 2014 by - Uncategorized

Forum-selection clauses are common and highly useful features of commercial contracts because they help make any future litigation on a contract more predictable for the parties and, in some cases, less expensive. But what procedure should a defendant use to enforce a forum-selection clause when the defendant is sued in a court that is not the contractually selected forum? On December 3, 2013, the U.S. Supreme Court issued a decision in Atlantic Marine Construction Co. v. United States District Court for the Western District of Texas (__ S.Ct. __, 2013 WL 6231157 (Dec. 3, 2013)) that answers this question. The Court held that, if the parties’ contract specifies one federal district court as the forum for litigating any disputes between the parties, but the plaintiff files suit in a different federal district court that lawfully has venue (and therefore could be a proper place for the parties to litigate), the defendant should seek to transfer the case to the court specified in the forum-selection clause by invoking the federal statute that permits transfers of venue “[f]or the convenience of the parties and witnesses, in the interest of justice.” If the contract’s forum-selection clause instead specifies a state court as the forum for litigating disputes, the defendant may invoke a different federal statute that requires dismissal or transfer of the case. Importantly, the Court held that the parties’ contractual choice of forum should be enforced except in the most unusual cases, and that the party resisting the forum-selection clause (i.e., the plaintiff who filed in a different court) has the burden of establishing that public interests disfavoring transfer outweigh the parties’ choice. Atlantic Marine is significant for the business community because it provides greater certainty regarding the enforceability of forum-selection clauses, giving commercial parties that employ such clauses in their contracts greater predictability about where they will face future litigation. The Court in Atlantic Marine reinforced the strong federal policy favoring the enforcement of such clauses, and clarified the mechanism for their enforcement. As the Court explained,

[w]hen parties have contracted in advance to litigate disputes in a particular forum, courts should not unnecessarily disrupt the parties’ settled expectations. A forum-selection clause, after all, may have figured centrally in the parties’ negotiations and may have affected how they set monetary and other contractual terms; it may, in fact, have been a critical factor in their agreement to do business together in the first place. In all but the most unusual cases, therefore, ‘the interest of justice’ is served by holding parties to their bargain.

In Atlantic Marine, the U.S. Army Corps of Engineers hired Atlantic Marine Construction to build a child-development center on a military base in Texas. Atlantic Marine subcontracted with another construction company, J-Crew Management, to provide labor and materials. That contract called for all disputes between Atlantic Marine and J-Crew Management to be resolved in the state or federal court in Norfolk, Virginia, where Atlantic Marine is based. But J-Crew Management sued Atlantic Marine in federal court in Texas over Atlantic Marine’s alleged failure to pay for construction work. Preferring to litigate in Virginia, as the parties had agreed to do, Atlantic Marine asked the federal district court in Texas to enforce the forum-selection clause. It argued that there were two ways that the district court might enforce that clause: under a federal statute that requires the dismissal or transfer of a case brought in the “wrong” venue, or under another federal statute that authorizes a transfer to a more convenient location. (The federal venue statute specifies which federal district or districts are permissible locations for a civil action to be brought, based on the residency of the defendants, the location of the events that are the subject of the suit, or the existence of personal jurisdiction over the defendant.) The district court denied Atlantic Marine’s request under both theories, reasoning that venue was proper in Texas despite the contract’s forum-selection clause, and that a convenience transfer was not warranted based on the balance of public and private interests. Atlantic Marine then asked the Fifth Circuit for a writ of mandamus to require the district court to transfer or dismiss the case. Over a dissent that noted the presumptive enforceability of forum-selection clauses, the court of appeals rejected that request. The Supreme Court granted Atlantic Marine’s request for review to resolve a circuit split over how to enforce a contract provision that selects a federal forum other than the one in which the case was filed. In a unanimous opinion by Justice Alito, the Supreme Court reversed and remanded. In doing so, it effectively disagreed with both sides of that dispute among the courts of appeals. The Court first rejected the argument that a forum-selection clause affects whether venue in a given district is “wrong” or “improper,” because the venue statute does not address forum-selection clauses. Accordingly, when a case is filed in a district in which venue is authorized by law, a party seeking to enforce a forum-selection clause must seek transfer to a more convenient forum. A clause selecting a federal forum may be enforced using the statutory convenience transfer, while a clause selecting a state forum may be enforced under the forum non conveniens doctrine. The Court then described the appropriate standard for transfer. In ordinary cases not involving forum-selection clauses, courts must balance “the convenience of the parties and various public-interest considerations” to determine whether transfer would promote “the interest of justice.” But that analysis shifts in three important ways, the Court explained, in cases involving forum-selection clauses. First, in balancing interests, the court may not consider “the plaintiff’s choice of forum,” because the plaintiff already agreed by contract that another forum is more appropriate. Although “plaintiffs are ordinarily allowed to select whatever forum they consider most advantageous,” when the parties have agreed in advance to a forum-selection clause, “the plaintiff has effectively exercised its ‘venue privilege’ before a dispute arises. Only that initial choice deserves deference.” Second, because forum-selection clauses “waive” the parties’ “right to challenge the preselected forum as inconvenient,” the courts are limited to “consider[ing] arguments about public-interest factors only.” And the parties’ contractual choice of forum will outweigh public-interest factors “‘in all but the most exceptional cases.’” Finally, the court should apply the choice-of-law rules of the state in which the parties selected their forum, so that the plaintiff does not gain an unfair advantage by ignoring the forum-selection clause. Ordinarily, plaintiffs may affect the substantive law that applies to their case by choosing where to file suit, because a federal court typically applies “the choice-of-law rules of the State in which it sits.” Although the Supreme Court has recognized an exception for cases transferred because of convenience – under which the court applies the choice-of-law rules of the district where the plaintiff first filed suit – the Court rejected that approach in Atlantic Marine. The transferee court in the contractually selected forum will apply that forum’s choice-of-law rules as if the case had been filed there initially, in order to avoid privileging a party that “flouts its contractual obligation and files suit in a different forum.” The Court also noted that the same revised analysis would apply regardless of whether the forum specified in the forum-selection clause is a federal, state, or foreign court. Because the federal transfer statute codifies the forum non conveniens doctrine, the Court explained, the statute and the doctrine function exactly the same way for these purposes, except that the remedy under the latter is dismissal (allowing the plaintiff to refile in a state or foreign court) rather than transfer. The Supreme Court did not ultimately decide which forum was proper in Atlantic Marine, however. Instead, it rejected the lower courts’ balancing of public and private interests, because the private interests cannot weigh against enforcing the forum-selection clause, and remanded to allow the lower courts to consider in the first instance whether any public-interest factors preclude enforcement of the clause in this case.

Discovery and Preservation of Social Media Evidence

Posted on January 22, 2014 by - Uncategorized

The ubiquitous nature of social media has made it an unrivaled source of evidence. Particularly in the areas of criminal, personal-injury, employment, and family law, social media evidence has played a key role in countless cases. But the use of social media is not limited to these practice areas. Businesses of every size can be affected by social media – both in the duty to preserve social media content and in the desire to access relevant social media evidence in litigation. 

The Duty to Preserve Social Media Evidence 

Data residing on social media platforms is subject to the same duty to preserve as other types of electronically stored information (ESI). The duty to preserve is triggered when a party reasonably foresees that evidence may be relevant to issues in litigation. All evidence in a party’s “possession, custody, or control” is subject to the duty to preserve. Evidence generally is considered to be within a party’s “control” when the party has the legal authority or practical ability to access it. 

As an initial matter, social media content should be included in litigation-hold notices instructing the preservation of all relevant evidence. Once the litigation-hold notice has been issued, parties have available to them a number of ways to preserve social media data, depending on the particular platform or application at issue. 

Methods of Preservation 

Facebook offers the ability to “Download Your Info.” With just one click of the mouse, users can download a zip file containing timeline information, posts, messages, and photos. Information that is not available by merely logging into an account also is included, such as the ads on which the user has clicked, IP addresses that are logged when the user accesses his or her Facebook account, as well as other potentially relevant information. 

Twitter offers a similar, although somewhat limited, option. Twitter users can download all Tweets posted to an account by requesting a copy of the user’s Twitter “archive.” Twitter does not, however, offer users a self-serve method of obtaining other, non-public information, such as IP logs. To obtain this additional information, users must request it directly from Twitter by sending an e-mail to [email protected] with the subject line, “Request for Own Account Information.” Twitter will respond to the e-mail with further instructions. 

Although these self-help methods can be an excellent start, they do not address all possible data. Therefore, it may be prudent to employ the assistance of a third-party vendor in order to ensure complete preservation. CloudPreservation and X1 Social Discovery are two examples of commercially available tools that are specifically designed for archiving and collecting social media content. 

Consequences of Failing to Preserve 

Regardless of the method employed, preservation of social media evidence is critically important and the consequences of failing to preserve can be significant. In the worst case, both counsel and client may be subject to sanctions for a failure to preserve relevant evidence. In the first reported decision involving sanctions in the social media context, Lester v. Allied Concrete Co., No. CL08-150 (Va. Cir. Ct. Sept. 01, 2011), aff’d, No. 120074 (Va. Ct. App. Jan. 10, 2013), the court sanctioned both the plaintiff and his counsel based, in large part, on its determination that they had engaged in spoliation of social media evidence. In that case, the lawyer told his paralegal to make sure the plaintiff “cleaned up” his Facebook page. The paralegal helped the plaintiff to deactivate his page and delete 16 pictures from his account. Although the pictures were later recovered by forensic experts, the court found that sanctions were warranted based on the misconduct. 

In contrast to Lester, a federal court in New Jersey imposed a significantly less severe remedy for the removal of Facebook posts. In Katiroll Company, Inc. v. Kati Roll and Platters, Inc., No. 10-3620 (GEB) (D.N.J. Aug. 3, 2011), the court determined that the defendant committed technical spoliation when he changed his Facebook profile picture, where the picture at issue was alleged to show infringing trade dress. Because the defendant had “control” over his Facebook page, he had the duty to preserve the photos. 

Because the photos were relevant to the litigation, their removal was “somewhat prejudicial” to the plaintiff. Instead of harsh monetary or evidentiary sanctions though, the court ordered a more practical-driven resolution. Specifically, the court ordered the defendant to coordinate with the plaintiff’s counsel to change the picture back to the allegedly infringing picture for a brief time during which the plaintiff could print whatever posts it believed to be relevant. 

Critical to the court’s decision not to award sanctions was its finding that the plaintiff had not explicitly requested that the defendant preserve his Facebook account as evidence. The court concluded, instead, that it would not have been immediately clear to the defendant that changing his Facebook profile picture would constitute the destruction of evidence. Thus, any spoliation was unintentional. This decision supports the idea that counsel should consider issuing a litigation-hold notice to opposing parties, as well as to one’s own client. 

Even inadvertent negligence for which sanctions are not warranted, can result in the loss of potentially relevant social media evidence. For example, in In re Pfizer, Inc. Securities Litigation, 288 F.R.D. 297 (S.D.N.Y. Jan. 8, 2013), the plaintiff-shareholders sought sanctions against Pfizer for failing to preserve data from “e-rooms.” The “e-rooms” were internal collaboration applications maintained by the company for use by employees in sharing documents and calendars, archiving e-mails, and communicating via discussion boards and instant messaging. Although the company had preserved (and produced) a tremendous amount of ESI, it had failed to preserve the data associated with the relevant e-rooms. 

The court took issue with the scope of Pfizer’s litigation-hold measures because they did not include e-rooms. Although documents and information included in the e-rooms were likely also maintained elsewhere and had likely been preserved and produced, the deletion of the e-rooms had resulted in the loss of discoverable information concerning the manner in which the employees internally organized information. 

The court found that this information was relevant because it would allow the plaintiffs to draw connections and understand the narrative of events in a way “not necessarily afforded by custodial production.” Thus, the court concluded, the company breached its duty to preserve because the scope of its litigation hold did not include the e-rooms. Sanctions, however, were not warranted because the conduct was merely negligent and the plaintiffs had not shown that any lost data was, indeed, relevant to their claims. 

Preservation in a “BYOD” World 

One question that remains unanswered relates to the obligation of a company to preserve the potentially relevant social media content of its employees. In Cotton v. Costco Wholesale Corp., No. 12-2731 (D. Kan. July 24, 2013), the court denied the employee-plaintiff’s motion to compel text messages sent or received by employees on their personal cell phones, finding that the employee had failed to show that the employer had any legal right to obtain the text messages. In other words, the phones and the data they contained were not in the “possession, custody, or control” of the employer. This recent discussion is one of the first of its kind and observers will have to wait to see whether the approach is adopted by other courts in cases to come. 

The Discoverability of Social Media

Preservation of social media evidence, of course, is only one part of the process. Parties will want to obtain relevant social media evidence as part of their informal and formal discovery efforts. Although some courts continue to struggle with disputes involving such efforts, discovery of social media merely requires the application of basic discovery principles in a somewhat novel context. 

No Reasonable Expectation of Privacy 

The user’s right to privacy is commonly an issue in discovery disputes involving social media. Litigants continue to believe that messages sent and posts made on their Facebook pages are “private” and should not be subject to discovery during litigation. In support of this, litigants claim that their Facebook pages are not publicly available but, instead, are available only to a limited number of designated Facebook “friends.” 

Courts consistently reject this argument, however. Instead, courts generally find that “private” is not necessarily the same as “not public.” By sharing the content with others – even if only a limited number of specially selected friends – the litigant has no reasonable expectation of privacy with respect to the shared content. Thus, the very purpose of social media – to share content with others – precludes the finding of an objectively reasonable expectation that content will remain “private.” Consequently, discoverability of social media is governed by the standard analysis and is not subject to any “social media” or “privacy” privilege. 

Relevancy as the Threshold Analysis 

Relevancy, therefore, becomes the focus of the discoverability analysis. Courts are wary about granting discovery of social media content where the requesting party has not identified some specific evidence tending to show that relevant information exists. However, a requesting party is only able to satisfy this burden if at least some part of producing party’s social media content is publicly available. Thus, when a litigant’s social-networking account is not publicly available, the likelihood of its discovery diminishes significantly. As more and more users understand the importance of privacy settings, the burden on the requesting party becomes more and more difficult to satisfy. 

Methods of Access to Social Media Evidence 

Assuming a litigant is able to meet its burden to establish the relevancy of social-networking content, the question becomes a practical one – how to obtain the sought-after information? Currently, this question has no good answer. There have been a variety of methods requested by litigants and ordered by the courts, with mixed degrees of success. 

Direct Access to Social Media Accounts

One of the most intrusive methods of discovery is to permit the requesting party access to the entire account. If analogized to traditional discovery, this would be the equivalent of granting access to a litigant’s entire office merely because a relevant file is stored there. Not surprisingly, this method of “production” has not been popular with parties or with courts. 

Nevertheless, there now are several decisions in which a court has ordered a party to produce his or her login and password information to the other side in response to a discovery request. One of these decisions, Largent v. Reed, No. 2009-1823 (Pa. C.C.P. Nov. 8, 2011), illustrates some of the procedural challenges that can result. 

In Largent, the court ordered the plaintiff to turn over her Facebook login information to defense counsel within 14 days of the date of the order. Defense counsel then would have 21 days to “inspect [the plaintiff’s] profile.” After that period, the plaintiff could change her password to prevent any further access to her account by defense counsel. Although the order specifically identified the defendant’s lawyer as the only party who would be given the login information, it did not specify whether the defendant was permitted to view the account’s contents once the attorney had logged in. 

Another case involving the exchange of login information resulted in more serious and permanent harm. In Gatto v. United Airlines, Inc., No. 10-1090-ES-SCM (D.N.J. Mar. 25, 2013), the plaintiff voluntarily provided his Facebook password to the defendants’ counsel during a settlement conference facilitated by the court. When the defendants’ attorney later logged into the account and printed portions of the plaintiff’s profile page as previously agreed, Facebook sent an automated message to the plaintiff, alerting him that his account had been accessed from an unauthorized ISP address. 

The plaintiff attempted to deactivate the account but deleted it instead. As a result, all of the data associated with the account was automatically and permanently deleted 14 days later. The court found that the plaintiff had failed to preserve relevant evidence and granted the defendants’ request for an adverse-inference instruction as a sanction. 

Not all courts have endorsed the idea of direct access to a party’s social media account. One court went so far as to hold that a blanket request for login information is per se unreasonable. In Trail v. Lesko, No. GD-10-017249 (Pa. C.C.P. July 3, 2012), both sides sought to obtain Facebook posts and pictures from the other. Neither complied and both parties filed motions seeking to compel the other to turn over its Facebook password and username. 

The court explained that a party is not entitled to free-reign access to the non-public social-networking posts of an opposing party merely because he asks the court for it. “To enable a party to roam around in an adversary’s Facebook account would result in the party to gain access to a great deal of information that has nothing to do with the litigation and [] cause embarrassment if viewed by persons who are not ‘Friends.’” 

One court went even further. In Chauvin v. State Farm Mutual Automobile Insurance Company, No. 10-11735, 2011 U.S. Dist. LEXIS 121600 (S.D. Mich. Oct. 20, 2011), the court affirmed an award of sanctions against the defendant due to its motion to compel production of the plaintiff’s Facebook password. The court upheld the decision of the magistrate judge, who had concluded that the content the defendant sought to discover was available “through less intrusive, less annoying and less speculative means,” even if relevant. Furthermore, there was no indication that granting access to the account would be reasonably calculated to lead to discovery of admissible information. Thus, the motion to compel warranted an award of sanctions. 

In Camera Review

In an effort to guard against overly broad disclosure of a party’s social media information, some courts have conducted an in camera review prior to production. For example, in Offenback v. Bowman, a No. 1:10-cv-1789, 2011 U.S. Dist. LEXIS 66432 (M.D. Pa. June 22, 2011), the magistrate judge conducted an in camera review of the plaintiff’s Facebook account and ordered the production of a “small segment” of the account as relevant to the plaintiff’s physical condition. 

In Douglas v. Riverwalk Grill, LLC, No. 11-15230, 2012 U.S. Dist. LEXIS 120538 (E.D. Mich. Aug. 24, 2012), the court ordered the plaintiff to provide the contents for in camera review. After conducting its review of “literally thousands of entries,” the court noted that “majority of the issues bear absolutely no relevance” to the case. In particular, the court found that the only entries that could be considered discoverable were those written by the plaintiff, which could be in the form of “comments” he made on another’s post or updates to his own “status.” The court identified the specific entries it had determined were discoverable. 

Many courts, understandably, have been less than enthusiastic about the idea of doing the parties’ burdensome discovery work. For example, in Tomkins v. Detroit Metropolitan Airport, 278 F.R.D. 387 (E.D. Mich. 2012), the court declined the parties’ suggestion that it conduct an in camera review, explaining that “such review is ordinarily utilized only when necessary to resolve disputes concerning privilege; it is rarely used to determine relevance.” 

At least one court has agreed to “friend” a litigant for the purpose of conducting an in camera review of the litigant’s Facebook page. In Barnes v. CUS Nashville, LLC, No. 3:09-cv-00764, 2011 U.S. Dist. LEXIS 143892 (M.D. Tenn. June 3, 2010), the magistrate judge offered to expedite the parties’ discovery dispute by creating a Facebook account and then “friending” two individuals “for the sole purpose of reviewing photographs and related comments in camera.” The judge then would “properly review and disseminate any relevant information to the parties . . . [and would] then close Facebook account.” 

Attorneys’ Eyes Only

In Thompson v. Autoliv ASP, Inc., No. 2:09-cv-01375 (D. Nev. June 20, 2012), the defendant obtained information from the plaintiff’s publicly available social-networking profiles that was relevant to the case, but asserted that the plaintiff had since changed her account settings to prevent the defendant from further access and had failed to produce (or had produced in overly-redacted form) information from these profiles in response to the defendant’s formal discovery requests. 

The defendant sought to have the court conduct an in camera review of the profiles in their entirety to determine whether the plaintiff’s discovery responses were complete. Instead, the court ordered the plaintiff to provide the requested information to the defendant’s counsel for an attorney’s-eyes-only review for the limited purpose of identifying whether information had been improperly withheld from production. The defendant’s counsel was instructed that it could not use the information for any other purpose without a further ruling by the court. 

Third-Party Subpoenas

While the discoverability analysis is a product of the common law, there is at least one statute relevant to the discussion. The Stored Communications Act (SCA) limits the ability of Internet-service providers to voluntarily disclose information about their customers and subscribers. Although providers may disclose electronic communications with the consent of the subscriber, the SCA does not contain an exception for disclosure pursuant to civil discovery subpoena. The application of the SCA to discovery of communications stored on social-networking sites has produced mixed results. 

Providers, including Facebook, take the position that the SCA prohibits them from disclosing social media contents, even by subpoena. From Facebook’s website: 

Federal law prohibits Facebook from disclosing “user content (such as messages, Wall (timeline) posts, photos, etc.), in response to a civil subpoena. Specifically, the Stored Communications Act, 18 U.S.C. § 2701 et seq., prohibits Facebook from disclosing the contents of an account to any non-governmental entity pursuant to a subpoena or court order. 

One of the earliest cases to address the issue, Crispin v. Christian Audigier, Inc., 717 F. Supp. 2d 965 (C.D. Cal. 2010), concluded that the SCA prohibited a social-networking site from producing a user’s account contents in response to a civil discovery subpoena. In that case, the defendants served subpoenas on several third parties, including Facebook and MySpace, seeking communications between the plaintiff and another individual. The plaintiff moved to quash the subpoenas. 

The court held that plaintiff had standing to bring the motion, explaining that “an individual has a personal right in information in his or her profile and inbox on a social-networking site and his or her webmail inbox in the same way that an individual has a personal right in employment and bank records.” Moreover, the court determined that the providers were electronic communication service (ECS) providers under the SCA and were thus prohibited from disclosing information contained in “electronic storage.” 

The SCA does not override a party’s obligation to produce relevant ESI, though. To the contrary, a party must produce information that is within its possession, custody, or control. Thus, a court can compel a party to execute an authorization for the release of social media content. With an executed authorization, a properly issued subpoena, and, in most cases, a reasonably small payment for associated costs, litigants can obtain all information related to a user’s social media account. 

Lessons Learned 

Although the world of social media and other new technology continues to present novel questions, the answers are often derived by applying a “pre-Facebook” analysis. For example, businesses understand that they have an obligation to preserve potentially relevant evidence. Social media evidence is no different and should be preserved in the same way as paper documents and emails. 

Similarly, parties in litigation are entitled to discovery of all relevant, non-privileged information. Thus, social media content is subject to discovery, despite the privacy settings imposed by the account user. Nevertheless, only relevant information must be produced and it is the responsibility of counsel to make the relevancy determination.

Parties and counsel are well advised to adjust their thinking so that social media becomes just another type of ESI. And, like emails and other forms of electronic data, social media must be preserved and is subject to discovery if relevant to the dispute.

 

 

 

 

Canada’s Tough New Anti-Spam Legislation: Beware Its Extra-Territorial Reach

Posted on January 22, 2014 by - Uncategorized

 

Canada’s new anti-spam laws (CASL), (S.C. 2010, c. 23), will come into force on July 1, 2014, and is the toughest anti-spam law in the world.  Whether or not your client is located in Canada, CASL may affect your client. Even if your client isn’t a spammer, CASL will affect your client’s business operations in and from Canada. 

Why should U.S. lawyers and their clients care about CASL?  The answer is that CASL has considerable extra-territorial reach. CASL applies where “a computer system located in Canada is used to send or access” an electronic message.  So, by way of example, CASL will apply if an e-mail is sent from the United States to a Canadian who receives and opens it on a computer located in Canada. In light of the long statutory reach outside of Canada and because of the unprecedented toughness of CASL, anyone involved in online commercial communications flowing into Canada needs to consider compliance with CASL. 

A violation of CASL attracts significant administrative monetary penalties of up to $1 million for individuals and $10 million for others. Corporate directors and officers may be personally liable if they direct, authorize, or assent to, or acquiesce or participate in, a contravention of CASL, subject to a due diligence defense.  Employers may be vicariously liable for violations of CASL by their employees, subject to a due diligence defense.  It is also an offense under CASL to aid, induce, procure, or cause to be procured the doing of any acts contrary to certain sections of CASL, including the sections relating to CEM’s. 

CASL regulates “commercial electronic messages” (CEM) which are defined broadly and includes any electronic message that has as its purpose, or as one of its purposes, the encouragement of participation in a commercial activity. An electronic message would include e-mail, text messages, and social media messaging and text, sound, voice, or image messages.  Even if the electronic message itself is not related to a commercial activity, it may still be a CEM, having regard to the hyperlinks to other content or websites or the contact information contained in the message. Commercial activity is defined in CASL to mean any transaction, act, or conduct or any regular course of conduct that is of a commercial character, whether or not the person who carries it out does so with the expectation of profit.  Common business activities, including sending e-mail messages to customers, operating a website, or making an application available for download, will therefore be subject to CASL. 

CASL is fundamentally different than the U.S. Can-Spam Act of 2003, (15 U.S.C. ch. 103, Public Law No. 108-187, was S. 877 of the 108th United States Congress), because, unlike the Can-Spam Act, which is based on an “opt-out” model which assumes that recipients of unsolicited electronic messages have implicitly consented to their receipt until and unless they take steps to opt-out of the receipt of such messages, Canada is moving to an “opt-in” consent regime.  This will prohibit the sending of CEM’s unless the recipient has given his or her express or implied consent, subject to limited exceptions.  Problematically, a CEM cannot be used to request this consent which means companies will need to obtain express consent without using e-mail. 

In addition to the obligation to obtain express or implicit consent to the sending of CEM’s,  CASL also regulates the content and form of CEM’s.  Every CEM must identify the sender, include prescribed contact information for the sender, and provide a specific unsubscribe mechanism which must permit the recipient to indicate, at no cost, that the recipient no longer wishes to receive CEM’s from the sender.  The sender must comply with requests to unsubscribe to CEM’s “without delay,” and in any event within 10 business days. Prescribed contact information for each CEM includes the name and mailing address of the person sending the CEM, and a telephone number, e-mail address, or web address of the person sending the CEM.  Where the CEM is being sent on behalf of another person, such as by a third-party service provider, the name of the third party as well as the name of the person on whose behalf the CEM is being sent must also be included. 

CASL establishes a right of private civil action which may be commenced by any individual or organization affected by a contravention of CASL; however, this private right of action will not come into force until July 1, 2017.  Class actions are also possible.  These actions are of significant concern for anyone doing business in Canada or communicating online with Canadians.  CASL also regulates the unsolicited installation of computer programs or software; however, these provisions will not come into force until January 15, 2015. 

As a result of consultation with many different stakeholders, the three sets of regulations to CASL include many important exceptions that have to be assessed carefully by clients when implementing a compliance program.  It is also important to consider Industry Canada’s Regulatory Impact Analysis Statement (RIAS) which clarifies questions raised during the consultation process, although the RIAS is not legally binding.  Given the complexity and novelty of CASL, compliance with CASL will be complex and must be tailored for each client’s specific operations and processes. 

The first phase of CASL’s implementation commences July 1, 2014, with the balance of its provisions being phased in over the following three-year period.  U.S. lawyers and their clients will want to act quickly to assess whether the client needs to comply with CASL and if so, the process for compliance with CASL.  Given the extremely high administrative monetary penalties, it is critical to act now.