Legal Opinions in SEC Filings (2013 Update)

Posted on August 6, 2013 by - Uncategorized

 

An Update of the 2004 Special Report of the Task Force on Securities Law Opinions, ABA Business Law Section*

This updated report reflects developments in opinion practice since the 2004 Special Report, including the publication on October 14, 2011 of Staff Legal Bulletin No. 19 by the SEC Division of Corporation Finance.1

I. INTRODUCTION

Section 7(a) of the Securities Act of 1933 (the “Securities Act”) requires a registration statement to contain the information specified in schedule A to the Act.2 Paragraph 29 of schedule A requires the filing of “a copy of the opinion or opinions of counsel in respect to the legality of the issue.”3 The Securities and Exchange Commission (the “SEC”) has addressed that requirement in item 601 of Regulation S-K.4 Under paragraph (b)(5) of item 601, a registration statement must include as an exhibit “[a]n opinion of counsel as to the legality of the securities being registered, indicating whether they will, when sold, be legally issued, fully paid and non-assessable, and, if debt securities, whether they will be binding obligations of the registrant.”5 Counsel to the issuer—either inside counsel or outside counsel—gives the opinion. The opinion on legality appears as exhibit 5 to a registration statement and is thus often referred to as an “Exhibit 5 opinion.” This 2013 Update examines Exhibit 5 opinions.

II. PRELIMINARY MATTERS

A. ADDRESSEES, LIMITATIONS ON RELIANCE, AND TIMING OF FILING

The Securities Act and the SEC rules under it are silent with regard to whom an Exhibit 5 opinion should be addressed. In practice, the opinion typically is addressed to the issuer.

The SEC staff (the “Staff ”) does not permit the inclusion in an Exhibit 5 opinion of any limitations on who may rely on the opinion6 and has stated that purchasers of securities in any offering to which an Exhibit 5 opinion relates are entitled to rely on that opinion without limitation.7 The Staff views any limitations on reliance (e.g., stating that the opinion is “only” or “solely” for the issuer or its board of directors) as being inconsistent with the purpose of paragraph 29 of schedule A to the Securities Act.

An Exhibit 5 opinion need not be included as an exhibit to a registration statement as initially filed but must be filed as an exhibit in order for the registration statement to be declared or become effective. Thus, the opinion often is filed with an amendment to the registration statement.8 As discussed further below, when counsel needs to include otherwise impermissible assumptions or qualifications to give an initial opinion before a registration statement becomes effective (e.g., in the case of a shelf registration statement), the Staff requires that an updated, unqualified opinion be filed not later than the closing date of each offering of securities pursuant to the registration statement.9

B. ASSUMPTIONS

The fact that the opinion must be filed before the securities are actually sold—and in the case of shelf registrations, often long before—gives rise to issues about the appropriateness of assumptions that are included in the opinion. Certain situations (e.g., the filing of shelf registration statements and the registration of rights under shareholder rights plans) require counsel to include broad and otherwise unacceptable assumptions that the Staff has deemed permissible in these limited circumstances. These are discussed in further detail below. In general, however, the Staff likely will object to any assumptions that it considers “overly broad, that ‘assume away’ the relevant issue or that assume any of the material facts underlying the opinion or any readily ascertainable facts.”10 Nevertheless, the Staff does not question the inclusion of certain standard opinion assumptions (e.g., the genuineness of signatures and the legal capacity of the signatories of documents reviewed by counsel), many of which “are understood as a matter of customary practice to apply, whether or not stated.”11 Although counsel need not expressly enumerate each of these customary assumptions for them to apply, some may choose to do so. In general, assumptions should be limited to matters that cannot be known until after the registration statement is effective, such as the terms of a particular series of debt securities or approval by directors of the price of shares being sold in a common stock offering.12

C. CONSENTS AND EXPERTISE

Rule 436 under the Securities Act requires that a written consent of counsel be filed as an exhibit to a registration statement, “[i]f any portion of the . . . opinion of . . . counsel is quoted or summarized as such in the registration statement or in a prospectus.”13 This requirement has led to speculation as to whether, by virtue of the reference in the prospectus to its having passed on the legality of the securities, counsel giving an Exhibit 5 opinion is an expert for purposes of section 7 of the Securities Act. The statute itself refers to:

any accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, [who] is named as having prepared or certified any part of the registration statement, or is named as having prepared or certified a report or valuation for use in connection with the registration statement.14

The statute does not specifically refer to lawyers, an omission that may explain why Rule 436 refers to the consent of “an expert or counsel.”15 In any event, Rule 436 requires that a consent of counsel “be filed as an exhibit to the registration statement.”16 That consent must be to the filing of the opinion as an exhibit to the registration statement and to both the discussion of the Exhibit 5 opinion and the reference to the counsel that gave it in the related prospectus.17 As a drafting matter, most lawyers include the consent in the opinion letter itself. Some also add a statement to the effect that the filing of the consent shall not be deemed an admission that counsel is an expert within the meaning of section 7 of the Securities Act. The Staff does not object to this “no admission” language. The Staff does object, however, to language affirmatively denying that counsel is an expert within the meaning of the Securities Act.18 Whether or not counsel includes the “no admission” language should have no bearing on whether counsel is or is not an expert under section 7.

Exhibit 5 opinion practice, including compliance with Rule 436, has varied when the law of multiple jurisdictions is implicated. A typical example would be the issuance of debt securities by an entity formed in a jurisdiction other than New York pursuant to an indenture governed by New York law. Unless expressly qualified, an opinion that debt securities issued under an indenture are valid and binding (a matter of contract law under the law of the jurisdiction whose law governs the indenture) is customarily understood to encompass an opinion that the indenture has been duly authorized, executed, and delivered (a matter of corporate or other entity law of the jurisdiction where the issuer was formed). If the opinion giver is able to cover both the law of the issuer’s jurisdiction of formation and the law that governs the indenture, it can cover all requisite elements of the opinion in a single Exhibit 5 opinion. If not, the opinions of two counsel will be required to cover all relevant opinion matters. There are two approaches typically used when two opinions are required. These two approaches often are referred to as the reliance approach and the separate opinion approach.

Rule 436(f ) under the Securities Act specifies that, if an opinion filed as an exhibit expressly relies on an opinion of another counsel, the consent of that other counsel need not be provided and that other counsel need not be named in the registration statement.19 Under this approach, the opinion of primary counsel covers all required matters (e.g., due authorization, execution, and delivery of the indenture as well as enforceability of the debt securities issued pursuant to the indenture), expressly relying on the opinion of other counsel for matters governed by the law of the jurisdiction where the issuer was formed. Despite the relief from filing a consent, the Staff has taken the position that a signed copy of the opinion on which primary counsel expressly relied must nevertheless be included as an exhibit to the registration statement.20

The Staff also has accepted a separate opinion approach when the law of multiple jurisdictions is involved. Under this approach, which is more consistent with typical third-party closing opinion practice, the opinion of one counsel covers all matters governed by the law of the jurisdiction where the issuer was formed (e.g., due authorization, execution, and delivery) and, assuming those matters, the opinion of another counsel covers enforceability. Under this approach, both opinions must be filed as exhibits to the registration statement and both counsel must file consents pursuant to Rule 436.21

III. PARTICULAR CLASSES OF SECURITIES

A. EQUITY SECURITIES

1. Substantive Requirements

Item 601 of Regulation S-K requires that the opinion state that the securities, when sold, will be:

  • legally issued,
  • fully paid, and
  • nonassessable.22

The phrase “legally issued,” although taken directly from the language of the Securities Act, is not the language lawyers customarily use when giving a third-party closing opinion on equity securities. Because the Staff does not insist on the “legally issued” language, many opinion givers use “validly issued” instead.23 Thus, in Exhibit 5 opinions, many lawyers use, and the Staff has accepted,24 a formulation of an Exhibit 5 opinion with respect to equity securities to the effect that the securities have been “duly authorized and, [when sold in accordance with the provisions of the applicable purchase agreement], will be validly issued, fully paid and nonassessable.”25 This is the language normally used in third-party closing opinions, and its meaning (as well as the meaning of “fully paid and nonassessable”) is the subject of numerous bar association reports.26

Because the Exhibit 5 opinion is delivered before the securities are sold, opinion givers often cast the opinion in the future tense, stating that the securities will be validly issued, fully paid, and nonassessable upon their sale in accordance with the applicable purchase agreement or governing document. Opinion givers also sometimes condition the opinion on further action by the board or a board committee. Opinion givers should be careful about the breadth of any such assumptions. Although an opinion giver may appropriately assume that a pricing committee—if permitted by the law of the jurisdiction where the issuer was formed and its constituent documents—will take the action necessary to set the sale price within a range established by the board,27 the Staff likely will object to an assumption that all action required to be taken prior to the issuance and sale of the securities has been taken.28 In general, as discussed above, assumptions should be limited to matters that as a practical matter cannot be known until after effectiveness of the registration statement.

2. Opinions on Delaware Corporations by Counsel Not Admitted to Practice in Delaware

The Staff has indicated that it will accept an opinion in respect of the law of a jurisdiction in which the opinion giver is not admitted to practice so long as the opinion giver does not attempt to qualify the opinion by “carv[ing] out” the very laws of the jurisdiction in question.29 Counsel not admitted to practice in Delaware, for example, often give Exhibit 5 opinions on stock issued by Delaware corporations.30 Usually, such counsel includes in its opinion a so-called coverage limitation specifying that the opinion’s coverage of Delaware law is limited to the Delaware General Corporation Law.

In the late 1990s, a question arose over the scope of the law covered by opinions on stock issued by Delaware corporations where coverage of the opinion was limited to the Delaware General Corporation Law. In the registration statement review process, the Staff frequently commented that this limitation unacceptably limited the scope of the opinion because, on its face, it focused only on the Delaware corporation statute and not on the Delaware Constitution and judicial interpretations. That controversy was resolved when the Staff accepted the view that the reference to the “Delaware General Corporation Law” was an opinion drafting convention, and that the practicing bar understood that phrase to cover the Delaware General Corporation Law, the applicable provisions of the Delaware Constitution, and reported judicial decisions interpreting these laws. The Staff ’s position was further clarified in Staff Legal Bulletin No. 19, in which the Staff confirmed that it shares the view that the phrase Delaware General Corporation Law includes reported judicial decisions interpreting that law.31 The Staff now routinely accepts a coverage limitation that states that the opinion is limited to the Delaware General Corporation Law.32 However, the Staff has reiterated that it “does not accept an opinion that explicitly excludes consideration of . . . reported judicial decisions. This position applies to the corporation and other entity statutes of all jurisdictions.”33

B. DEBT SECURITIES

1. Binding Obligations

For debt securities, item 601 of Regulation S-K requires the filing of an opinion that the securities will be “binding obligations of the registrant.”34 This opinion, often referred to in the context of general opinion practice as the “remedies” or “enforceability” opinion, is stated in various ways. Perhaps the most common formulation is that the debt securities constitute valid and binding obligations of the issuer, enforceable against the issuer in accordance with their terms “except as may be limited by bankruptcy, insolvency or other similar laws affecting the rights and remedies of creditors generally and general principles of equity.”35 Minor differences in wording do not change the meaning of the opinion.36

Exhibit 5 opinions on debt securities typically refer to the debt instruments themselves rather than the indenture under which they are issued. An enforceability opinion on the debt securities covers those portions of the indenture that relate to the terms of the securities, including any terms in the indenture that further define terms in the securities, such as the terms for conversion.37

2. Governing Law

Unlike the law governing the validity of equity securities (which is the entity law of the jurisdiction where the issuer was formed), the law governing the enforceability of debt securities is generally the law chosen in the instrument under which the securities are issued. Often New York law is chosen to govern the obligations of the issuer in a registered debt offering. In the context of third-party closing opinions, when counsel for the issuer is not in a position to give an opinion on New York contract law, underwriters may be willing to accept an opinion on the enforceability of the debt as if the law of counsel’s home jurisdiction applied.38 However, that practice is not acceptable to the Staff in the context of an Exhibit 5 opinion.39 The Securities Act requires an opinion on the legality of the issue, and the Staff takes the position that anything short of an opinion on the law that actually governs the enforceability of the debt securities will not suffice.40

3. Non-Standard Exceptions

Sometimes counsel includes exceptions, in addition to the standard bankruptcy exception and equitable principles limitation, to identify issues that affect the enforceability of particular provisions of the securities being registered. When including additional exceptions, counsel should consider whether they relate to issues requiring disclosure in the prospectus. In addition, counsel should be prepared for possible Staff comments.41 If the exceptions simply make explicit what is understood as a matter of customary practice to be implicit or otherwise are not material, additional exceptions should not require prospectus disclosure.

C. OPTIONS, WARRANTS, AND RIGHTS

Rights to acquire securities, either equity or debt, are contractual rights. In that respect they are more like debt securities than equity securities.42 In the case of warrants, for example, an opinion that a warrant is validly issued, fully paid, and nonassessable would be inapt because these concepts relate to stock— not contractual obligations.

As with opinions relating to debt securities, an Exhibit 5 opinion on warrants, for example, should address their enforceability under the law chosen to govern the warrants. Typically, the offer and sale of the warrants and the securities underlying the warrants are registered at the same time. In that case, the Exhibit 5 opinion should state not only that the warrants are enforceable, but also that the underlying shares (in the case of warrants to purchase stock) have been duly authorized and, upon delivery in accordance with the terms of the warrants, will be validly issued, fully paid, and nonassessable.43

Shareholder rights plans (sometimes referred to as “poison pills”) take the form of the issuance of rights to purchase shares of an issuer’s capital stock. These rights are attached to the shares of the issuer’s common stock and are issued each time a share of common stock is issued.44 The underlying stock may be common stock or preferred stock. Although the discussion above with respect to opinions on the binding effect of rights to acquire securities applies to rights issued pursuant to rights plans, the potential use of rights plans as takeover deterrents, the associated fiduciary issues under state corporate law, and the unpredictable facts and circumstances that may have an effect on whether such rights are binding in any given situation created uncertainty as to whether counsel could give an unqualified Exhibit 5 opinion with respect to these rights.

Following discussions with representatives of the ABA Business Law Section, the Staff has provided guidance regarding the assumptions that it considers permissible in Exhibit 5 opinions on rights issued pursuant to shareholder rights plans. The Staff has stated that it will not object if an Exhibit 5 opinion stating that such rights are binding obligations includes language to the effect that:

[1] the opinion does not address the determination a court of competent jurisdiction may make regarding whether the board of directors would be required to redeem or terminate, or take other action with respect to, the rights at some future time based on the facts and circumstances existing at that time;

[2] board members are assumed to have acted in a manner consistent with their fiduciary duties as required under applicable law in adopting the rights agreement; and

[3] the opinion addresses the rights and the rights agreement in their entirety, and it is not settled whether the invalidity of any particular provision of a rights agreement or of rights issued thereunder would result in invalidating such rights in their entirety.45

IV. PARTICULAR TYPES OF OFFERINGS

Opinion practice varies, depending not only on the type of securities being offered, but also on the type of offering. A signed Exhibit 5 opinion—not simply an unsigned form of opinion—must be on file in order for the registration statement to be declared or become effective.46

A. SHELF OFFERINGS

Shelf offerings under Rule 415 permit issuers to offer and sell securities long after a registration statement becomes effective.47 Moreover, in the case of universal shelf registrations, the class or classes and types of securities to be offered and sold may not be known on the effective date. Exhibit 5 opinion practice has evolved to accommodate shelf offerings.

1. Shelf Registrations for Common Stock

When an issuer registers common stock to be issued from time to time in the future, the opinion should state that the shares have been duly authorized. The remainder of the opinion, however, often requires assumptions that various actions will be taken before the shares are issued. In addition to the assumptions that apply whenever shares are being issued in the future, such as the issuer’s receipt of the required consideration, the opinion giver typically will need to assume expressly that the board of directors adopts resolutions approving the issuance and sale of the common stock at a specified price or pursuant to a specified pricing mechanism.

If the opinion is filed prior to effectiveness of the registration statement and the only substantive assumptions are that specified actions required to set the sale price of the shares will be taken and that the consideration for their issuance and sale will be received, no further opinion will be required when the shares are issued so long as the specified actions are permitted by the law of the jurisdiction where the issuer was formed and the issuer’s constituent documents.

Some issuers filing a shelf registration statement for common stock register a specific number of shares rather than an aggregate dollar amount. If the issuer decides to register an aggregate dollar amount of common stock, the opinion giver should expressly assume that no more than a specified number of shares, based on the then current market price, will be issued and sold under the registration statement and should confirm that the number of shares so specified is authorized and available under the issuer’s charter. If the issuer ultimately wishes to sell more shares than were covered by the original opinion or the opinion includes other substantive assumptions, a new unqualified opinion should be filed at the time of the sale as described below.

2. Universal Shelf Registrations

Universal shelf registrations permit issuers to register an aggregate dollar amount of securities, designating by class the various types of securities (e.g., common stock, debt securities, convertible debt securities, preferred stock, and warrants) that may subsequently be issued, without allocating such aggregate dollar amount among the several types of securities. In addition, following the adoption of securities offering reform in 2005,48 a universal shelf registration statement filed by a well-known seasoned issuer (a “WKSI”)49 may omit altogether any specific amount of securities registered, thus registering an unspecified and indeterminate aggregate initial offering price or number of securities.50 An Exhibit 5 opinion for a universal shelf registration statement thus requires more assumptions than even a shelf registration for a particular class of security. The board of directors typically will not have approved the terms of the debt securities or preferred stock at the time of effectiveness of the shelf registration statement. In the case of common stock, the issuer may not have sufficient authorized shares to permit an opinion that, were the issuer to elect to sell the entire aggregate dollar amount of securities registered as common stock at current market prices (or, in the case of universal shelf filed by a WKSI, were the issuer to elect to sell any common stock whatsoever), the stock to be sold has been duly authorized.51 Assumptions and qualifications, therefore, are necessary, and the Staff has not objected to opinions that include appropriate assumptions.

3. Filing Updated Opinions

Shelf registration was not contemplated at the time Congress enacted the legality opinion requirement. Permitting assumptions in Exhibit 5 opinions is necessary for the shelf registration process to work. Consistent with a position it had previously taken in its telephone interpretations, in Staff Legal Bulletin No. 19 the Staff permits the filing, before a shelf registration statement is declared or becomes effective, of an Exhibit 5 opinion that includes assumptions regarding the future issuance of the securities being registered that “would not generally be acceptable in connection with a non-shelf offering.”52 In Staff Legal Bulletin No. 19, however, the Staff, again consistent with its previous position, conditioned inclusion of those assumptions on the filing of “an appropriately unqualified opinion . . . no later than the closing date of the offering of the securities covered by the registration statement.”53

Thus, in connection with a shelf registration statement, counsel for the issuer typically files more than one opinion: an opinion before the registration statement becomes effective and subsequent opinions for each takedown. The initial opinion is highly qualified and contains broad assumptions intended to address the different securities being registered for subsequent issuance. The subsequent opinions, which are filed no later than the closing date for the offering to which they relate, address the particular securities being issued and take the form of a traditional unqualified Exhibit 5 opinion.

In filing an updated opinion, an issuer can make an exhibit-only filing pursuant to Rule 462(d), which provides for the immediate effectiveness of post-effective amendments filed solely to include exhibits.54 Alternatively, for shelf offerings conducted by an issuer under Rule 415(a)(1)(x), which must be registered under Form S-3 or F-3,55 the opinion may be incorporated by reference into the registration statement through a Form 8-K or 6-K filing.56

B. ACQUISITIONS AND EXCHANGE OFFERS

Acquisitions and exchange offers that involve the offer and sale of securities are registered on Form S-4. These registration statements require an Exhibit 5 opinion on the securities being issued in the acquisition. Often the issuance of the securities being registered requires the approval of shareholders, whether as a requirement of state corporation law or a securities exchange. Because an opinion must be on file before the registration statement is declared effective, as with shelf registrations, these opinions may be based on an express assumption that the required shareholder approval will be received.57 As with a qualified opinion filed prior to the effectiveness of an initial shelf registration statement, any such qualified opinion must be supplemented by an unqualified opinion filed by post effective amendment or on Form 8-K or Form 6-K, as out-lined above, no later than the closing date of the exchange offer.58

_____________

* The Task Force included members of the Legal Opinions Committee and the Subcommittee on Securities Law Opinions of the Committee on Federal Regulation of Securities of the American Bar Association Business Law Section. This Updated Report is being issued by the Subcommittee on Securities Law Opinions. Keith F. Higgins served as reporter for the 2004 Report and Andrew J. Pitts served as reporter for this 2013 Update.

1. SEC Staff Legal Bulletin No. 19 (Oct. 14, 2011), 2011 WL 4957889 [hereinafter SLB 19], available at http://www.sec.gov/interps/legal/cfslb19.htm. In addition to the guidance on Exhibit 5 opinions discussed in this 2013 Update, SLB 19 provides guidance on Exhibit 8 tax opinions. Id. On April 4, 2012, the New York State Bar Association published a report on tax opinions in registered offerings. See N.Y. STATE BAR ASS’N TAX SECTION, REPORT ON TAX OPINIONS IN REGISTERED OFFERINGS (2012), available at http://www.nysba.org/Content/ContentFolders20/TaxLawSection/TaxReports/1261NYSBATaxSectionReportonTaxOpinionsinRegisteredOfferings.pdf.

2. 15 U.S.C. § 77g(a) (2012).

3. Id. § 77aa(29).

4. 17 C.F.R. § 229.601 (2013).

5. Id. § 229.601(b)(5).

6. This is in contrast to third-party closing opinions, which often expressly limit reliance.

7. SLB 19, supra note 1, § II.B.3.d.

8. If there is a long delay between the initial filing of the registration statement and the effective date, the Staff previously required that an updated opinion be filed before declaring the registration statement effective. Recently, Staff members have indicated that the Staff no longer requires the filing of an updated opinion solely because of the passage of time. This position is based on the recognition that under section 11 of the Securities Act the opinion must be correct at the time the registration statement becomes effective regardless of when the opinion is dated or filed. Therefore, should the opinion cease to be correct, for example as a result of a change in the law, after it is filed and before the registration statement becomes effective, counsel would have to file an updated opinion even if an update is not requested by the Staff.

9. See infra Part IV.A.3. The Staff formerly asked counsel to remove language from the opinion stating that counsel had no duty to update the opinion, but Staff members recently indicated that the Staff had changed this practice and will no longer ask for that language to be removed.

10. SLB 19, supra note 1, § II.B.3.a. The Staff has specifically noted that counsel may not assume conclusions of law relevant to the opinion, e.g., that the issuer is “legally incorporated; has sufficient authorized shares; is not in bankruptcy; or has taken all corporate actions necessary to authorize the issuance of the securities.” Id.

11. Id. § II.B.3.a n.32 (citing, e.g., TriBar Opinion Comm., Third-Party “Closing” Opinions: A Report of the TriBar Opinion Committee, 53 BUS. LAW. 592, 615 (1998) (§ 2.3(a)) [hereinafter TriBar 1998 Report]). Many bar association reports describe opinion practice in particular states. By following the approach taken for third-party closing opinions, opinion givers should be able to rely on the substantial body of literature describing customary practice regarding those opinions.

12. See infra Part IV.B.

13. 17 C.F.R. § 230.436(a) (2013).

14. 15 U.S.C. § 77g(a) (2012).

15. 17 C.F.R. § 230.436(a) (2013).

16. Id.

17. SLB 19, supra note 1, § IV.

18. Id. (citing Div. of Corp. Fin., Securities Act Rules Compliance and Disclosure Interpretations §§ 233.01–.02, SEC.GOV (Nov. 26, 2008), http://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm).

19. 17 C.F.R. § 230.436(f ) (2013).

20. SLB 19, supra note 1, § II.B.1.e. The Staff further notes that in such a situation, while primary counsel’s opinion cannot then “assume” the matters for which it is relying on the other counsel’s opinion, it may nevertheless “note that [primary counsel’s] opinion as to these matters is subject to the same qualifications, assumptions and limitations as are set forth” in the other counsel’s opinion. Id. § II.B.1.e. n.21.

21. Id. § II.B.1.e.

22. 17 C.F.R. § 229.601(b)(5) (2013). The Staff outlines its understanding of the meanings of each of “legally (or validly) issued,” “fully paid,” and “non-assessable” in detail in SLB 19, supra note 1, § II.B.1.a.

23. In the case of a corporation, shares must be duly authorized to be validly issued, and the opinion as to due authorization is subsumed in the “validly issued” opinion. The Staff also has provided guidance on the meaning of these concepts and the form of the Exhibit 5 opinion when the issuer is not a corporation but rather a limited liability company, limited partnership, or statutory trust. See SLB 19, supra note 1, § II.B.1.b. With respect to limited liability companies, the Staff has indicated that it will accept the form of opinion set forth in TriBar Opinion Comm., Supplemental TriBar LLC Opinion Report: Opinions on LLC Membership Interests, 66 BUS. LAW. 1065, 1072 n.43 (2011).

24. SLB 19, supra note 1, § II.B.1.a.

25. See DONALD W. GLAZER ET AL., GLAZER AND FITZGIBBON ON LEGAL OPINIONS: DRAFTING, INTERPRETING AND SUPPORTING CLOSING OPINIONS IN BUSINESS TRANSACTIONS § 10.1, at 409–10 n.3 (3d ed. 2008).

26. See, e.g., TriBar 1998 Report, supra note 11, at 648–52 (discussing third-party closing opinions). The Staff has noted that “[i]f counsel does not opine that the securities will be legally issued, the Division [of Corporation Finance] will not accelerate the effectiveness of the registration statement. On the other hand, if counsel opines that the securities are not fully paid or are assessable, the effectiveness of the registration statement may be accelerated so long as the disclosures about partial payment or assessability are adequate.” SLB 19, supra note 1, § II.B.1.a.

27. For example, this practice is usually followed when, in reliance on Rule 430A, the registration statement is declared effective before pricing occurs. See generally 17 C.F.R. § 230.430A(a) (2013) (indicating that a registration statement that omits the public offering price may be declared effective); see also SLB 19, supra note 1, § II.B.3.a.

28. Unless, as discussed below, the opinion is being given in the context of a shelf registration of securities for future sale and a subsequent unqualified opinion will be filed in connection with each specific offering. See supra Part II.B; see also infra Part IV.A.

29. SLB 19, supra note 1, § II.B.3.b. In general, the Staff does not require that counsel be admitted to practice in the jurisdiction whose law is covered by the opinion, but it will object if an opinion states that counsel is not qualified to opine on the law of the covered jurisdiction.

30. Id.

31. Id. § II.B.3.c. In 2000, the Staff had revised its procedures to require counsel to confirm to the Staff in writing that reference to the “Delaware General Corporation Law” included not only the statutory provisions, but also all applicable provisions of the Delaware Constitution and reported judicial decisions interpreting that law. With the publication of Staff Legal Bulletin No. 19, however, that requirement was eliminated. In addition, in 2004, the specific provision of the Delaware Constitution addressing the due issuance of stock of Delaware corporations was repealed.

32. Similarly, opinions on Delaware limited liability companies and limited partnerships that are limited to the Delaware Limited Liability Company Act or the Delaware Revised Uniform Limited Partnership Act are now routinely accepted by the Staff.

33. SLB 19, supra note 1, § II.B.3.c.

34. 17 C.F.R. § 229.601(b)(5) (2013). When debt securities are guaranteed, counsel must also give an opinion that each guarantee will be the binding obligation of the applicable guarantor. SLB 19, supra note 1, § II.B.1.e.

35. TriBar 1998 Report, supra note 11, at 622–23 (noting the bankruptcy exception and equitable principles limitation to an “enforceability” opinion). The bankruptcy exception and equitable principles limitation are standard exceptions that are understood to apply even when not stated expressly. Id. at 623. These exceptions do not require prospectus disclosure, and the Staff does not object to their being stated expressly. SLB 19, supra note 1, § II.B.1.e.

36. TriBar 1998 Report, supra note 11, at 619–20.

37. Furthermore, the Staff has noted that “counsel need not expressly state in the opinion that the agreement or instrument pursuant to which the debt security or guarantee is issued, such as an indenture, is enforceable in accordance with its terms, although the opinion may include such language.” SLB 19, supra note 1, § II.B.1.e.

38. TriBar 1998 Report, supra note 11, at 635 n.98.

39. SLB 19, supra note 1, at § II.B.1.e. n.19.

40. See id. The Staff permits counsel to exclude federal law (including the federal securities laws) and state securities laws from the coverage of the opinion. Id. § II.B.3.c. See also supra Part II.C. Because the opinion need only cover the legality of the issue under state law, such exclusions are not required whether or not the Exhibit 5 opinion contains a statement that the opinion is limited to applicable state corporation law (e.g., the Delaware General Corporation Law).

41. Counsel should keep in mind that “boilerplate” exceptions that do not relate to the securities being offered are likely to be questioned by the Staff.

42. This is the case even though an option, warrant, or right fits the definition of “equity security” in Rule 405 under the Securities Act. 17 C.F.R. § 230.405 (2013).

43. SLB 19, supra note 1, § II.B.1.e. In the case of warrants to purchase debt securities, the opinion on the underlying securities would track the opinion required to be given in respect of debt securities.

44. The rights only become separable from the issuer’s common stock and exercisable under specified circumstances, typically involving the acquisition by a third party of beneficial ownership of a specified percentage of the issuer’s common stock. Delaware courts generally have tested the validity of rights under shareholder rights plans under the Delaware General Corporation Law rather than as a matter of traditional contract law. See, e.g., Leonard Loventhal Account v. Hilton Hotels Corp., No. Civ. A. 17803, 2000 WL 1528909 (Del. Ch. Oct. 10, 2000), aff ’d sub nom. Account v. Hilton Hotels Corp., 780 A.2d 245 (Del. 2001); Moran v. Household Int’l, Inc., 500 A.2d 1346 (Del. 1985). In addition, the corporation statutes of many states contain a provision that expressly permits the issuance of rights under shareholder rights plans.

45. SLB 19, supra note 1, § II.B.1.g.

46. Id. § II.B.2.a.

47. 17 C.F.R. § 230.415 (2013).

48. Securities Offering Reform, Securities Act Release No. 33-8591, 70 Fed. Reg. 44722 (Aug. 3, 2005) (to be codified at 17 C.F.R. pts. 200, 228, 229, 230, 239, 240, 243, 249 & 274) (effective date of Dec. 1, 2005).

49. 17 C.F.R. § 230.405 (2013) (defining “well-known seasoned issuer”).

50. Securities Offering Reform, supra note 48, at 44771, 44779; see also 17 C.F.R. § 230.430B(a) (2013) (indicating the types of information that may be omitted from a shelf registration statement when it is declared effective or, in the case of an automatic shelf registration statement, when it becomes effective).

51. This problem can be solved, for example, by assuming that, after the sale of shares of common stock under the registration statement, the total issued shares will not exceed the number of authorized shares in the issuer’s certificate or articles of incorporation, an assumption to which the Staff does not object in the context of a shelf offering. SLB 19, supra note 1, § II.B.2.a. n.25.

52. See id. § II.B.2.a.

53. Id.

54. 17 C.F.R. § 230.462(d) (2013).

55. Id. § 230.415(a)(1)(x).

56. See SLB 19, supra note 1, § II.B.2.a.

57. An assumption will not be necessary, however, if shareholder approval is needed solely to satisfy listing requirements because the shares would still be validly issued even if shareholder approval is not obtained.

58. SLB 19, supra note 1, § II.B.2.d. The Staff ’s position appears to be that the requirement to file an unqualified opinion by closing applies in any situation in which an initial and necessarily qualified opinion has been filed prior to the effectiveness of any type of registration statement (e.g., an acquisition shelf registration statement with respect to which an initially filed opinion necessarily assumed that the number of shares to be offered and sold will not exceed the number of shares authorized in the issuer’s certificate or articles of association, and that the board will adopt resolutions in appropriate form and content authorizing the issuance and sale of the shares). Id.

 

Non-Uniform Filing Rules Will Remain Despite the 2010 Amendments to UCC Article 9

Posted on July 17, 2013 by - Uncategorized

There may be legal professionals who expect that the 2010 Amendments to UCC Article 9 (the Amendments) will finally do away with all those pesky non-uniform filing requirements that states have enacted over the years. Unfortunately, that won’t happen. While the Amendments do provide many welcome revisions, very few states have used the enactment process to replace non-uniform filing provisions with the official text from Part 5 of Article 9.

The remaining non-uniform filing requirements pose risks for UCC filers because they are not always obvious. This article identifies by state a sampling of non-uniform departures from the official text of Article 9 that will not be affected by enactment of the Amendments. This article also offers some suggestions to avoid the potentially costly traps non-uniform versions of Article 9 create for those who file UCC records.

Florida

A non-uniform addition to Fla. Stat. § 679.512(1)(a) requires that all amendments provide the names of the debtor and secured party of record. The filing office refuses to accept an amendment that omits the party names under Section 679.516(2)(c) on the grounds that the record fails to correctly identify the initial financing statement in compliance with Section 679.512(1)(a).

Ordinarily, a rejected amendment poses little risk for the secured party. The filer will simply resubmit a corrected version after receiving the rejection notice. Unless, of course, the filing office rejects a time-sensitive record, such as a continuation statement submitted at the end of the six-month window. In that case, the secured party could be at risk. Consequently, a UCC filer should always include the party names when filing an amendment in Florida. The party names can be provided either on the amendment form, space permitting, or on an attached exhibit.

Georgia

The official text of UCC § 9-515(a) provides the general rule that a financing statement is initially effective for five years. There are some exceptions, however. If the record indicates that it is filed in connection with a public-finance or manufactured-home transaction, then Section 9-515(b) provides that it is effective for 30 years. Likewise, if the record indicates that the debtor is a transmitting utility, then Section 9-515(f) makes it effective until terminated.

Some states omitted either public-finance or manufactured-home transactions from the scope of Section 9-515(b). Georgia, however, omitted the official text of subsections (b) and (f) entirely from Ga. Code Ann. § 11-9-515. As a result, all financing statements filed in Georgia are initially effective for a five-year period, no exceptions.

If a secured party sets its continuation tickler based on the assumption that Georgia law follows the uniform effective periods, it will not be reminded to file a continuation statement at the correct time and the record will lapse.

Georgia’s version of Article 9 also creates a trap for the unwary UCC filer when the collateral includes growing crops. Georgia law treats growing crops in the same manner as timber to be cut, as-extracted collateral and fixtures. In other states there are no special requirements for financing statements that cover growing crops.

Under Ga. Code Ann. § 11-9-501(a)(1)(A), however, the proper place to file a financing statement covering growing crops is the same office where a mortgage would be recorded on the affected real property, not the regular UCC index. Likewise, a financing statement that covers growing crops must satisfy the additional Section 11-9-502(b) content requirements for records that cover real-estate-related collateral. Unless a financing statement covering growing crops located in Georgia is filed in accordance with Section 11-9-501(a)(1)(A) and Section 11-9-502(b), then the secured party may find itself with an unperfected security interest.

The Amendments may bring one significant Georgia statutory deviation back into uniformity with the official text. Under current Section 11- 9-502(c), a record of a mortgage cannot be effective as a financing statement filed as a fixture filing. The bill introduced in Georgia this year to enact the Amendments replaces current Section 11-9-502(c) with the uniform text from UCC § 9-502(c). However, the legislation, as introduced, will not change the other non-uniform provisions described above.

Idaho

Perfecting a security interest in any farm products requires special care in Idaho. If a security interest includes farm products as collateral, non-uniform Idaho Code Ann. § 28-9-502(e) imposes additional requirements for the sufficiency of the financing statement.

Under the official text of UCC § 9-502(a), a financing statement is sufficient if it provides just three pieces of information: the name of the debtor, name of the secured party, and an indication of the collateral. There are no special rules for the sufficiency of a financing statement that cover farm products.

In Idaho, however, Section 28-9-502(e) applies the federal requirements for an “Effective Financing Statement,” as defined in 7 U.S.C. § 1631(c)(4) of the Food Security Act, to the sufficiency of a UCC financing statement that covers farm products. Under this non- uniform provision, a written financing statement covering farm products is sufficient if it provides the names and addresses of the parties, is signed or authenticated by the debtor, and includes the debtor’s Social Security Number (SSN) or other unique identifier selected by the secretary of state. Moreover, the record must describe the farm products by category and identify the locations by county where the farm products are produced or located.

To further complicate matters, the content requirements differ for records filed electronically and those submitted on written forms. For example, the debtor must sign or otherwise authenticate a written UCC record that covers farm products. The same record submitted electronically, however, would not require the debtor’s signature or authentication.

Indiana

A non-uniform provision added to Ind. Code § 26-1-9.1-502 imposes a unique duty on the secured party following the filing of a financing statement. Subsection (f) requires the secured party to furnish a copy of a financing statement to the debtor within 30 days of the file date. The provision also places the burden of proving compliance with this requirement squarely on the secured party.

It is significant that the text of Section 26-1-9.1-502(f) does not limit the secured party’s responsibility to providing the debtor with a copy of just an “initial financing statement.” Instead, subsection (f) uses the broader term “financing statement.” The official text of Article 9 and Ind. Code § 26-1-9.1-102(a)(39) both define “financing statement” to include any filed record related to the initial financing statement. Consequently, this provision arguably requires the secured party to send the debtor a copy not just of the initial financing statement, but also any related amendments filed at a later date.

A secured party’s failure to send a copy of the filed record to the debtor will not make the record ineffective. Nevertheless, there are potential costs if the secured party overlooks this requirement. A secured party that fails to comply with subsection (f) is subject to the penalties set forth in Ind. Code § 26-1-9.1-625. To play it safe, a prudent UCC filer should promptly send the debtor a copy of any UCC record filed in Indiana by a method that provides proof of delivery.

Louisiana

The risk of filing office error generally falls on those who search the UCC records. A secured party is protected against a filing office indexing error by UCC § 9-517. Likewise, UCC § 9-516(d) partially protects the secured party when the filing office wrongfully refuses to accept the record, except in Louisiana.

Louisiana omitted subsection (d) when it enacted La. Rev. Stat. § 10:9-516. Consequently, a record wrongfully rejected by a Louisiana filing office through no fault of the secured party is nevertheless ineffective against other creditors.

To avoid the risk caused by the omission of UCC § 9-516(d) in Louisiana, filers should assume that a wrongfully rejected record is ineffective. The UCC filer must respond promptly to any notice of rejection from a Louisiana filing office and do what it takes to get the record filed.

South Dakota

Prior to 2001, several states required financing statements to include the SSN of an individual debtor. By early 2012, only South Dakota still required an individual’s SSN by statute for all financing statements. It was widely hoped that South Dakota would use the Amendments legislation as an opportunity to finally eliminate the SSN requirement. That did not happen. When it enacted the Amendments in March 2012, South Dakota retained the SSN requirement for sufficiency in S.D. Codified Laws § 57A-9-502(a)(1).

UCC filers must continue to provide an individual debtor’s SSN on any financing statement submitted in South Dakota or the filing office will reject the record. Moreover, the SSN is a requirement for sufficiency under S.D. Codified Laws § 57A-9-502(a)(1). A record without the SSN may not be effective even if the filing office accepts it. The safest course of action, therefore, is to ensure that all financing statements submitted to a South Dakota filing office provide the individual debtor’s SSN.

Wyoming

In 2013, Wyoming enacted a significant non-uniform amendment to the Article 9 financing statement duration and effectiveness rules. The new law amends Wyo. Stat. Ann. § 34.1-9-515(a) to provide that financing statements filed after July 1, 2013, will be effective for 10 years. In addition, the filing of a continuation statement after July 1, 2013, will extend the effectiveness of the related financing statement for an additional 10-year period.

The reasoning behind this non-uniform departure from the official text of UCC § 9-515(a) is that a growing number of finance transactions now extend beyond five years. A 10-year effective period for financing statements reduces the risk that a lender would inadvertently miss the continuation deadline and become unperfected. It also saves lenders the cost of filing continuation statements because nearly all transactions will conclude within that 10-year period.

A 10-year effective period for UCC financing statements should reduce the number of instances where a record inadvertently lapses because the secured party missed the continuation deadline. Whether this benefit outweighs the added costs of a longer effective period remains to be seen. It will take several years before the lenders and debtors feel the full impact of the increased transaction costs.

Conclusion

The states listed above are by no means the only jurisdictions that enacted UCC Article 9 with non-uniform filing requirements. Perhaps someday, every state will finally adopt the full official text of the Article 9 filing provisions. Until then, non-uniform filing requirements will continue to create risk for secured parties and their legal counsel. The best way to limit that risk is never to assume that the filing requirements are entirely uniform. The UCC filer must carefully review the statutory requirements prior to filing in a particular state.

Exit Stage Left: Getting out of Your Limited Liability Company

Posted on July 17, 2013 by - Uncategorized

At the outset of any relationship, be it professional or personal, the parties to the relationship are not interested in discussing how it will end. For various reasons, many investors in limited liability companies (LLCs) seek to exit those companies by seeking judicial dissolution of the LLC. Based on recent case law in Delaware, however, members of an LLC should not take comfort in, or rely upon, the statutory provisions of the Delaware Limited Liability Company Act (DLLCA) as an “exit mechanism.” Although Section 18-802 of the DLLCA provides a possible exit mechanism for members of an LLC, recent case law has shown that the Delaware courts are loath to dissolve an LLC merely because of changed circumstances, including bad economic conditions or a failure by the LLC to perform as anticipated. (Although the focus of this article is Delaware limited liability companies, the discussion with respect to exit mechanisms is applicable to LLCs formed in other jurisdictions as well.)

The DLLCA (Section 18-1101(b) of the Delaware Limited Liability Company Act) and relevant case law (Ross Holding & Mgmt. Co. v. Advance Realty Group LLC, 2010 WL 3448227, at *5 (Del. Ch. Sept. 2, 2010)) make clear that LLCs are creatures of contract and provide the members with substantial flexibility to tailor a business relationship in a manner that best suits their needs. Given the contractual flexibility provided by the DLLCA, members of an LLC and counsel drafting the limited liability company agreement (LLC Agreement) should be careful to include terms in the LLC Agreement that will provide the parties with an exit mechanism that meets the goals and objectives of the members. Depending on the purpose for which the LLC is being formed and the tenor of the negotiations between the parties to the LLC Agreement, it may be desirable for the members to rely on the statutory exit mechanism provided by the DLLCA. In the event the parties will rely on the statutory exit mechanism, the nature of this statutory exit mechanism should be explained to the members prior to entering into the LLC Agreement to ensure they understand the limits of the exit mechanism provided by the DLLCA. This article highlights the importance of addressing the issue of exit mechanisms in an LLC Agreement and provides a brief description of possible exit mechanisms that could be included in an LLC Agreement.

The DLLCA Default Provisions

In the event an LLC Agreement does not contain an exit mechanism, the members’ ability to exit the LLC will be governed by the default provisions of the DLLCA. Under Section 18-603 of the DLLCA, a member of an LLC does not have the right to withdraw from an LLC unless the LLC Agreement specifically provides such right. Therefore, unless a member has the right to resign under the LLC Agreement, a member cannot resign or withdraw from the LLC until it has been dissolved and wound up pursuant to its LLC Agreement or the DLLCA. Under Section 18-801 of the DLLCA, an LLC shall be dissolved (1) as provided in its LLC Agreement, (2) upon the requisite vote of members of the LLC, (3) at any time the LLC has no members, unless the LLC is continued as provided in the DLLCA or (4) upon an entry of a decree of judicial dissolution under Section 18-802 of the DLLCA.

The typical multi-member LLC Agreement is drafted in such a way that the LLC is dissolved solely upon a vote of the members (which vote often requires the consent of multiple members) or upon a judicial dissolution pursuant to Section 18-802 of the DLLCA. Thus, a typical multi-member LLC Agreement will not allow a member to unilaterally withdraw or cause the dissolution of the LLC. Therefore, if a member of an LLC governed by such an LLC Agreement determines, for any number of reasons, that it wants to exit the LLC, neither the LLC Agreement nor the DLLCA would provide the member with attractive options to exit the LLC. Such member may either (1) negotiate with the other members of the LLC for an exit acceptable to such member or (2) petition the Court of Chancery of the State of Delaware for the judicial dissolution of the LLC. The foregoing options may not be appealing to the member desiring to withdraw because none of the options can be taken unilaterally by such member.

With respect to the first option, negotiating an exit with the other members, the member that desires to withdraw will need to persuade the other members, or the LLC, to purchase its interest (which may not be a viable option for the LLC or the other members); or, such member will need to persuade the other members to dissolve the LLC. Presumably, the other members will only agree to either of the foregoing options if it makes business sense for them to do so at that time. Therefore, the member that desires to withdraw will have little influence over its power to withdraw. In the event that such member is unable to persuade the other members to purchase its interest or dissolve the LLC, such member may seek judicial dissolution of the LLC pursuant to Section 18-802 of the DLLCA.

Under Section 18-802 of the DLLCA, “on application by or for a member or manager the Delaware Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” At first blush, the statutory exit mechanism provided in Section 18-802 of the DLLCA may appear to be a reasonable option for parties to rely upon instead of having the difficult discussion at the formation of the LLC about how members may exit the LLC. But the case law applying and interpreting Section 18-802 of the DLLCA makes clear that such reliance may not be justified. The Delaware Court of Chancery has made clear that the remedy of judicial dissolution is an extreme remedy that should be used sparingly, and even if a petitioner is successful in proving the requisite elements under Section 18-802 of the DLLCA, as described by the court, it is still within the court’s discretion to grant judicial dissolution. In re Arrow Inv. Advisors, LLC, 2009 WL 1101682, at *2 (Del. Ch. Apr. 23, 2009).

Under Section 18-802 of the DLLCA, the case law shows that the Delaware Court of Chancery will grant judicial dissolution if either (1) the purpose for which the LLC was created no longer exists or can no longer be achieved (i.e., “frustration of purpose”) or (2) a deadlock exists. With respect to a petition for judicial dissolution due to “frustration of purpose,” the petitioner will need to show that it is not reasonably practicable for the LLC to carry on its business in conformity with its LLC Agreement because the defined purpose of the LLC can no longer be fulfilled. With respect to a judicial dissolution due to a deadlock, the Delaware Court of Chancery has found that the following factors are relevant (although no one factor is dispositive): (1) is there a deadlock?, (2) does the governing document provide a means of navigating around the deadlock?, and (3) whether due to the LLC’s financial position, is there still a business to operate? See Fisk Ventures v. Segal, 2009 WL 73957 (Del. Ch. January 13, 2009). Thus, due to the difficulty of obtaining a decree of judicial dissolution, Section 18-802 of the DLLCA may offer cold comfort to a member that wants to exit an LLC. The expense of a full trial litigating judicial dissolution will not be attractive to a member, particularly when the outcome – even if the member is successful in proving the “requisite elements” required under Section 18-802 of the DLLCA – is within the Court of Chancery’s broad discretion. Thus, this article recommends that counsel and his or her client consider including an appropriate exit mechanism in a multi-member LLC Agreement. A well drafted exit mechanism will save the parties money and time, should one of the parties wish to withdraw from the LLC.

Exit Mechanisms

Section 18-1101(b) of the DLLCA states that “[i]t is the policy of the [DLLCA] to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Further, the Delaware Court of Chancery has stated that LLC Agreements are creatures of contract; therefore the options available to members of an LLC in crafting exit mechanisms are vast. In drafting the exit mechanism provisions, counsel should understand the goals and objectives of the client and try to identify the circumstances that might cause the client to want to withdraw from the LLC. The reasons for wanting to withdraw from an LLC are limitless, but some of the reasons that typically crop up are listed below:

  • Purpose. A member may want to withdraw from an LLC because the defined purpose of the LLC can no longer be fulfilled. For example, the defined purpose of an LLC may be frustrated if the company was formed to develop and market technology that has since become obsolete. However, if the purpose clause is broad and the client does not have authority to veto a decision to cause the LLC to enter into a different area of business, such member may find itself stuck in an undesirable line of business.
  • Member Breach. A member may want to withdraw from an LLC because of a breach of the LLC Agreement by another member. Or, even if the other member has not technically breached the LLC Agreement, a member may want to withdraw because the other member has failed to perform as expected and has not lived up to the benefit of the bargain made by the members.
  • Disagreement on Strategy. A member may want to withdraw from an LLC because the parties cannot agree on the LLC’s strategy. Often when this occurs, a deadlock will result if management is split equally and decisions require the consent of the other members.
  • Lock in Gains. A member may want to withdraw because the LLC has been successful and it wants to lock in and realize the gain on its investment.

Understanding the reasons why a member would want to withdraw from an LLC will enable counsel to draft appropriate exit mechanism provisions. Further, this exercise will help align the exit triggers with the exit mechanisms. Certain exit mechanisms may not match an exit trigger. For example, the parties to an LLC Agreement may not want to provide a breaching party with a “put” right upon its breach of the LLC Agreement, which could have the effect of rewarding the breaching member for its misconduct.

One indirect way to address exit mechanisms is for counsel drafting the LLC Agreement to ensure that the defined purpose clause in the LLC Agreement accurately reflects the objectives and purposes for the LLC. Members entering into a multi-member LLC Agreement should consider whether a broad or narrow purpose clause should be included in the LLC Agreement. A broad purpose clause will typically state that the LLC is formed for the purpose of engaging in any lawful act or activity for which Delaware limited liability companies can be formed. A broad purpose clause like the one described in the preceding sentence will make it difficult for a petitioner to obtain a judicial dissolution of the LLC for “frustration of purpose.” Thus, if the purpose for which the LLC is being created is narrow and limited, the defined purpose clause in the LLC Agreement should also be narrow and limited. Further, provisions should be added to the LLC Agreement to prohibit the LLC from operating for a different purpose, or amending the purpose clause, without unanimous member consent.

As noted above, possible exit mechanisms in an LLC Agreement are limited only by the imagination of the drafter, but a few options are as follows: (1) a right to terminate the LLC upon the occurrence of a specified event, (2) a right to “put” interests to the LLC or the other members upon the occurrence of a specified event, (3) a right of a member or the LLC to “call” interests in the LLC upon the occurrence of a specified event, (4) a buy-sell provision which gives the parties the right to either be a buyer or seller of the LLC interests upon the occurrence of a specified event, or (5) a right to sell all of the LLC interests in the company (or just the exiting member’s interest) upon the occurrence of a specified event. As previously noted, care should be taken by the drafter to correctly match an exit mechanism with an exit trigger to ensure that the parties to the LLC Agreement are incentivized to maximize the value of the enterprise consistent with their duties and obligations under the LLC Agreement.

Termination

Under Sections 18-801(a)(i) and (a)(ii) of the DLLCA, an LLC is dissolved upon the time specified in its LLC Agreement or upon the happening of events specified in the LLC Agreement. Thus, the parties to an LLC Agreement may want to provide that the LLC terminates upon the occurrence and/or non-occurrence of certain events specified in the LLC Agreement. Such a provision, with clear and objective triggers, will be helpful if the parties to the LLC Agreement disagree upon the strategic direction of the LLC. The range of triggers that might cause a termination of the LLC are limitless, but whatever the trigger is, the drafter of the LLC Agreement should take care to ensure the trigger is clear and objective in order to avoid litigation as to whether the trigger event in fact has occurred.

Put or Call Rights

Members of an LLC may want to include put or call rights with respect to their LLC interests in the LLC Agreement. Again, care should be taken by the drafter to ensure that the put or call right is correctly aligned with the appropriate trigger to create incentives that are desirable to the LLC and its members. Pursuant to a put right, the holder of such right will have the ability to cause the LLC, or the other members, to purchase its LLC interest upon the occurrence of certain events. A put right enables a member to monetize its LLC interest and withdraw upon the occurrence of certain events. In drafting the put right, and certain other exit mechanisms described below, the drafter of the LLC Agreement should carefully consider how the LLC interests will be valued and how the purchase of such LLC interests will be financed.

Similar to the put right, a member or the LLC may be granted a call right, which would give a member or the LLC the right to purchase another members’ interest in the LLC upon the occurrence of certain events. This right may be attractive to a member that no longer wishes to be in business with the other member due to that member’s breach, or some other reason. A call right would enable the holder of the call right to purchase a member’s interest upon certain trigger event(s). The valuation issues described above should also be considered with respect to a call right.

Buy-Sell Provision

Members of an LLC may want to include a buy-sell provision in the LLC Agreement. In using this type of exit mechanism, a member will set a price at which it would be willing to buy or sell its LLC interests. The other member then has the right to either buy or sell at the offering member’s suggested purchase price. This right will allow members to terminate their relationship, presumably at a fair price. The purchase price should be fair because the initiating member will presumably suggest a fair price because it will not know at the outset whether it will be a buyer or seller.

Sale Rights

Another exit mechanism that the members may want to include in the LLC Agreement is the right to sell the LLC or the right of the exiting member to sell its interest in the LLC to a third party. Typically, a multi-member LLC Agreement will contain transfer restrictions that prohibit a member from transferring its interest in the LLC to a third party without the consent of the other members. But the parties to an LLC Agreement may want to consider adding a provision that allows a member to sell the LLC or its interest in the LLC to a third party. If the sale right provision will permit the exiting member to cause the sale of the LLC as a whole, then the LLC Agreement will also need to contain a drag-along provision to force the other members to sell their LLC interests in the LLC to the third party.

Additional Provisions

In addition to the foregoing exit mechanisms, the parties may also want to consider adding dispute resolution provisions to resolve any disputes among the members, including disputes over valuing the LLC interests in connection with any of the exit mechanisms described above. This would be particularly important in an LLC with two members in which management is split equally and decisions require the consent of the other member. The drafters of the LLC Agreement should specify whether the exit mechanisms set forth in the LLC Agreement are intended to trump the default provisions of the DLLCA or simply supplement those provisions. Thus, the parties should consider whether members should retain the right to seek judicial dissolution in spite of the negotiated exit mechanisms set forth in the LLC Agreement.

Conclusion

The foregoing discussion is not meant to suggest that an inordinate amount of energy, time, or expense should be devoted to drafting the exit mechanisms contained in an LLC Agreement. But rather, the purpose of this article is to suggest that as part of the process of negotiating and drafting an LLC Agreement, the members should consider how the parties will exit the LLC. In spite of the foregoing suggestion, the author recognizes that at times it may be preferable for members of an LLC to not address termination or exit provisions at the outset, because it would be better to address those issues at the time a member wishes to exit the LLC based on the circumstances as they exist at that time. Nevertheless, the parties to the LLC agreement should realize the consequences of that decision and the risk that the parties may not be able to agree as to acceptable exit terms; and furthermore, reliance on the judicial dissolution provision in the DLLCA may not be warranted, considering the lack of success that parties have had petitioning the Delaware Court of Chancery for judicial dissolution. Although counsel representing an investor in an LLC should not assume the failure of the LLC or future discord among members of the LLC, he or she should carefully educate the client as to the risks involved and the possible ways to resolve such risks.

Nelson v. Knight: Can a Worker Be Fired for Being Too Irresistible?

Posted on June 14, 2013 by - Uncategorized

 

In December 2012, the Iowa Supreme Court issued a controversial ruling in a sex discrimination case brought under Iowa law. In Nelson v. Knight, the court held 7–0 that a male employer may fire a female employee, though she did nothing wrong, because his wife was concerned about their relationship. Although critics maligned the decision as manifestly unfair, it is consistent with the case law. But one can envision fact patterns that might lead to a different outcome. 

Nelson was a stellar dental assistant for Knight for 10 years. At some point they began texting about such innocuous matters as their children’s activities. Nelson (age 32) said she saw Knight (age 53) as a father figure and never sought an intimate relationship. Knight’s wife learned of the texts, however, and demanded that he fire Nelson. He did so, in part because of that demand, but also because he said he wasn’t sure he could avoid trying to have an affair with her otherwise. 

Iowa law, on this point, is modeled after Title VII of the 1964 Civil Rights Act, which prohibits employers with at least 15 employees from discriminating against an employee because of his or her sex. To have a viable disparate treatment claim, a plaintiff must prove that he or she suffered an adverse employment action (e.g., termination or a promotion denial), and that sexual identity was a motivating factor in the action. A claim for disparate impact discrimination lies where an employer has a facially neutral practice that has a disproportionately negative impact on a specific gender and is not justified by business necessity. 

Nelson advanced a straightforward “but-for” argument: she would not have been fired but for her gender. Knight said she was fired because of the perceived threat to his marriage. Nelson countered that the threat would not have existed had she not been female. After reviewing cases holding that an employer does not violate Title VII by firing a female employee involved in a consensual relationship that has triggered jealousy, although the relationship and jealousy presumably would not have existed had the employee been male, the court upheld the district court’s decision to grant summary judgment for Knight. 

The ruling has been criticized on a number of grounds. One is that it sends the message that men cannot be held accountable for their sexual desires and women have to monitor and control their bosses’ urges; if these urges get out of hand, women can be legally fired. In the end, however, the court found a distinction between an isolated personnel decision based on personal relations (assuming no coercion or quid pro quo), even if the relations would not have existed had the employee been of the opposite sex, and a decision based on gender itself. The court also stressed that Knight hired Nelson and also replaced her with a woman, which indicates that sex did not motivate the termination decision. 

The Knight court relied on Tenge v. Phillips Modern Ag. Co., where a business owner fired a valued employee at the urging of his wife. The difference was that Tenge “came on” to the owner so there were grounds for the wife’s suspicion of an intimate relationship. Noting that sexual favoritism – treating an employee better than the opposite sex because of a consensual relationship with the boss – does not violate Title VII because any benefits of the relationship are due to the employee’s sexual conduct, not gender, the court implicitly reasoned that treating an employee unfavorably due to such a relationship is legal. 

In Platner v. Cash & Thomas Contractors, Inc., which was also cited, an employer fired a female employee who worked on the same crew as his son after the son’s wife became jealous of her. Concluding that the owner was faced with an escalating family conflict that he resolved by firing a non-relative instead of his son, the court found that Platner was fired, not because of her gender, but because of favoritism for a close relative. Nepotism is unfortunate, said the court, but it does not violate Title VII. 

All of these courts stressed, as others have, that Title VII is not a general fairness law and an employer does not violate it by treating an employee unfairly as long as he or she does not act because of the employee’s protected status. This echoes U.S. Supreme Court Justice Scalia’s admonition in a 1998 sexual harassment case that Title VII is not a general workplace civility code. It is also consistent with the approach taken in a 2010 age discrimination case, where the U.S. Supreme Court held that a plaintiff can prevail only if he or she proves that age was not just a motivating factor in his or her termination, but the sole, or but-for, cause. 

Nelson did not claim sexual harassment, although Knight engaged in questionable conduct, e.g., telling her that if she saw his pants bulging, she would know her clothing was too revealing, and saying, regarding her infrequent sex life, that it was like having a Lamborghini in the garage and never driving it. Sexual harassment is a form of sex discrimination. It may be quid pro quo, where a tangible employment action is conditioned on the granting of sexual favors, or a hostile environment, where an employee is subjected to conduct that is unwelcome and sufficiently severe or pervasive to alter the conditions of one’s employment. Possibly, Nelson did not assert this claim because there was no evidence of an explicit or implicit quid pro quo or conduct that was non-consensual, unwelcome, severe, or pervasive in nature. Different facts, however, could support such a claim. 

The outcome might also be different if one fires several female employees because his wife was jealous of them; then, one might infer that gender, not the relationship, was the cause of the terminations. This could fit into the disparate impact category. One could also run afoul of the gender stereotyping theory, which establishes that sex discrimination occurs if an employer evaluates employees by assuming or insisting that they match the stereotype associated with their group. 

Recent case law is replete with examples of courts reading the “because of sex” language with increasing exactitude, largely due to the fear of making a Title VII case out of every arbitrary or unfair employment decision. The Knight case is consistent with this approach. What happened seems unfair, for had Nelson not been female Knight wouldn’t have had the feelings he had and she wouldn’t be out of a job. It is also, arguably, unsound business practice to fire a top-flight employee for the reasons Knight offered. In the end, however, the case reinforces the fact that unfair is one thing and illegally discriminatory is quite another. 

A Brief Guide to Intellectual Property in Hong Kong

Posted on June 14, 2013 by - Uncategorized

An entrepôt during its colonial era, Hong Kong has retained its strategic position as a trading hub in Asia and a gateway to China. With constant reinforcement of the “one-country, two-systems” principle, which is set to continue until 2047, the uncertainties that surrounded the 1997 handover have largely been removed, and while its long-term future may be uncertain, Hong Kong continues to have one of the most stable, effective, and certain legal systems in the world. With over 250 million tons of goods passing through it each year, and its proximity to China’s Pearl River Delta, one of the world’s worst intellectual property (IP) piracy and counterfeiting hotspots, Hong Kong is strategically important for all IP owners.

Under the “one-country, two-systems” principle, Hong Kong’s constitution, the “Basic Law,” specifically provides that Hong Kong should, on its own, develop appropriate policies and afford legal protection for IP rights. Therefore, despite being part of China, Hong Kong and China have separate legal systems. IP rights registered in Hong Kong will not be automatically protected in mainland China, and vice versa.

What Is Intellectual Property?

IP rights are proprietary rights granted to protect original products of creation. They are intended to encourage and reward creativity and fair competition in the marketplace. IP rights can be relied upon to prevent others from using one’s trademark, patented invention, copyright work, or design without consent. IP is territorial in nature and exists for set periods of time.

Hong Kong has had an English legal system for over 150 years, which was retained on the 1997 handover to China. The courts still rely on a great deal of English case law, and proceedings (whether administrative or judicial) can be conducted in either English or Chinese. Although its English legal system makes Hong Kong an ideal stepping stone for doing business in China, IP owners will need to pay extra attention to a number of issues that are unique to this city that stands between the East and the West.

Trademarks

What Is a Trademark?

A trademark can be a word, phrase, symbol, shape, color, sound, smell, or a combination of these used to identify a product or service. It functions as a badge of origin, helping consumers distinguish the products and services of one trader from those of another. In other words, a trademark helps consumers answer the questions “Who makes this product?” and “Who provides this service?” Word marks in Hong Kong can be in any language or dialect, and can be in Latin or Chinese characters. They can be transliterated between English and Chinese based on how they sound, or based on their meaning or some description of their characteristics or aspiration, or a combination of the two.

How Are Trademarks Protected in Hong Kong?

Trademarks that are used, or intended to be used, in Hong Kong can be registered with the Hong Kong Intellectual Property Department (IPD). The IPD does not differentiate between local and foreign proprietors.

Trademarks are registered in relation to particular goods or services. The Nice Classification, which is used internationally, sets out 45 classes of goods and services. In the majority of cases, an application will only be considered if the applicant is using or intending to use the mark on, or in relation to, the goods or services for which registration is sought. The system is a “first to use” system. Rights to a mark are determined on the basis of first use rather than registration. While an unregistered mark will be capable of protection, enforcement and commercialization will be easier and more satisfactory if the mark is registered.

Is My Trademark Registrable?

A trademark is not registrable if it is:

  • Merely descriptive (e.g., “Lavender Soap” for lavender-scented soap) or not sufficiently distinctive – unless you can show that the mark has acquired distinctiveness through extensive use;
  • Contrary to public policy or likely to deceive or confuse the public; or
  • Applied for in bad faith.

The trademarks examiner will also search the IPD’s register for any conflicting prior applications or registrations. The examiner will object to an application if the subject mark is too similar to a mark that is already on the register.

How Long Does Registration Take?

If the application is straightforward, the IPD is usually able to register the mark within six months of the date of filing. If the examiner raises objections, or third parties formally oppose the application, then the registration process will generally take longer.

An Examination Report is usually issued two months after the application is filed. The report informs the applicant whether the trademark applied for satisfies the requirements for registration. If no objections are raised by the examiner, the mark will be published in the Hong Kong Intellectual Property Journal. Third parties are then given three months from the date of the publication to lodge objections. If none is raised, the application will be entered onto the register, and the registration will take effect from the date the application was filed.

If a third party files an opposition, and the applicant either subsequently withdraws its application or is not successful at an inter-party hearing, the applicant may have to pay the opponent’s costs of the opposition.

Do I Have to Use My Trademark?

In general, yes. If a registered mark has not been used for a continuous period of three years without a valid reason, the registration may be challenged by third parties and revoked, in full or in part.

However, in some cases it may be possible to show that an international mark is “exceptionally well known” within Hong Kong, even though it is not used here. It can then be registered defensively in order to prevent misappropriation by third parties.

How Long Does a Trademark Registration Last?

With continued use, trademarks can last indefinitely, but must be renewed every 10 years.

What Rights Do I Receive upon Registration?

A registered trademark gives the registrant exclusive rights to prevent others from:

  • Using a mark identical to the registrant’s mark on or in relation to identical goods or services;
  • Using a mark identical or similar to the registrant’s mark on or in relation to identical or similar goods or services, where there is a likelihood of confusion on the part of the public; and
  • Using a mark identical or similar to the registrant’s mark in relation to identical, similar, or dissimilar goods or services if the use takes unfair advantage of or is detrimental to the distinctive character or reputation of the registrant’s mark – but only if the registrant’s mark is “well known.”

If a trademark is unregistered, it may still enjoy legal protection. This can be achieved by bringing a passing-off action. In order for a passing-off action to be successful, a plaintiff needs to show:

  1. Goodwill or reputation in its mark;
  2. A misrepresentation by the defendant causing confusion to consumers; and
  3. Damages.

This is likely to involve extensive civil litigation, and is clearly more burdensome and difficult than merely being able to point to a registration. A registered trademark grants prima facie exclusivity and saves the mark owner a lot of trouble in the long run.

What If I License My Trademark?

Licensing trademarks is an important part of manufacturing, sale, distribution, merchandising, and franchising of goods.

The license should be registered with the IPD; otherwise the licensee will not be entitled to claim damages in an infringement action.

Patents

What Is a Patent?

A patent gives its owner (properly called a “patentee”) the exclusive right, for a limited period, to prevent others from exploiting the invention without permission. In exchange for this right, the applicant must disclose to the public how to carry out the invention in order to promote further advancement in the field.

Patents in Hong Kong are granted to the first person to file an application, rather than necessarily the first person who created the invention. Therefore, inventors can lose out if they do not patent quickly enough. Patents are territorial rights: a Hong Kong–registered patent confers exclusivity only within Hong Kong. Like other forms of property, patents can be bought, sold, and licensed.

Is My Invention Patentable?

To be patentable, an invention must:

  • Be new; that is, it must never have been made public in any way, anywhere in the world, before the “priority date” (the date the patent application is filed, or up to one year prior to that date where a suitable “priority document” has been filed somewhere else in the world);
  • Involve an inventive step over what was known at the priority date – i.e., it must not be obvious to someone with good knowledge and experience of the subject (known as a person skilled in the art); and
  • Be capable of industrial application; that is, it must take some practical form and be capable of being made or used in some kind of industry. So, while the invention need not be technically or commercially beneficial, impossible or futuristic inventions like perpetual motion machines are not allowed.

There are also some things that are specifically excluded. These include scientific discoveries, scientific theories or mathematical methods, aesthetic creations, schemes or methods for performing a mental act or playing a game, presentations of information, methods of treatment of humans or animals, and new animal or plant varieties.

How Do I Obtain a Patent in Hong Kong?

Patents in Hong Kong are essentially re-registrations of foreign patents. There is no substantive examination performed by the IPD. The grant of a standard patent in Hong Kong is based on the registration of a patent granted by one of three “designated patent offices”:

  • The State Intellectual Property Office, People’s Republic of China (PRC).
  • The European Patent Office, in respect of a patent designating the United Kingdom.
  • The United Kingdom Patent Office.

The whole process will usually take between three and five years. Hong Kong also has a “short-term” patent for which there is no substantive examination. The applicant need only comply with formalities and submit a search report obtained from one of the designated patent offices. A grant of a short-term patent is therefore much quicker and cheaper than for a full-invention patent; however, anyone can see the search report, which will not necessarily be favorable to your client.

How Long Does Patent Protection Last?

Standard patents in Hong Kong are protected for a maximum period of 20 years. Short-term patents are granted for a maximum period of eight years.

What Rights Do I Receive?

Once a patent has been granted, the patentee is entitled to take legal action against others who infringe upon the monopoly granted with respect to the invention. In this way, the patentee can prevent the unlicensed manufacture, use, importation, or sale of a product incorporating the patented invention. This right can be used to develop a business based on the invention, or it can be assigned or licensed to another person or company.

Once Granted, Is My Patent Safe?

Not necessarily. A patent may be attacked during its life for a variety of reasons, including that the invention is not new, that it is obvious, or that it does not have industrial applicability. In particular, since short-term patents are not substantively examined, they are more likely to be challenged and it is up to the patentee to prove their validity.

There are, however, some limits on the patentee’s rights. For instance, private acts done for noncommercial purposes and experiments into the subject matter of the patent will not count as infringements.

Registered Designs

What Is a Registered Design?

Registered designs – the equivalent of design patents in the PRC – are registered monopoly rights that protect the appearance of the whole or part of a product. Product features such as lines, contours, colors, shapes, texture, material, and ornamentation can be protected by design registration.

There is no provision for the protection of unregistered designs in Hong Kong.

How Do I Apply?

A completed application must be submitted to the IPD accompanied by representations of the product that clearly illustrate the features to be registered. The representations may be design drawings or just photographs of the product.

To qualify for protection, a design must:

  • Be new; that is, it must not be the same as any design that has already been made available to the public; and
  • Concern the aesthetic appearance of the product to which it is applied. Designs that are primarily functional will not be registrable.

What Rights Do I Receive?

Registered designs are protected for a maximum period of 25 years. The registration is renewable for five-year periods.

The owner of a registered design has the exclusive right to prevent others from using (including making, selling, and importing) goods made to the same or substantially the same design, and also to stop them from producing tools used for making such goods. The owner cannot, however, restrain infringing acts that are carried out for noncommercial, educational, or research purposes.

Copyright

What Does Copyright Apply To?

Copyright protects a wide variety of original works, including those embodied in books, photographs, paintings, sculpture, music, drama, records, films, CDs, videos, architecture, computer software, broadcasts, and the typographical arrangements of published works. Copyright can apply even where the work is computer generated.

Do I Need to Register Copyright?

Copyright arises automatically in Hong Kong when an eligible, original work is made. There is no need or provision for any form of registration. Because of this it can be difficult to prove ownership and is, therefore, important to keep proper records.

It is advisable to attach a copyright notice to the work, setting out the “©” symbol followed by the copyright owner’s name and the date of first publication. This notice can help to establish ownership in the event of infringement proceedings. It also serves as a warning notice to others against copying.

Under the Berne Convention, works protected by copyright in other Berne member states are automatically protected in Hong Kong.

What Does Copyright Provide?

Copyright does not protect against the independent development of the same ideas; it protects only against actual copying. In the case of complex works, it may be possible to infer copying from the quantity and exactness of the various copied features.

Also note that, in general, copyright will only protect the expression of an idea, not the idea itself. The extent to which this applies, however, depends on the detail of the idea, how it has been set out, and how much of it has been copied.

A copyright owner is able to prevent the unauthorized use of its work, such as the making of copies of the whole or substantial parts of the work, use of the work on the Internet, or translation or adaptation of the work.

There are other rights related to copyright that creators may enjoy in parallel with copyright. For instance, “moral rights” include the right to be identified as the author of a work and to object to its derogatory treatment.

How Long Does Copyright Protection Last?

In Hong Kong, copyright protects literary, dramatic, musical, or artistic works for the author’s lifetime plus 50 years thereafter. Sound recordings and broadcasts are protected for 50 years from the year of first publication and films are protected for 50 years from the year in which the last principal director, author, or composer dies. Typographical arrangements of published works are protected for 25 years from the year of first publication.

Confidential Information

Confidential information, such as industrial and commercial secrets and know-how, is by its very nature highly sensitive. In some cases, confidential information can be the most valuable asset of a business – witness the formula for Coca-Cola.

Unlike the other rights, rights in confidential information will usually derive from confidentiality agreements (often known as NDA or nondisclosure agreements) rather than from legislation. In this context, any misuse or misappropriation of the information will be actionable as a breach of contract.

However, an action for breach of confidence per se can arise where a third party discloses certain identifiable information that it has received in circumstances that imposed an obligation of confidence.

Businesses with confidential information as assets should take the necessary steps to protect this information. These may include:

  • Ensuring that staff do not disclose any information to persons who do not “need to know,” whether inside or outside the workplace;
  • Imposing nondisclosure obligations for a period after the employees resign from and leave the business; and
  • Requiring possible business partners to sign an NDA prior to disclosure.

In a nutshell, do not rely on implied confidentiality. It is safer to buttress confidential information with contractual obligations; breach of contract will be easier to establish and contractual damages will often be higher than those awarded for breach of confidence.

Remedies include damages, injunctions (it is important to contain the confidential information before its further release), account of profits, delivery up of all materials containing confidential information (i.e., handing them over to the owner), or destruction of such materials under oath.

Domain Names

All domain names ending in “.hk” are governed by the Hong Kong Internet Registration Corporation Ltd.; international domain names such as “.com” are governed by the Internet Corporation for Assigned Names and Numbers (ICANN). Both organizations operate a dispute resolution service to resolve cases of squatting (unauthorized use of a third party’s mark in the domain name) and misleading domain names, without having to turn to litigation. Usually, squatting amounts to passing-off (see above at “Trademarks”), but in the vast majority of cases, using the dispute resolution service is quicker and cheaper than going to court (although there is no provision for the recovery of costs).

In each case, the governing body may order the transfer of a domain name if:

  • It is identical or confusingly similar to the complainant’s Hong Kong trademark;
  • The registrant has no rights or legitimate interest in the domain name; and
  • The domain name was registered and is being used in bad faith.

Enforcement

Registration of IP rights can have a deterrent value in itself, but to derive the full benefit of IP rights, it is necessary to enforce them.

In Hong Kong, IP owners often learn of infringements through investigations by their own employees or by sightings referred by their lawyers, consultants, or investigators. After learning of the infringement, it is normally best to conduct an investigation to determine how bad the problem is and who is responsible for it. A good investigation will reveal the following:

  • Who and where the infringer is;
  • Whether the infringer manufactures and/or sells the goods;
  • The volume of infringing goods produced/sold; and
  • The possible location of the goods.

A low-key and low-cost first step in enforcing IP rights is simply to write to the infringer setting out the case, and demanding that it cease the infringing activity. The letter will normally also request an undertaking not to infringe further. The signed undertaking can be relied on if the infringer recommences infringing activity in the future. The downside is that unless written very carefully, such a letter, if unjustified, can constitute an actionable threat that will enable the recipient to commence proceedings for damages.

If, however, the infringer does not provide a positive response, or if the infringing activities continue, it may be necessary to enforce IP rights through the courts.

Damages awarded by the courts will rarely compensate the plaintiff in full for the damage suffered or for the full costs of the legal action. In many cases, it may be more advantageous for IP owners to seek to resolve the dispute by negotiation. In any particular case, the best approach should be carefully considered and determined in consultation with legal or other professional advisers.

Conclusion

In Hong Kong, trademarks, patents, designs, and domain names can be registered, whereas copyright does not require registration. It is necessary to determine the necessary scope of protection as products and services often embody a number of IP rights.

Registration of IP rights in Hong Kong is territorial in that they do not extend to China, and vice versa.

Setting Up a Company in Hong Kong

Posted on June 14, 2013 by - Uncategorized

Every year since 1995, Hong Kong has been voted the world’s freest economy by the Heritage Foundation and the Wall Street Journal’s Index of Economic Freedom. It also has one of the lowest tax rates in the world. According to the Paying Taxes 2013 study conducted by PricewaterhouseCoopers and the World Bank Group, Hong Kong is the fourth-easiest place in the world to pay taxes, just behind three countries in the Middle East. Hong Kong is ideally located in the heart of Asia and serves as a gateway to and from Mainland China. Moreover, Hong Kong signed the Closer Economic Partnership Agreement (CEPA) with Mainland China and is treated more favorably than other foreign investors in many aspects. These advantages make Hong Kong an attractive place for foreign investors. 

Hong Kong is an important location for U.S. interests. According to the U.S. Department of State, as of 2012, there are some 1,400 U.S. firms, including 840 regional operations (315 regional headquarters and 525 regional offices), and over 60,000 American residents in Hong Kong. According to the U.S. Department of Commerce, as of February 2013, Hong Kong is the United States’ seventh-largest trading partner in terms of imports from the United States, while Mainland China is third. 

This article gives an overview of the major issues that U.S. investors should consider when setting up a company in Hong Kong. 

The Companies Ordinance (the CO) is the main piece of legislation governing companies in Hong Kong. The CO is being completely rewritten, and the new CO will come into force in the first quarter of 2014. Where changes will be brought about by the new CO regarding the issues discussed in this article, the new CO provisions will be introduced as well. 

Types of Permitted Operations in Hong Kong

Depending on the scope of operations, foreign companies seeking to operate in Hong Kong have three alternative permitted forms of business presence. 

Representative Office 

A representative office is suitable for a foreign company that intends to conduct only minimal activities in Hong Kong. A representative office cannot conduct any trade, professional, or business activities or transactions in Hong Kong and cannot enter into any contracts in Hong Kong. A representative office is appropriate, for example, for acting as a liaison office without creating any binding business obligations. 

Branch Office 

If a foreign company establishes a place of business in Hong Kong, it will require registration as a foreign company under the CO. A “place of business” includes a place used by a company to transact any business that creates legal obligations. The foreign company is liable for the debts and liabilities of its Hong Kong branch, and a branch office cannot take full advantage of Hong Kong’s tax benefits. 

Hong Kong Subsidiary

Due to the limitations of a representative office and branch office as described above, a foreign company usually favors establishing a Hong Kong–incorporated company as a subsidiary to operate in Hong Kong. This is generally the preferred type of business structure because the entity may be sued only to the extent of the limited assets of the Hong Kong subsidiary.

Classification of a Company

Under the CO, a “private company” is a company that restricts the right to transfer its shares, prohibits public subscription for its shares or debentures, and limits the number of shareholders to 50. Any company which cannot satisfy all three requirements is a public company. A public company can be listed on a stock exchange or unlisted. This article does not discuss public companies. 

A company can also be classified by whether it is limited by shares or by guarantee, or is an unlimited company. This article focuses on a company limited by shares, which is the most common type and is usually referred to as a “limited company.” A company limited by guarantee in Hong Kong is usually a nonprofit organization. 

The new CO makes it clear that there are five types of companies that can be set up under the CO: 

  1. A public company limited by shares;
  2. A private company limited by shares;
  3. A public unlimited company with a share capital;
  4. A private unlimited company with a share capital; and
  5. A company limited by guarantee without a share capital. 

Requirements for a Hong Kong Private Company

At a minimum, a Hong Kong private limited company must have the following: 

  1. One shareholder;
  2. One director;
  3. A company secretary;
  4. A registered office address in Hong Kong;
  5. An auditor; and
  6. A business registration certificate.

Director

A director must be at least 18 years of age, must not be an undischarged bankrupt, must not be subject to a disqualification order, must comply with any share qualification requirement, and must consent to act. There is no restriction on the nationality of a director. 

A private company can have a director that is a corporation, but under the new CO, a private company must have at least one director who is a natural person (but a company that is a member of a group of companies of which a listed company is a member cannot have any corporate directors). 

Company Secretary 

A company secretary must be either an individual resident in Hong Kong or a company with a registered office or place of business in Hong Kong. 

Business Registration Certificate 

A one-stop Company and Business Registration Service has been launched by the Companies Registry and the Inland Revenue Department. Applications for both incorporation and business registration may now be undertaken simultaneously. 

In addition to the business registration certificate, certain types of businesses may need additional forms of licensing. For example, a company conducting regulated financial services activity (such as asset management, dealing in securities, or advising on securities) in Hong Kong requires licenses from the Securities and Futures Commission. 

Generally 

There is no prescribed minimum paid-up capital. Under the new CO, the concept of nominal or authorized share capital and nominal or par value will be abolished. Instead, the articles of the company with a share capital must include a statement of capital containing some prescribed information and the initial shareholdings. 

The same person can be the secretary, director, and shareholder of a company, except that the sole director of a company cannot also be the secretary of the company. 

A company’s statutory records should be kept at its registered office. If they are kept at a different place, a notice must be filed with the Companies Registry. 

Under the new CO, the memorandum of association will be abolished as the constitution of a company. The articles of association will be the sole constitutional document of the company. Moreover, it will no longer be compulsory for companies to have a common seal. There are new provisions for execution of documents by authorized signatories where the document would take effect as if executed under seal. 

Information Available to the Public

Compared to other jurisdictions (e.g., the British Virgin Islands and the Cayman Islands), Hong Kong companies are much more transparent in terms of information that is available to the public. In addition to basic information, one can search for all the documents filed with the Companies Registry in relation to a particular company. One can also search for the registered charges of a company and disqualification orders made. Moreover, one can search for all the companies in which an individual has directorships and the particulars of that director, such as his or her identity number and residential address. 

It was originally proposed under the new CO that the residential address of a director and the full identification numbers of any person would not be made available for public inspection. This new arrangement has been subject to a heated public debate over the balance between personal data privacy and information transparency. The implementation of this new arrangement has now been delayed, and will not come into force along with the other provisions under the new CO. 

Establishing a Private Company

There are two ways of establishing a private company in Hong Kong: incorporating a new company or buying a shelf (or existing) company. 

Incorporation involves applying to the Companies Registry, which then issues a certificate of incorporation within four working days after submission of the application by post (online applications may be processed within an hour). The newly incorporated company then needs to be activated by holding its first board meeting and a shareholders’ meeting, if necessary. 

Buying a shelf company is useful when a company is urgently needed. One just needs to acquire a shelf company and then activate it by effecting a change of shareholders and directors and holding a board meeting (and a shareholders’ meeting, if necessary). 

Continuing Compliance Requirements

A company should hold an annual general meeting (AGM) each year, and not more than 15 months from the previous AGM, unless everything that is required to be done at the meeting is done by written resolution and the relevant documents are provided to each member. The following matters are usually dealt with at the AGM: 

  1. Adoption of audited accounts comprised of the balance sheets, directors’ report, and auditors’ report;
  2. Declaration of dividends;
  3. Election of directors; and
  4. Appointment of auditors. 

The new CO provides that a company is not required to hold an AGM if it has only one member or the AGM is dispensed with by unanimous members’ consent. 

Other compliance requirements include, among others, the following: 

  1. A company should keep a register of members and a register of directors and secretaries;
  2. Various returns have to be filed with the Companies Registry within stipulated deadlines for changes in relation to the company, such as changes in directorship and secretary, registered office, share capital, etc.;
  3. A company must file an annual return;
  4. A company must have annual audited accounts. The CO prescribes detailed requirements regarding the types of accounts to be prepared. A directors’ report must also be prepared in conjunction with the annual accounts;
  5. Shareholders’ or board meetings should be held as may be necessary or required under the CO. The minutes or written resolutions should be filed in a minute book and resolutions or notices should be filed with the Companies Registry as required under the CO; and
  6. A company also needs to renew its business registration certificate before it expires and file profit tax returns for the company and the employer’s return for its employees with the Inland Revenue Department. 

If a company fails to comply with these requirements, the company and every officer of the company who is in default may be liable for a fine and/or imprisonment. 

Tax Issues

Profits Tax

Hong Kong adopts a territorial corporate tax system. Corporations are taxed on profits at a rate, for assessment year 2012/2013, of 16.5 percent. Profits tax is charged on Hong Kong–sourced profits and is collected by the Inland Revenue Department. The tax rate on profit derived in Hong Kong is the same for Hong Kong and foreign companies.

Specifically, domestic and foreign entities meeting the following three criteria are subject to profits tax:

  1. The entity carries on a trade, profession, or business in Hong Kong;
  2. The profits are from such trade, profession, or business carried on by the entity in Hong Kong; and
  3. The profits arose in, or were derived from, Hong Kong.

A Hong Kong resident may derive profits from abroad that are not subject to Hong Kong profits tax; conversely, a nonresident may be liable for tax on profits arising in Hong Kong. The question of whether a business is carried on in Hong Kong and whether profits are derived from Hong Kong is largely one of fact. Profits arising from activities conducted abroad, even if they are remitted into Hong Kong, are not subject to profits tax.

Salaries Tax

Income received by employees from Hong Kong–sourced employment is subject to salaries tax. Subject to certain exemptions, income subject to salaries tax includes salaries, wages, commissions, tips, bonuses, allowances, perquisites, leave pay, terminal/retirement awards, contract gratuities, and noncash benefits such as housing allowances and stock-based awards.

In determining assessable income, outgoings and expenses (other than expenses of a domestic or private nature and capital expenditure) wholly, exclusively, and necessarily incurred in the production of the assessable income and depreciation allowances in respect of the plant and machinery, the use of which is essential to the production of the assessable income, are deductible. Other permitted deductions include:

  1. Loss brought forward from previous years of assessment;
  2. Expenses of self-education paid;
  3. Elderly residential care expenses paid;
  4. Home loan interest paid;
  5. Contributions to recognized retirement schemes; and
  6. Donations to approved charities.

Salaries tax is computed on net chargeable income at scaled rates between 2 percent and 17 percent for assessment year 2012/13. Salaries tax will not in any event exceed (i.e., is capped at) 15 percent of net income before allowances.

Double Taxation

The United States is absent from Hong Kong’s otherwise comprehensive double-taxation treaty network. However, Hong Kong adopts the territoriality basis of taxation, whereby only Hong Kong–sourced income or profit is subject to tax and non–Hong Kong sourced income or profit is, in most cases, not subject to tax. Accordingly, Hong Kong generally does not double-tax its residents. The Inland Revenue Department allows a deduction for foreign tax paid on turnover basis in respect of an income that is also subject to tax in Hong Kong.

General Tax Benefits

Dividends or overseas branch profits repatriated to Hong Kong are not subject to Hong Kong tax. In addition, dividends paid by a Hong Kong company to its shareholders are not subject to Hong Kong tax in the hands of shareholders (tax already having been paid by the company on the profits underlying those dividends), nor is there any withholding tax on dividends paid to shareholders outside Hong Kong. Capital gains are also tax-exempt. A stamp duty is imposed on certain documents such as share transfers, leases of real property, and sale of real property. There is no sales tax, value-added tax, or estate tax in Hong Kong.

For 2012/2013, a one-off reduction of 75 percent of the final tax payable under the profits tax, salaries tax, and tax under personal assessment, subject to a ceiling of HK$10,000 per case, was proposed in the 2013–14 financial budget. This reduction is pending legislative approval.

FATCA Issues 

Under the new U.S. Foreign Account Tax Compliance Act (FATCA), all foreign financial services institutions have to report the activities of their U.S. clients to the U.S. Internal Revenue Service if assets in their offshore accounts reach US$50,000. FATCA was designed to catch tax evasion by U.S. taxpayers overseas. Foreign countries have until 2014 to come into compliance or risk sanctions by the U.S. government. As at this writing, Hong Kong does not have a FATCA compliance plan. 

Employment Issues

Protection Under the Employment Ordinance

Irrespective of their hours of work, all employees covered by the Employment Ordinance (Chapter 57 of the Laws of Hong Kong) are entitled to basic protections, which include wages and statutory holidays. Employees who are employed under “continuous contracts” are also entitled to benefits such as rest days, paid annual leave, sickness allowance, severance payment, and long-term payment. An employee who has been employed continuously by the same employer for four weeks or more (with at least 18 working hours each week) is regarded as being employed under a “continuous contract.” The definition of “continuous contract” is currently under review.

Minimum Wage

Starting from May 1, 2013, the minimum wage rate in Hong Kong is HK$30 per hour.

Mandatory Provident Fund 

In Hong Kong, all employers and their employees aged 18 to 65 must join an employment-based retirement pension scheme unless an exemption applies (e.g., if the employee earns less than HK$6,500 per month), or if the employee is an existing member of an overseas pension scheme. Mandatory contributions are calculated on the basis of 5 percent of an employee’s relevant income, up to a maximum mandatory contribution of HK$1,250 a month, with the employer matching the employee’s contribution.

Employment Visa Issues

As a general rule, any person, other than those having the right of abode or the right to land in Hong Kong, must obtain a visa before coming to Hong Kong for the purpose of taking up employment. This includes secondees from an overseas office.

Conclusion

This article gives an overview of the main issues relating to setting up a business in Hong Kong. One may also need to consider issues other than the ones discussed above, such as opening bank accounts, entering into leases for office premises, recruiting employees, arranging financing, and protecting trademarks and other intellectual property rights and establishing data protection policies.

Hong Kong has always been keen to attract foreign investment to reinforce its status as an international financial center. Government policies generally favor foreign investment. For example, Hong Kong and Mainland China regularly enter into new supplements to CEPA to give more advantages to Hong Kong. These are the advantages that Hong Kong has that foreign investors should consider when they decide where to establish their business.

 

 

 

Hong Kong as a Base for Doing Business in Mainland China

Posted on June 14, 2013 by - Uncategorized

The Peoples’ Republic of China (PRC, China, or Mainland China) is the second largest economy in the world after the United States and is the world’s fastest-growing major economy, with growth rates averaging 10 percent over the past 30 years. Since the implementation of its open-door policy in the late 1970s, China has become the world’s premier destination for foreign investment. China was the largest recipient of global foreign direct investment in the first six months of 2012. Over 480 of the Fortune Global 500 firms are doing business in China. China joined the World Trade Organization (WTO) in 2001 to enhance its competitiveness in the global market, and by 2010, China’s exports amounted US$1.19 trillion. Its main export partners are the United States (17.7 percent), Hong Kong (13.3 percent), and Japan (8.1 percent). China’s trade surplus in March 2013 amounted to US$11.19 billion.

Hong Kong is the world’s 10th largest trading economy and 11th largest exporter of commercial services. It has always had a laissez-faire policy aimed at promoting barrier-free trade. Foreign direct investment (FDI) is very active in Hong Kong. According to UNCTAD World Investment Report 2012, Hong Kong is the second largest source of FDI in Asia after Japan, with an outflow of US$81.6 billion in 2011. Hong Kong is also the key entrepôt of China. According to Hong Kong government statistics, in 2011, China was the destination of 54 percent of Hong Kong’s re-exports. A majority of the direct investments in China are implemented through Hong Kong. 

Hong Kong’s Role in the Economic Development of China

In March 2011, the 11th National People’s Congress (NPC) passed the 12th Five-Year Plan for the National Economic and Social Development of PRC (12th Five-Year Plan). For the first time, PRC’s National Five-Year Plan contains a chapter on the role of Hong Kong in the development of China. It aims at:

  1. Further consolidating and elevating Hong Kong’s competitive advantages, including its status as an international center for financial services, trade, and shipping;
  2. Developing Hong Kong into an international asset management center and offshore renminbi (RMB) business center, so as to strengthen its global influence in the financial sector; and
  3. Nurturing emerging industries and facilitating extending their fields of cooperation and scope of service in China.

In response to the 12th Five-Year Plan, the Hong Kong government encourages its enterprises to tap into the China market with emphasis on promoting Hong Kong’s role as an offshore RMB business center. As for industrial development, the Hong Kong government set up the Financial Services Development Council to promote Hong Kong’s financial services industry and complement the internationalization of RMB and Mainland China’s financial market. 

Hong Kong has become a conduit to funnel capital, high-caliber talent, and technology into China from all over the world, while also introducing China’s enterprises, products, and services to the global market. In essence, Hong Kong provides a springboard to China’s strategy of “going out” and “bringing in.”

Advantages of Doing Business in China via Hong Kong

Hong Kong is the largest foreign direct investment source in China. As of June 2011, there were 3,752 regional headquarters and regional offices in Hong Kong representing their parent companies located outside Hong Kong, with an increase of 3.1 percent from the previous year. Of these companies, 81 percent were responsible for business in China, confirming Hong Kong’s role as a gateway to China.

Robust Legal System

Hong Kong was a British colony from 1842 to 1997. After the handover in 1997, the “Basic Law” has been the supreme law of Hong Kong. Its underlying principle of “one country, two systems” enacted by the NPC indicates that the prior colonial-era capitalist system and way of life are to remain unchanged for 50 years. The most prominent feature of the Basic Law is the upholding of the common law system and rule of equity. Also, all ordinances not contradicted by the Basic Law are to remain in force. Hong Kong has a robust legal system and an independent judiciary that provide a fair and just operating environment for businesses. Under the Basic Law, Hong Kong has its own final appellate body, the Court of Final Appeal, which is crucial in maintaining the independence of the judiciary. Over the years, it has invited distinguished overseas judges to sit on its court and assist in the development of local jurisprudence. For example, Sir Anthony Mason, a former chief justice of the High Court of Australia, frequently sits in the Court of Final Appeal. The same applies to many law lords from the United Kingdom. This arrangement, which is unprecedented, not only signifies Hong Kong’s determination to retain judicial independence, but, equally important, it adds an international dimension to Hong Kong’s legal system.

Availability of quality legal services is an important factor for corporations that use Hong Kong as a regional center. Hong Kong is a one-stop professional advisory services center with over 7,400 practicing solicitors, 1,100 barristers, and more than 33,000 certified public accountants. Over 1,400 foreign lawyers qualified in 29 different overseas jurisdictions are practicing in Hong Kong and are capable of counseling on matters pertaining to the laws of the United Kingdom, United States, China, and others. In recent years, leading U.S. law firms have established bases in Hong Kong, making it a true international legal hub. According to statistics published in the October 2012 issue of American Lawyer, out of the top 100 global law firms ranked by revenue, 65 have offices in Hong Kong, and 50 of them are practicing as local Hong Kong firms of solicitors. 

The in-depth knowledge of Hong Kong legal practitioners in the Mainland China market and Hong Kong’s regulatory framework facilitate transactions involving parties from China by acting as a bridge between clients from the international and China capital markets. Also, sophisticated legal services are provided for fund-raising, finance, securities, international trade, and cross-border transactions. 

Effective Dispute Resolution 

In addition to a fair and efficient judicial system, alternative dispute resolution mechanisms to deal with business disputes are available. Hong Kong provides highly cost-effective arbitration services. In June 2011, Hong Kong reformed its Arbitration Ordinance Cap. 609; it now has a unitary regime of arbitration based on UNCITRAL Model Law for all types of arbitration, abolishing the distinction between domestic and international arbitration. 

Under Mainland Judgments (Reciprocal Enforcement) Ordinance Cap. 597, certain commercial judgments by either the China or Hong Kong courts may be enforced reciprocally. Arbitration awards made in Hong Kong are enforceable in more than 140 jurisdictions through the New York Convention and the Arrangement Concerning Mutual Enforcement of Arbitral Awards between China and Hong Kong. 

In Noble Resources Limited v. Zhoushan Zhonghai Food and Oil Industrial Limited (2009), whereby the party applied for approval from the Supreme People’s Court of its denial of enforcement of a Hong Kong International Arbitration Centre award on the basis of public policy, the Zhejiang Higher People’s Court highlighted that “there has not been any precedent of denying enforcement of HKIAC awards in the Mainland.” The Supreme People’s Court enforced the award finding in favor of the foreign party. 

With sophisticated legal expertise, internationally recognized regulatory standards, an independent judiciary, and an effective alternative dispute resolution system, Hong Kong is truly a one-stop hub in Asia that provides efficient and wide-ranging services that meet the needs of different kinds of businesses at different stages of development.

Mainland–Hong Kong Closer Economic Partnership Arrangement

Hong Kong enjoys a unique advantage under the Mainland–Hong Kong Closer Economic Partnership Arrangement (CEPA), which was first concluded in June 2003, with the latest supplement effective on January 1, 2013. CEPA plays an important role in strengthening cooperation between Hong Kong and China in areas of finance, trade, and investment facilitation and in promoting joint prosperity and development of the two entities. Prominent preferential liberalizations for goods and services of Hong Kong to enter the China market were announced. It is expected that free service trade between the two entities will be further promoted in the coming supplements. The liberalizations under CEPA provide better terms than the WTO commitments of China, adding to the desirability of Hong Kong as a base for doing business in China.

All products “made in Hong Kong” complying with CEPA origin rules and upon application by local manufacturers, except for a few prohibited articles, can be exported to China tariff-free under CEPA. “Made in Hong Kong” means goods must be “substantially transformed” in Hong Kong with at least 30 percent of value added therein (including R&D and design costs). Since the implementation of CEPA, the number of goods eligible for tariff-free treatment increased from 273 to 1,739. 

International firms that incorporate in Hong Kong enjoy all the benefits available under CEPA, as well as the obvious geographic advantage of being located in Hong Kong, which facilitates connecting with suppliers and consumers in China.

Also, Hong Kong service suppliers enjoy preferential treatment and relaxed market access conditions when setting up business in China. Financial, geographical, and ownership constraints are reduced or removed, such as allowing wholly owned operations and reducing registered capital requirements, which facilitate entrance to the China market for small to medium enterprises. Free trade in services between Guangdong and Hong Kong is expected to be achieved in 2014. 

Any company can benefit from CEPA if it is incorporated in Hong Kong with three to five years’ operation (depending on the sector). Fifty percent of its staff must be employed locally and liable to pay Hong Kong tax. Overseas service providers can partner with, invest in, or buy into a CEPA-qualified company to acquire easier access to China. 

Languages and Accessibility 

Hong Kong has the root of Chinese cultures with British features from its colonial history. Chinese and English are both official languages in Hong Kong and are commonly used in business.

Hong Kong’s geographical location has made it the central hub of the Asia-Pacific region. It is within easy flying distance of China, Southeast Asia, India, and Australia. Hong Kong is the world’s third-busiest container port system. Hong Kong International Airport is the world’s busiest cargo gateway and two additional runways are planned to increase its capacity by 2020. 

Construction for the Hong Kong-Zhuhai-Macao Bridge is expected to be completed in 2016, enhancing the economic development of the region. The Hong Kong section of the Guangzhou-Shenzhen-Hong Kong Express Rail Link is expected to be completed in 2015, strengthening economic ties between the areas, accelerating the economic integration of the Western Pan River Delta and its neighboring provinces, and increasing Hong Kong’s competitiveness.

Banking and Finance in Hong Kong

As an important banking and financial center in the Asia-Pacific region, 70 of the world’s top 100 banks are based in Hong Kong. According to the Bank for International Settlements, Hong Kong is the third-largest foreign exchange market in Asia and the sixth-largest in the world. In 2011, Hong Kong was first in the world for initial public offerings (IPO) for a third year in succession and was a prominent offshore capital-raising center for China enterprises. As at December 2011, there were 640 China companies listed in Hong Kong, making up 55.5 percent (i.e., US$1.2 trillion) of the market total. Listed companies in Hong Kong are regulated by the Securities and Futures Commission and the Hong Kong Stock Exchange, which have strong reputations and high standards for listing.

Eight licensed China-incorporated banks and five representative offices operate in Hong Kong. Some of them have set up their branches in Hong Kong, such as the Bank of China, China Construction Bank, Industrial and Commercial Bank of China, and Agricultural Bank of China.

Benefits of Using a Hong Kong Holding Company

The Foreign Investment Industrial Guidance Catalogue (2011 Revision), amended by the Ministry of Commerce, came into effect on January 30, 2012. The Catalogue is a tool used by the China government to control foreign investors and divides foreign investment industries into three categories: (1) Encouraged; (2) Restricted; and (3) Prohibited.

For investment in the Encouraged category, foreign investors are generally allowed to establish wholly foreign-owned enterprises (WFOE). The Encouraged category includes mining and textile manufacturing. For investment in the Restricted category, foreign investors generally need to make their investment through a joint venture with a China partner. The foreign investor’s equity interest in the joint venture can be subject to limitation. As for industrial projects in the Prohibited category, foreign investment is not allowed, for instance, in postal services and media. 

On the other hand, Hong Kong provides foreign investors freedom of investment, as the restriction and limitation control by the Hong Kong government is minimal. For example, a foreign investor can set up a company in Hong Kong to hold 100 percent of a WFOE, or to incorporate in a joint venture in China. 

The benefit of this practice is that, by an appropriate shareholders’ agreement, stock option plan, or asset and business management agreement, the maintenance and management of a WFOE or joint venture can be operated at the Hong Kong holding company level, which is governed by the laws of Hong Kong, and any transfer of shareholding at the Hong Kong holding company level will not require approval by the China government. 

Second, as a benefit of Hong Kong’s mature banking and finance system, the Hong Kong holding company level can conveniently obtain loans and credits. 

Third, on August 21, 2006, the China and Hong Kong governments signed the Arrangement for the Avoidance of Double Taxation on Income and Prevention of Fiscal Evasion, which provides added incentives for international investors to enter the China market through Hong Kong. For instance, where a Hong Kong resident company disposes of less than 25 percent of shareholding in a China company and the assets of the China company are not comprised of mainly immovable property situated in China, gain derived from such disposal will be tax exempted. Without this preferential treatment, the gain would be subject to a 10 percent withholding tax. As for indirect income such as interest, dividends, and royalties, Hong Kong investors are provided with preferential treatment. 

Conclusion

In brief, we have set out the advantages of using Hong Kong as a base for doing business in China, including, but not limited to, a robust legal system, a simple tax regime, a leading capital market and financial center, a regional hub, quality manpower, proximity to China, an efficient government, free trade and a free market economy, global connections, and a logistic center with efficient transportation. 

In this mini-theme covering Hong Kong legal services, my fellow colleagues of the Law Society of Hong Kong will cover additional legal topics that will be of interest to you and your clients that wish to do business in China.

Lien “Strip Down” vs. Lien “Strip Off”: Dewsnup v. Timm Is Still the Law – Isn’t It?

Posted on May 23, 2013 by - Uncategorized

The real estate collapse of 2008 hurt senior mortgage lenders, but it pummeled junior lenders, whose second liens went from above to below water, almost in a heartbeat. Some homeowners, however, saw an opportunity: if a home purportedly had no value above the amount of the senior lender’s claim, why not use Chapter 7 of the United States Bankruptcy Code to value the junior lender’s secured claim at zero – effectively stripping the junior lien off of the property and leaving the home closer to the water’s surface, where the borrower might more easily start re-building equity?

Bankruptcy professionals might have thought they knew the answer to that question. Over 20 years ago, the United States Supreme Court, in Dewsnup v. Timm, barred Chapter 7 debtors from stripping a creditor’s partially-secured claim down to the value of the collateral securing it.

However, a unanimous panel of the Eleventh Circuit Court of Appeals recently found Dewsnup to be irrelevant when applied to a junior lien on collateral of insufficient value to put the second lien holder in the money. The appellate panel instead relied on one of its own pre-Dewsnup decisions, a decision some bankruptcy courts thought had been abrogated by Dewsnup. Then, by refusing to publish its opinion, the Eleventh Circuit left debtors, lawyers, and judges in a quandary from which they have yet to emerge. (The case is In re McNeal, Appeal No. 11-11352, 2012 WL 1649853 (11th Cir. May 11, 2012).)

Under the Bankruptcy Code, an undersecured creditor with an “allowed” claim (that is, a claim that is entitled to be paid out of the bankruptcy estate) really has two claims: a secured claim in an amount equal to the value of the creditor’s collateral and an unsecured claim for the remainder. For example, a lender holding a $1 million mortgage claim secured by real estate worth $400,000 would have a secured claim for $400,000 and an unsecured deficiency claim for $600,000. Moreover, the same section of the Bankruptcy Code that provides for bifurcating the lender’s claim into secured and unsecured portions also provides that, to the extent a lien secures a claim that is not an allowed secured claim, that lien is void.

Before the Dewsnup decision, therefore, a homeowner in bankruptcy might ask the court to value his or her home at less than the full amount owed on the mortgage; if the court did so, the homeowner would then ask the court to void the lien to the extent that the lender’s claim exceeded that court-determined value – a procedure informally referred to as “stripping down” the lien. The debtor might then pay that value and extinguish the lien. Of course, if the court had undervalued the property or the property later appreciated in value, the debtor, not the lender, benefited from the additional value.

In 1991, the Supreme Court, in Dewsnup, put a stop to lien-stripping in Chapter 7 cases, finding that, so long as an allowed claim is secured by a lien – even one worth less than the full amount of the claim – a debtor could not strip down the lien. Instead, the lien would survive the bankruptcy, and the lender could foreclose it even after the Chapter 7 debtor received a discharge of his or her debts. While the discharge prevented the lender from collecting a deficiency from the former debtor, the lender would, at least, benefit from any increase in the value of the real estate itself, whether by appreciation or as a result of the court’s low-ball valuation. At least two considerations weighed heavily in the Court’s ruling: 

  • honoring the bargain between the borrower and the lender that the lien would stay with the property until foreclosure, thereby insuring that increases in property value would benefit the lender; and
  • observing the rule, established long before the enactment of the Bankruptcy Code, that liens survive bankruptcy.

The Dewsnup opinion may have given comfort to Lorraine McNeal’s junior lender. McNeal owed $176,413 to her first mortgage lender and $44,444 to her second, each of which held liens encumbering a home that, the parties agreed, was worth just $141,416 – less than the amount of the first mortgage, leaving the junior lien completely valueless. McNeal argued that, because the lien of the second mortgage holder did not actually secure any allowed secured claim – the junior lender’s claim was wholly unsecured – that lien was void and should be “stripped off” of her home completely.

Most courts, including bankruptcy courts within the Eleventh Circuit, had held that the Dewsnup rule against “stripping down” liens that had some value applied equally to “stripping off” liens that had no apparent value, and the bankruptcy and district courts both held against McNeal, forbidding her from stripping the second lien from her home.

However, the Eleventh Circuit found that Dewsnup did not control its decision, and it reversed, holding for the debtor. Without significant analysis, the panel decided that the case of a lien determined to have some value (Dewsnup) had no relevance to the case of a lien determined to have no value (McNeal), and, instead, applied a pre-Dewsnup Eleventh Circuit decision that had permitted a lien to be stripped off of collateral whose value was insufficient to support the second lien. The result is surprising, in part, because it splits from the opposite rulings of the Fourth and Sixth Circuits and departs from the understanding of Dewsnup found in opinions of some bankruptcy courts in the Eleventh Circuit. It also departs from the central policy arguments advanced by the Supreme Court in Dewsnup, which appear to apply equally to “strip down” and “strip off” cases: that courts should respect the lender’s bargain with its borrower and that they should preserve the long-standing practice of leaving liens unaffected by bankruptcy.

Perhaps even more confounding is the fact that the Eleventh Circuit chose not to publish its McNeal opinion. Under the Circuit’s rules, that means McNeal is not binding precedent, but may be cited as “persuasive authority.” One might sympathize with bankruptcy courts in Alabama, Florida, and Georgia as they try to determine the degree to which they should be “persuaded” by a unanimous panel decision from their controlling circuit that nonetheless is not strictly precedential. Some practitioners in those jurisdictions report that, where Chapter 7 debtors have filed contested motions to strip second liens off of their homes, the bankruptcy courts are simply holding the motions in abeyance, indefinitely, pending further guidance from the Eleventh Circuit. Meanwhile, debtors in jurisdictions outside the Eleventh Circuit have also sought to strip second liens from their property.

Guidance does not appear to be within ready reach. In January, debtor’s counsel asked the appellate panel to publish its opinion in McNeal and thereby put to rest the issue of McNeal‘s authority within the circuit. However, at the time of that request, both lender-appellees had commenced Chapter 11 bankruptcy cases, and, in February, the Eleventh Circuit therefore stayed all proceedings in the McNeal appeal, until it is notified that the bankruptcy court has granted relief from the automatic stay in the lenders’ cases.

For now, then, debtors with homes worth less than their total mortgage debt have found a friend in the Eleventh Circuit, while home equity lenders may impose stricter loan-to-value requirements as they try to weigh the risks posed by McNeal.

Robocalling and Wireless Numbers: Understanding the Regulatory Landscape

Posted on May 23, 2013 by - Uncategorized

Key provisions of the Federal Communications Commission’s (FCC) Telephone Consumer Protection Act (TCPA) rule are scheduled to take effect in October of this year. These changes will require written consent for autodialed and prerecorded telemarketing calls and text messages to cell phones, and will require written consent for prerecorded telemarketing calls to landlines.

The TCPA has a private right of action, and recent class actions alleging violations of the law’s autodialer provisions have settled for tens of millions of dollars. The filing of TCPA complaints is on the rise, and recent court decisions have complicated the TCPA litigation landscape.

In this article, we discuss the TCPA and the FCC rules, the amendments to the FCC rules under the TCPA, and new litigation developments under the TCPA.

Background to the TCPA

Under the TCPA, it is “unlawful . . . to make any call (other than a call . . . made with the prior express consent of the called party) using any automatic telephone dialing system or an artificial or prerecorded voice . . . to any telephone number assigned to a . . . cellular telephone service.” This law was passed in 1991 and reflects the now-obsolete notion that some cell phone users must pay for incoming calls, and “automated” calls should therefore be limited.

The TCPA defines the term “automatic telephone dialing system” or “ATDS” as “equipment which has the capacity – (A) to store or produce telephone numbers to be called, using a random or sequential number generator; and (B) to dial such numbers.” It seems clear that Congress intended the law to apply to random sequential dialers and similar devices that dial numbers continuously until they obtain an answer. For example, the legislative history indicates that “automatic dialers will dial numbers in sequence, thereby tying up all the lines of a business and preventing any outgoing calls.”

In 2003, the FCC interpreted the term ATDS to include a predictive dialer, where the dialer has the capacity to randomly generate and dial sequential telephone numbers, even if that capacity has not been enabled: “A predictive dialer is equipment that dials numbers and, when certain computer software is attached, also assists telemarketers in predicting when a sales agent will be available to take calls. The hardware, when paired with certain software, has the capacity to store or produce numbers and dial those numbers at random, in sequential order, or from a database of numbers.” Many businesses use telephone systems to contact their customers that, if paired with certain software, are capable of generating and dialing sequential numbers at random.

The FCC’s TCPA Rule

The FCC has made a rule under the TCPA (TCPA Rule or Rule), which generally prohibits making telephone calls to cellular telephones using an ATDS or a prerecorded message without the prior express consent of the called party. These prohibitions apply to telemarketing calls as well as to purely informational or transactional calls such as flight updates, debt collection calls, surveys, and bank account fraud alerts.

The TCPA Rule also prohibits making a telemarketing call to a residential landline telephone using a prerecorded message without the prior express consent of the called party, unless the caller has an established business relationship with the called party.

Revisions to the TCPA Rule

The FCC has revised its TCPA Rule to require an automated, interactive opt-out mechanism for prerecorded telemarketing messages to both cell phones and landlines. The revision took effect on January 14, 2013.

In addition, effective October 16, 2013, the Rule will be revised to:

  • Require prior express written consent requirement for telemarketing calls made to cell phones using an ATDS or a prerecorded message, but will maintain the prior express consent requirement for non-telemarketing calls to cell phones;
  • Require prior express written consent for telemarketing calls made to residential landlines using a prerecorded message; and
  • Eliminate the established business relationship exception to the obligation to obtain consent for telemarketing calls made to residential landlines using a prerecorded message.

These revisions are intended to maximize consistency with the Federal Trade Commission’s (FTC) Telemarketing Sales Rule (TSR).

Automated, Interactive Opt-Out Mechanism

As of January 14, 2013, the TCPA Rule now requires that every prerecorded telemarketing message, whether delivered to a cell phone or a residential landline, provide an automated, interactive voice- and/or key press-activated mechanism for the consumer to request no further telemarketing calls from the seller. The mechanism must be presented, together with instructions on how to use it, within two seconds of the caller’s statement of identity at the beginning of the message. When a consumer uses the opt-out mechanism, his or her number must be automatically added to the seller’s do-not-call list, and the call must immediately terminate. When the message is left on an answering machine, it must also provide a toll-free number that the consumer may use to connect directly to the automated, interactive voice- and/or key press-activated opt-out mechanism. These new FCC requirements are consistent with those already imposed by the FTC’s TSR.

Prior Express Written Consent

Effective October 16, 2013, the TCPA Rule will require prior express written consent to deliver an autodialed or prerecorded telemarketing call to a cell phone, and will require prior express written consent to deliver a prerecorded telemarketing message to a residential landline. The Rule defines “prior express written consent” as a signed written agreement that clearly and conspicuously discloses to the consumer that:

  • By signing the agreement, he or she authorizes the seller to deliver, to a designated phone number, telemarketing calls using an automatic telephone dialing system or an artificial or prerecorded voice; and
  • The consumer is not required to sign the agreement or agree to enter into it as a condition of purchasing any property, goods, or services.

The required signature may be “obtained in compliance with the E-SIGN Act,” including via an e-mail, website form, text message, telephone key press, or voice recording.

Although these provisions do not apply to purely informational or transactional calls or messages, such as flight updates, debt collection calls, surveys, or bank account fraud alerts, an informational call that includes an upsell – such as a flight update followed by an offer inviting the consumer to upgrade to first class – would require written consent. The FCC has stated that “if the call, notwithstanding its free offer or other information, is intended to offer property, goods, or services for sale either during the call, or in the future, that call is an advertisement.”

It is also important to note that because both the FCC and courts consider a text message to be a “call” for purposes of the rules promulgated pursuant to the TCPA, the written consent requirement will apply to the delivery of telemarketing text message campaigns. It is already industry practice for companies to obtain prior express consent to the receipt of such messages; however, the signature requirement and disclosure obligations (described above) are new.

Litigation and Regulatory Actions

The TCPA allows private actions and provides for between $500 and $1,500 in statutory damages for each violation, with treble damages available for willful or knowing violations, as well as injunctive relief. The TCPA also can be enforced by the FCC and state attorneys general.

TCPA litigation has trended upward in recent years, with TCPA suits rising by 63% between 2011 and 2012. Several factors appear to be fueling this trend:

  • Increased consumer use of cell phones as primary phones: According to a recent Centers for Disease Control and Prevention Semi-Annual National Health Interview Survey, nearly 36% of American households used cell phones only and nearly 16% received all or nearly all of their calls on cell phones even if they also use landline telephones. Additionally, 60.1% of adults between the ages of 25 and 29 live in households that use cell phones only. Companies that rely on autodialers to contact consumers, therefore, are increasingly at risk of dialing numbers in violation of the TCPA’s autodialing prohibitions.
  • Increased ease of filing TCPA class action suits: In Mims v. Arrow Fin. Servs., LLC, the Supreme Court ruled that federal and state courts exercise concurrent jurisdiction over TCPA claims, thus weakening arguments that state law governs whether claims may be brought as class actions.
  • Defects in consent: For calls where only prior express consent is required to use an autodialer, a 1992 TCPA order by the FCC states that “persons who knowingly release their phone numbers have in effect given their invitation or permission to be called at the number which they have given, absent instructions to the contrary.” This view of what reasonably evidences prior express consent is reinforced by the TCPA’s legislative history. Nevertheless, a lack of robust controls around ensuring, for example, that prior express consent has been obtained to call a number with an autodialer may result in difficulty overcoming individual claims of a lack of consent.

Several recent court decisions have also complicated the TCPA litigation landscape, one of the most notable being the Seventh Circuit Court of Appeals decision in Soppet v. Enhanced Recovery Co., LLC, 679 F. 3d 637 (7th Cir. 2012). In Soppet, a debt collector used an autodialer to call two cell phone numbers on behalf of AT&T to collect debts owed. The numbers had been provided to AT&T by the debtors, but at the time of debt collection calls they had been reassigned to new subscribers who had not consented to receive autodialed calls. The new subscribers sued the debt collector for violating the TCPA’s prohibition on using an autodialer to call a cell phone number without the prior express consent of the “called party.” The debt collector argued that the term “called party” meant “intended recipient of the call.” The Seventh Circuit rejected this argument, holding that “called party” means the current cell phone subscriber at the time the call is made. The import of the holding is that consent to autodial a cell phone number can no longer be presumed valid day-to-day unless a reliable mechanism is in place for confirming ownership of the number prior to dialing it. At a minimum, the Soppet decision should prompt businesses to consider whether to alter their dialing strategies for consumers resident in Seventh Circuit states (Illinois, Indiana, and Wisconsin).

Chesbro v. Best Buy Stores, LP, 697 F. 3d 1230 (9th Cir. 2012), serves as a cautionary tale for businesses seeking to leverage artificial or prerecorded voice robocalls to deliver messages thought to be purely informational. After purchasing a computer from Best Buy, the plaintiff in Chesbro began receiving prerecorded phone messages about Best Buy’s rewards program. The plaintiff complained to Best Buy on several occasions about the calls and was eventually placed on its internal Do Not Call (DNC) list. Several months later, however, the plaintiff received another prerecorded phone message from Best Buy about its rewards program, which prompted the filing of a class action complaint in Washington State against Best Buy alleging violation of the TCPA’s ban on prerecorded message calls that include or introduce unsolicited advertisements or constitute telephone solicitations. The district court granted summary judgment in Best Buy’s favor, finding that the calls were purely informational courtesy calls about its rewards program. On appeal, the Ninth Circuit determined that because the calls encouraged the plaintiff to redeem rewards points, the calls were telephone solicitations, reasoning that redemption of rewards points “required going to a Best Buy store and making further purchases of Best Buy’s goods . . . [t]hus, the calls encouraged the listener to make future purchases at Best Buy.” Perhaps most significantly, the Ninth Circuit found that the TCPA did not require that telephone solicitations explicitly mention a good, product, or service “where the implication is clear from the context” and that “[a]ny additional information provided in the calls does not inoculate them.” The upshot of the ruling is that businesses should carefully review any outgoing prerecorded voice messages that are purported to be informational.

Text messaging is another area in which there has been active litigation. As previously noted, the issue of whether text messages constitute “calls” under the TCPA is well-settled, see, e.g., Lozano v. Twentieth Century Fox Film Corp., 702 F. Supp. 2d 999 (N.D. Ill. 2010); Abbas v. Selling Source, LLC, N.D. Ill. 2009; Satterfield v. Simon & Schuster, Inc., 569 F. 3d 946 (9th Cir. 2009). Recent cases have tested whether confirmatory texts – i.e., text messages sent to called party confirming the party’s choice to opt out of text messaging – violate the TCPA. Here, however, plaintiffs have not had success. As the court in Ryabyshchuck v. Citibank, 11-CV-1236 – IEG (WVG) (S.D. Ca. Oct. 30, 2012) noted, “a simple, confirmatory [text message] response to plaintiff-initiated contact can hardly be termed an invasion of plaintiff’s privacy under the TCPA. A finding to the contrary would stretch an inflexible interpretation beyond the realm of reason.” The FCC, in a declaratory ruling issued in November of 2012, generally agreed with the idea that confirmatory texts do not violate the TCPA, but included some important caveats in its ruling, including that (1) prior express consent to receive texts messages is required; (2) confirmatory texts must “merely confirm the consumer’s opt-out request and do not include any marketing or promotional information”; (3) confirmatory texts are to be the only additional messages sent to customers after they opt out; and (4) confirmatory texts should be sent within five minutes of the opt out request, as “the longer [the] delay [in sending confirmatory texts], the more difficult it will be to demonstrate that such messages fall within the original prior consent.” Significantly, the FCC did not entertain the petitioner’s argument that confirmatory texts do not violate the TCPA if an autodialer is not used to send them. Rather, the FCC implied in its order that obtaining prior express consent to receive text messages means confirmatory texts may be sent with or without an autodialer.

Given the perilous and quickly changing litigation landscape and the new FCC rules regarding consent, businesses are advised to examine their calling and text messaging practices to determine whether any changes to how they operate and obtain consent are necessary.

An Overview of the Consumer Financial Protection Bureau’s Ability-to-Repay and Qualified Mortgage Rule

Posted on April 22, 2013 by - Uncategorized

Lenders made millions of mortgages during the decade of the 2000s, some of which were not rigorously underwritten, and for some of which the borrowers had no hope of repaying. As the loans went into default, lenders’ losses mounted and borrowers’ woes increased. The mortgage market’s collapse led to the second greatest economic recession in the last 100 years and nearly brought the United States’ economy to its knees.

To remedy this situation, Congress and various federal agencies required lenders to assess a consumer’s ability to repay a home loan before the creditor could extend the consumer the credit. To encourage responsible lending, Congress provided for penalties where a loan was made to a borrower who did not have the ability to repay it fully. Congress also permitted the regulators to create a “safe harbor” for creditors, where it would be presumed that the borrower had the ability to repay a mortgage loan.

On January 10, 2013, the Consumer Financial Protection Bureau (Bureau) released its final Ability-to-Repay and Qualified Mortgage Rule, effective January 10, 2014. This article will look at that rule by first exploring the background and financial situation that led to the release of the rule, Congress’ statutory enactments permitting the rule, and the final rule itself.

Background

In the early part of the last decade, as housing prices rocketed skyward, lenders began introducing products that permitted borrowers to take advantage of their increasing equity. Lenders moved away from the fully-amortizing, fixed-rate, 30-year loan, and offered hybrid adjustable-rate mortgages where the initial interest rate was set at a below-market rate for a fixed period, such as two, three, five, or seven years. Lenders offered fully adjustable rate loans, where the interest rate was adjusted on a monthly or yearly basis. As the demand for loans increased, both by borrowers and investors, lenders offered loans with an interest-only payment, deferring the repayment of principal for a period of years. This permitted borrowers to obtain larger loans than could be afforded if the loans had to be repaid in equal payments of principal and interest over 30 years. Finally, the industry offered option ARM loans, where a borrower could choose to repay a portion of the interest owed, adding the remainder to an increasing principal balance.

To facilitate these loans, lenders relaxed their underwriting standards. Low-document and no-document loans proliferated. Borrowers could state their income, without offering any verification of it, and lenders would rely on the representations. Lenders would check borrowers’ credit and the value of the property, and little else. As long as the property value elevator rode upward, lenders made the loans, borrowers obtained loans, and investors bought loans.

Many borrowers took advantage of these loans, obtaining cash-out refinances. The cash-out portion may not have been used to improve the value of the property, and was often lost to repayment of other (overextended) debts, or to fund new purchases of vacations, impermanent assets, or consumables. In addition, with the advent of easier-to-obtain loans, new borrowers entered the housing market and became first-time homeowners for a small or no down payment. These borrowers often obtained loans with adjustable rate features or limited principal repayment that exposed the market to risk as payments adjusted or property values declined.

In the middle to late 2000s, the housing market slowed and reversed, and many borrowers were unable to repay their loans. As loans went into default and foreclosures increased, lenders and servicers were overwhelmed, and investors began to take losses. With the collapse of the housing market, America, and the world, entered the most serious recession since the Great Depression.

Reaction to the Housing Crisis – Ability to Repay Consideration

In 2008, the Federal Reserve Board (Board) adopted a rule under the Truth in Lending Act which prohibited creditors from making “higher-price” mortgage loans without assessing consumers’ ability to repay the loans. Under the Board’s rule, a creditor is presumed to have complied with the ability-to-repay requirement if the creditor followed specified underwriting practices.

In 2010, when Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), Sections 1411 and 1412 required lenders to assess consumers’ ability to repay all home loans before extending credit and provided that the regulators could create a safe harbor and presumption of compliance with the ability-to-repay requirement for “qualified mortgages.” Congress set forth the requirements in a new section of the Truth in Lending Act, Section 129C (link here), and permitted rulemaking to interpret the act and provide guidance to the industry and consumers.

The Bureau conducted extensive research and analysis on this issue. It sought public comment on new data and information, and the Bureau met with stakeholders on all sides in formulating the rule. On January 10, 2013, the Bureau released the final rule. (See “Ability to Repay and Qualified Mortgage Standards Under the Truth in Lending Act (Regulation Z)” at www.consumerfinance.gov. See also Ability-to-Repay and Qualified Mortgage Standards under the Truth in Lending Act, Final Rule, 78 Fed. Reg. 6408 (January 30, 2013), to be codified at 12 C.F.R. § 1026.) The Bureau stated that the rule protects consumers from risky practices that helped cause the mortgage crisis. It helps ensure that responsible consumers obtain responsible loans and that creditors can extend credit responsibly, without worrying about competition from unscrupulous lenders.

Under the statute, the ability-to-repay requirements are effective as of January 21, 2013. The final rule delays the implementation of the ability-to-repay requirements until January 10, 2014. If a successful challenge is mounted to the recess appointment of Richard Cordray as director of the Bureau, the ability-to-repay provisions are effective immediately. It is unknown whether they will have a retroactive effect.

Ability-to-Repay Rule

The Ability-to-Repay Rule, Regulation Z Section 1026.43, requires that a creditor make a “reasonable and good faith determination at or before consummation that the consumer will have a reasonable ability to repay the loan according to its terms.” The creditor must follow underwriting requirements and verify the information by using reasonably relied upon third-party records. The rule applies to all residential mortgages including purchase loans, refinances, home equity loans, first liens, and subordinate liens. In short, if the creditor is making a loan secured by a principal residence, second or vacation home, condominium, or mobile or manufactured home, the creditor must verify the borrowers’ ability to repay the loan. The section does not apply to commercial or business loans, even if secured by a personal dwelling. It also does not apply to loans for timeshares, reverse mortgages, loan modifications, and temporary bridge loans.

The creditor must consider and evaluate at least the following eight factors:

Current or reasonably expected income or assets. The creditor may consider borrowers’ assets and income that borrowers will use to repay the loan. The creditor may not consider the value of the secured property, including any equity in the dwelling. Because of seasonal work, or other factors that result in variable income, the creditor may consider current income and “reasonably” expected income. A creditor may also consider a joint applicant’s income and assets.

Current employment status. The creditor must consider borrowers’ current employment status to the extent that the creditor relies on the employment income to repay the loan. If borrowers’ intend to repay the loan with investment income, employment need not be considered.

Monthly payments on the covered transaction. The monthly payment obligation is based on the “full” payment. The payment must be considered on a monthly basis, and be at the fully adjusted indexed rate or the introductory rate, whichever is higher. In short, teaser rates and other “low” starting rates are not to be considered in the ability-to-repay analysis.

Monthly payments on a simultaneous loan. The creditor must consider the “full” monthly payments on any simultaneous loan that the creditor knows or has reason to know will be made on or before consummation when secured by the same dwelling. This includes piggy-back loans, concurrent loans, and open-ended home equity loans, even if made by another creditor. The rule applies to purchases and refinances.

Monthly payments for mortgage-related obligations. The creditor must consider payments for mortgage-related obligations, according to the loan’s terms, and all applicable taxes, hazard insurance, mortgage guarantee insurance, assessments, ground lease payments, and special assessments (if known). The creditor must consider these amounts whether or not an escrow is established. Where these charges are paid on an annual or periodic basis, they are to be calculated as if paid monthly. However, where the charge is a onetime, up-front fee, it need not be considered in the ability-to-repay calculation.

Current debt obligations, alimony, and child support. The creditor must consider borrowers’ other debt obligations that are actually owed. Each applicant’s obligations are to be evaluated, but the creditor does not need to consider other obligations of sureties or guarantors. Creditors are given significant flexibility in this area and may use reasonable means to consider other debt obligations.

Monthly debt-to-income ratio or residual income. The rule gives the creditor flexibility in defining “income” and “debt” based on governmental and non-governmental underwriting standards. The rule also gives the creditor flexibility in evaluating the appropriate debt-to-income ratio in light of residual income. For example, where the debt-to-income ratio is high and the borrowers have a large income, the borrowers should have sufficient remaining income to satisfy living expenses and therefore justify the loan. The determination is subject to a reasonable and good faith standard.

Credit history. A creditor must consider borrowers’ credit histories, but does not have to review a specific credit report or minimum credit score. Creditors may consider factors such as the number and age of credit lines, payment history, and any judgments, collections, or bankruptcies. The creditors must review borrowers’ credit histories and give various aspects as much or little weight as is appropriate to reach a reasonable, good faith determination of borrowers’ ability to repay the loan.

Creditors will typically use third-party records (not prepared by the consumer, creditor, mortgage broker, or any of their agents) to make a reasonable and good faith determination, based on verified and documented information, that a consumer has a reasonable ability to repay the mortgage loan. The rule requires that the creditor retain evidence of the ability to repay for three years. However, because of possible challenges by borrowers to the ability-to-repay determination, it is recommended that creditors and their successors maintain these records for the life of the loan.

The Ability-to-Repay Rule does not apply to every loan. Principally, the rule does not apply where a
non-standard mortgage (such as an adjustable rate loan, interest-only loan, or negative amortization loan) is refinanced into a standard mortgage, where the current creditor provides the refinance, the new payment will be materially (10 percent) lower, and most of the previous payments were timely. However, the ability-to-repay analysis implicitly applies to the new loan.

Qualified Mortgages

The Dodd Frank Act provided that “qualified mortgages” are entitled to a presumption that the creditor making the loan satisfied the ability-to-repay requirements. The Bureau’s rule establishes a safe harbor and creates a conclusive presumption for loans that meet certain criteria and are not high-priced loans that the creditor made a good faith and reasonable determination of the consumer’s ability to repay. Where the loan satisfies the requirements of a qualified mortgage and is a high-priced loan, there is a rebuttable presumption that the creditor complied with the ability-to-repay requirement. Borrowers may overcome the presumption when they can show that after making all mortgage related payments there is insufficient income left over to meet living expenses. The longer it takes for borrowers to default, the more difficult it is to overcome the presumption.

A qualified mortgage includes the following criteria:

Regular substantially equal periodic payments. This does not include negative amortization loans, interest only payments, and balloon payments. If the loan does not require monthly payments, the payments are to be calculated as if paid monthly.

Term is 30 years or less.

Total points and fees to not exceed 3 percent of the loan amount. Points and fees are broadly interpreted. The 3 percent cap is adjusted as the loan balance falls below $100,000. Points and fees include all items in the finance charge as defined in the Truth in Lending Act, other than interest. The points and fees include loan originator compensation paid by the consumer or creditor, as known at the time the interest rate is set, if attributable to the transaction, whether paid to the individual loan officer or a broker. The points and fees include charges paid to the creditor, originator, or affiliate, even if the same fees would not be included if charged by an independent third party. For example, title charges by an affiliated title company are included in the 3 percent calculation, but similar charges by an independent title company are not. The points and fees included other charges as detailed by the rule. The loan amount is the amount stated in the promissory note.

Monthly payment calculated based on the highest expected payment in the first five years. The creditor must underwrite the loan based on a fully amortized payment schedule taking into account the highest adjustment of any loan payment, and all other mortgage-related payments, including taxes and insurance, whether or not impounded by the creditor.

Consider current and reasonably expected income and expenses. This includes debt obligations, alimony, and child support. The income and expenses must be verified and documented, as discussed above. This eliminates low-document and no-document loans from being qualified mortgages.

Debt-to-income ratio does not exceed 43 percent. The debt includes all mortgage-related expenses, and simultaneous mortgage-related expenses that the creditor knows or has reason to know.

If these criteria are met and the loan is underwritten with good faith and reasonable reliance on verified third-party provided documentation, then the loan is a qualified mortgage entitled to a conclusive presumption that the loan meets the ability-to-pay requirements.

Alternative Qualified Mortgages

The Bureau established a second, temporary class of qualified mortgages based on the belief that certain consumers can afford loans with a higher debt-to-income ratio of 43 percent based on their particular circumstances. In addition, the temporary class of qualified mortgages may help overcome any initial reluctance of creditors to make loans that might not be qualified mortgages. These loans may be underwritten with more flexibility, but still require a reasonable and good faith belief in borrowers’ ability to repay the loans.

These alternative qualified mortgage loans must satisfy the general product feature prerequisites for a qualified mortgage and also satisfy the underwriting requirements of, and are eligible to be purchased, guaranteed or insured by (1) the GSEs while they operate under federal conservatorship or receivership or (2) the U.S. Department of Housing and Urban Development, Department of Veterans Affairs, or Department of Agriculture or Rural Housing Service. This temporary class will phase out as each agency issues its own qualified mortgage rules, or the GSE conservatorship ends, or seven years elapse.

Note that the rule does not define how the eligibility determination is made if the GSEs or federal agency does not actually purchase, guarantee, or insure the loan. Similarly, in light of the current state of repurchase litigation, even if the loan is purchased, guaranteed, or insured, it is unknown if that determination creates a qualified mortgage “presumption” that is conclusive or rebuttable.

Failure to Comply with Ability-to-Repay

A creditor must properly determine whether borrowers have the ability to repay their loans. Where a creditor does not act properly, the Bureau retains the ability to issue cease and desist orders, or impose civil monetary penalties.

The rule provides a private right of action to borrowers. They may seek actual damages, statutory damages, costs, and attorneys’ fees, and special damages equal to the finance charges and fees incurred. In short, where the creditor does not properly assess borrowers’ ability to repay loans, borrowers must repay the principal amount of the loan, less damages, and could end up with a “free” loan. Borrowers may also seek damages in class action litigation and individual cases. While current law provides for a one-year statute of limitation on damage actions, borrowers have three years to bring their ability-to-repay damage claims.

Borrowers may also assert the ability-to-repay defense in response to a foreclosure action and seek recoupment or set-off. The three-year statute of limitation does not apply, but borrowers are limited to three years of finance charges and fees as special damages. Assignees are liable for the errors of the original creditor.

Conclusion

Creditors must assess borrowers’ ability to repay a loan based on verifiable information. Creditors must act in a good faith and reasonable manner to determine whether borrowers can afford the loan(s) offered. To avoid liability under a faulty ability-to-pay determination, creditors may rely on the safe harbor of the qualified mortgage conclusive presumption. Qualified mortgages must be fully underwritten, at the maximum adjusted payment, based on verifiable information provided by third parties, to a high level of specification, even though the rule provides the creditor with discretion to make its determination. It is unknown what types of loans will be offered to borrowers and whether the loans will be purchased in the secondary market. However, it is expected that in the initial term, most residential mortgages will be low cost, fixed-rate loans, issued to very credit-worthy borrowers who meet all lending criteria. As GSEs and other agencies agree to purchase, guarantee or insure loans, the pool of available loans will expand, helping the Bureau meet its goal of ensuring that responsible consumers obtain responsible loans and that creditors extend credit responsibly, without worrying about competition from unscrupulous lenders.