The Impact of Corporate Restructuring on Foreign National Employees

Posted on April 18, 2013 by - Uncategorized

We are only one quarter into 2013, but this year has already seen a flurry of multi-billion-dollar mergers and acquisitions from some of corporate America’s most recognizable names. In the past few months, airline giants American Airlines and US Airways announced they would be merging in an $11 billion deal, while Warren Buffett’s Berkshire Hathaway and global investment firm 3G Capital announced the acquisition of the H.J. Heinz Company for $28 billion. Those deals came just a week after Dell Inc. announced that company founder Michael Dell had partnered with global technology investment firm Silver Lake Partners to acquire and privatize the company in a transaction valued at $24.4 billion.

Managing the legal aspects of corporate restructuring is a difficult task. For companies that employ foreign nationals, that task is even more complicated as there are significant immigration-related consequences that must be addressed prior to sealing the deal on a merger or acquisition. Because most work visas are employer-specific, changes in a company’s structure could affect the validity of a foreign national employee’s nonimmigrant visa status or pending green card application. In addition, a company’s failure to recognize the immigration issues arising as a result of its restructuring activities can not only seriously impact its foreign national employees, but also have serious consequences for the company. Employers who fail to take the proper measures may find themselves being sued by foreign national employees for negligence in handling their immigration matters. For example, when a company’s actions cause the foreign national employees to fall out of legal status, have problems pursuing permanent residency, or even potentially face bars on reentering the United States after travel abroad, those employees may seek action against the employer. Additionally, employers with immigration violations potentially face:

  • Worksite raids and loss of business during the raid;
  • Compliance audits;
  • Significant fines;
  • Criminal sanctions;
  • Revocation of state business licenses and government contracts; and
  • Negative publicity.

Worksite enforcement has become increasingly aggressive over the past few years and there has been a noticeable shift from monetary fines to criminal prosecution of employers with unlawful hires and paperwork violations.

In view of the recent crackdowns by federal and state governments on immigration compliance, the steady stream of lawsuits being filed by affected employees, and the media hype surrounding immigration reform, it is critical for companies that hire foreign nationals to include potential immigration consequences of a corporate restructuring as part of the due diligence process.

Issues Affecting Nonimmigrant Visa Holders

In these situations it is important to determine whether the employer after a corporate restructuring is the same employer that filed the approved visa petition with the U.S. Citizenship and Immigration Services (USCIS) or Department of State (DOS). The consequences of a merger or acquisition depend upon the type of nonimmigrant visas that the company’s employees hold.

The most common temporary work visa is the H-1B visa, which is used by U.S. companies to temporarily hire foreign national workers for specialty occupations that require at least a bachelor’s degree or its equivalent to perform the job duties. H-1B workers are authorized to work for a specific company in a specific geographic location in a specific position and for a specific salary. Companies that hire an H-1B worker are required to make an attestation to the U.S. Department of Labor (DOL) that they will pay the worker a salary that meets or exceeds the prevailing wage for the listed occupation in the geographic area of intended employment for the duration of the employee’s status. This attestation is made in what is called a Labor Condition Application (LCA).

If an H-1B worker changes employers, the new employer must generally file a new H-1B petition with USCIS. However, if the new employer is a “successor-in-interest” to the previous employer, an amended petition may not be needed. USCIS requires an amended H-1B visa petition to be filed if there are any “material changes” in the terms and conditions of an H-1B worker’s employment or eligibility (for example, a major change in the employee’s job duties). However, USCIS does not automatically require the filing of a new LCA and amended H-1B petition where a new corporate entity succeeds to the interests and obligations of the original petitioning employer and where the terms and conditions of the employment remain the same but for the identity of the petitioner. In this situation, the new employer, called a successor-in-interest, must make available for public inspection a sworn statement that it accepts all the obligations and liabilities of the LCAs filed by the predecessor entity, a list of affected LCAs and their dates of certification by DOL, a description of the new entity’s actual wage system, and the federal employer identification number (EIN). The new entity must provide this sworn statement before the H-1B employees are transferred to the new employer. If, however, there is a material change in the terms of an H-1B worker’s employment as a result of a merger or acquisition, then a new LCA or amended H-1B petition may need to be filed. For example, if the new employer transfers an H-1B employee to another location, a new LCA may be required. In this case, the new LCA must be filed with DOL prior to the relocation of the employee in order to avoid filing an amended H-1B visa petition. Otherwise, if this issue is overlooked, an amended H-1B petition will need to be filed with USCIS, potentially costing the company thousands of dollars per employee.

One issue that often comes up in the situation of a successor-in-interest is when an H-1B employee needs to travel abroad. Generally, in order to reenter the United States, the employee must have a valid H-1B visa annotated with the petitioning employer’s name. However, in this case, the visa annotation would list the predecessor employer, which could cause the employee difficulty when trying to reenter the United States. In addition, a new visa may only be obtained when the successor employer files an extension or amended H-1B visa petition with USCIS, and that petition is subsequently approved on behalf of the employee. Collaboration with an experienced immigration attorney prior to finalizing the corporate reorganization can help prevent these issues from occurring, thereby minimizing the stress to employees and human resource specialists.

Another potential issue with regard to H-1B visas is whether a merger or acquisition results in the new entity becoming H-1B dependent. An employer is considered to be H-1B dependent if it has fewer than 25 full-time employees, more than 7 of whom are on H-1B visas; 26-50 full-time employees with more than 12 on H-1B visas; or more than 50 full-time employees where more than 15 percent are on H-1B visas. This is a critical determination to make because H-1B dependent employers are subject to additional compliance and attestation requirements. For example, prior to hiring an H-1B worker, an H-1B dependent employer must make a good faith effort to recruit U.S. workers for the offered position through advertising, job fairs, and other forms of industry-wide recruitment. Furthermore, the employer must offer the job to any equally or better qualified U.S. worker who applies for the position and must not favor current nonimmigrant employees who have not yet obtained H-1B status (such as students currently working pursuant to Optional Practical Training). Because of the arduous process that H-1B dependent employers have to go through prior to hiring a foreign national, most companies try to avoid becoming H-1B dependent at all costs.

Another visa category commonly affected by a corporate transaction is the L-1 temporary work visa. The L-1 visa is useful for multinational companies that wish to transfer managers, executives, and specialized knowledge employees to serve in similar positions at a qualifying organization in the United States. In order to qualify for an L-1 visa, the employee must have been employed for at least one year in the past three years by a foreign parent, subsidiary, affiliate, or branch of the U.S. company. Therefore, if the merger or acquisition of a company alters the organizational structure so that there is no longer a qualifying corporate relationship between the U.S. employer and the foreign entity, L-1 employees in the United States may lose their eligibility. It is important to note, however, that the foreign entity that actually employed the L-1 transferee does not have to remain in existence as long as there is another foreign entity that has a qualifying relationship with the U.S. employer. A merger or acquisition that does not destroy the qualifying relationship merely imposes an obligation upon the employer to notify USCIS of the change in the organizational structure at the time of filing a petition for the extension of the employee’s L-1 visa status. However, if the worker is moved to a different related entity, an amended L-1 petition may need to be filed with USCIS.

Mergers and acquisitions can also create qualifying relationships for purposes of the L-1 visa. In this situation, L-1 visa petitions may not be filed until the relationship has been formed, which usually involves the transfer of stock. An agreement to create a relationship is not sufficient to establish the qualifying relationship because it does not involve the necessary ownership and control.

A third visa category often used by multinational companies that could be affected by a corporate reorganization is the E visa category. The E-1 visa is used by citizens of countries with which the United States maintains a treaty of commerce and navigation who are coming to the United States to carry on substantial trade, principally between the United States and the treaty country (for example, an Israeli citizen who is coming to the United States to work for a company that imports security systems from Israel). The E-2 visa is used by citizens of countries with which the United States maintains a bilateral treaty who are coming to the United States to work for a company that is owned by nationals of the same treaty country as the employee (for example, a Swiss citizen coming to the United States to work for the Swiss cheese company, La Fromagerie).

In order for an E-1 or E-2 employee to work in the United States, the U.S. employer must qualify as a treaty company, either because a majority (more than 50 percent) of its trade is with the treaty country (E-1) or because it is at least 50-percent owned by nationals of the treaty country (E-2).

In the E-1 scenario above, if the U.S. company is acquired and the new employer continues to carry on a majority of its trade with Israel, then the Israeli E-1 employee may continue to work in the U.S. in E-1 visa status (although it is recommended that an amended E-1 petition be filed to reflect the change in corporate structure). However, if the new employer cannot show that more than 50 percent of its trade is with Israel, the E-1 employee will no longer qualify for E-1 visa status and will have to change to a different visa status.

In the E-2 scenario, the Swiss citizen may only obtain an E-2 visa if he or she works for a company in the United States that is at least 50 percent Swiss owned. Owners who are United States permanent residents or who are dual citizens of both the United States and the treaty country are treated as U.S. nationals for this purpose and their ownership interest is not counted toward the requirement for 50 percent ownership by treaty country nationals. Therefore, 50 percent ownership by the treaty country nationals must be maintained in any merger or acquisition; if the treaty company (La Fromagerie, in the example above) is acquired by a company that is not Swiss, E-2 employees will no longer meet the requirements for this category and will be forced to leave the United States if they are not eligible to apply for a different visa category.

Issues Affecting Pending Green Card Applications

The employment-based green card application process generally consists of three steps (see sidebar). In the case of pending green card applications, it is critical to first determine whether the new employer entity is considered a successor-in-interest. If not, the new employer will have to start the green card process over from the very beginning, potentially costing the company thousands of dollars in legal and filing fees and delaying the green card by several years. For purposes of the green card process, a new employer entity will be considered a successor-in-interest if (1) the job opportunity is the same as the job opportunity listed in the labor certification; (2) the new employer establishes its eligibility as a successor-in-interest in all respects, including providing evidence of the predecessor’s ability to pay the employee the offered wage as of the date of the filing of the Program Electronic Review Management (PERM) application; and (3) the new entity’s I-140 petition documents the transfer and assumption of the ownership of the predecessor entity.

In addition, an employee’s ability to continue with the permanent residence (green card) application depends on where in the process he or she is at the time of the corporate restructuring. If the labor certification is pending, it will remain valid as long as the new employer is a successor-in-interest to the employer that filed the original labor certification and there have been no changes in job position or location. Whether or not the new employer qualifies as a successor-in-interest is decided by USCIS at the time of the filing of the I-140 petition. Once the labor certification is approved by DOL, the new employer would then file the I-140 petition with USCIS along with evidence of the successor-in-interest relationship. However, if there are any changes in job position or location, or if the new employer does not qualify as a successor-in-interest, the pending labor certification will be invalidated and the new employer will have to file a new labor certification. This can have serious repercussions for employees who are relying on the pending labor certifications to continue extending their underlying nonimmigrant visa status. It will also delay the green card process significantly, especially for those employees concerned with priority dates due to immigrant visa backlogs.

If the I-140 petition is pending when the corporate restructuring occurs, but the adjustment of status application has not yet been filed, then the new employer will need to file an amended I-140 with USCIS showing that the requisite successor-in-interest relationship exists. The same is true if the I-140 has been approved but no adjustment of status application has been filed yet.

The best scenario for both the new employer and foreign national employees in the middle of the green card process is an approved I-140 and a pending adjustment of status application. This is because the American Competitiveness in the 21st Century Act (AC21) allows a foreign national to change employers if the I-140 has been approved and the adjustment of status application has been pending for 180 days or more, as long as the new position is in the “same or similar occupational classification.” In determining whether a new position is the “same or similar” as the position on the approved labor certification, USCIS looks at several factors including the job descriptions of both positions, the salaries, and the DOL’s Dictionary of Occupational Titles (DOT) and/or Standard Occupational Classification (SOC) codes for each position. While there is no requirement to notify USCIS of a change in employer with respect to a pending adjustment of status application, many attorneys recommend proactively notifying USCIS of the change in employer and showing that the new position is the “same or similar.”

Multinational managers and executive transferees (see L-1 visas above) do not have to go through the arduous labor certification process when applying for a green card. However, because their eligibility for permanent residence hinges upon the relationship between the foreign employer and the U.S. employer, a corporate restructuring can have negative consequences on these employees’ eligibility to qualify for permanent residence in this category.

When the U.S. company and the foreign company are affiliated through the ownership of a group of individuals, mergers and acquisitions become an issue because each group of individuals must own and control each business and each individual in the group must hold approximately the same proportion of each business (or the same shareholders must have a controlling interest in each business). Additionally, the U.S. employer must have been doing business in the United States for at least one year to be able to file this type of petition on behalf of one of its employees. Interestingly, there is no requirement that a qualifying relationship exist between the United States and the foreign entities for the one-year period, so a U.S. entity acquired by a foreign entity may immediately apply for an otherwise qualifying manager or executive. However, the foreign entity that actually employed the transferee must continue to exist in order to file an immigrant visa petition on behalf of a multinational manager or executive.

I-9 Compliance

One of the most important (but overlooked) issues that an employer should be concerned with at the time of a restructuring is the Form I-9. The Immigration Control and Reform Act of 1986 requires that a Form I-9 (Employment Eligibility Verification) be completed for each newly-hired employee, with some exceptions. A successor-in-interest may assume the I-9 liabilities of the predecessor employee; however, this means that the new employer is also liable for any mistakes in the I-9s previously completed by the predecessor. Therefore, before a transaction is undertaken, an examination of the organization’s I-9s should be conducted through either an audit or a review. If the successor organization does not assume I-9s of the predecessor, new I-9s may be completed for each of the organization’s employees within three days of the transaction to avoid any allegation of an unfair immigration-related employment practice such as document abuse or discrimination on the basis of citizenship or nationality.

Conclusion

It is critical for in-house counsel to be aware of immigration-related issues that may arise as a result of a restructuring between companies that employ foreign nationals. Companies should work with competent and experienced immigration counsel early on in any transaction to ensure that they are in compliance with immigration regulations and to ensure that foreign national employees remain authorized to work in the United States.

The Bureau’s Loan Originator Compensation Rule: Changes, Clarifications, Qualifications and More

Posted on April 2, 2013 by - Uncategorized

On January 20, 2013, the Consumer Financial Protection Bureau (Bureau) released its final rule regarding the loan originator compensation requirements under the Truth in Lending Act (Rule). It followed up by publishing the Rule in the Federal Register on February 15, 2013. Despite the Bureau’s labeling of the Rule, it does more than implement statutorily required loan originator compensation changes. It also clarifies existing loan origination compensation requirements, including those based on prior informal interpretations rather than the plain language of Regulation Z or its commentary. Less obvious from the name of the Rule, it includes loan originator qualification requirements, requires the use of unique identifiers on certain loan documents, prohibits mandatory arbitration provisions and the financing of single-premium credit insurance for covered loans, and extends record keeping requirements. It also addresses the statutory prohibition on upfront points and fees in certain loans. The provisions regarding mandatory arbitration and the financing of single premium credit insurance have a stated effective date of June 1, 2013. The remainder of the Rule has a stated effective date of January 10, 2014.

The Rule revises the definition of the term “loan originator.” The term generally will mean a person, who in the expectation of compensation, does any of the following in connection with a residential mortgage loan: offers, arranges, negotiates, takes an application for, assists a consumer in obtaining or applying for, or otherwise obtains or makes a residential mortgage loan for another person. It will also include a person that advertises that the person can or will perform any of these activities. The Bureau will interpret this definition broadly and, consistent with prior informal interpretations, will include referral activity within the scope of covered loan origination activities. However, the Rule and related commentary provide some clarifications regarding the scope of covered referral activity. For example, covered referral activity will not include, among other things, providing general information in response to inquiries or, if the person is an employee of a creditor or mortgage broker, providing contact information for a loan originator in response to a request, unless the employee does so based on the inquiring person’s financial characteristics or discusses particular loan terms. Additionally, the Rule lists several categories of persons that will not be loan originators, including certain bona fide third-party advisors, certain licensed or registered real estate brokers, certain seller financers, and loan servicers and their employees when modifying or offering to modify an existing loan that is in default or is likely to go into default. It also clarifies when administrative and clerical staff members are not acting as loan originators.

The Rule continues the prohibition on basing loan originator compensation on any of the residential mortgage loan transaction’s terms or conditions, including any factor that is a proxy for a loan term or condition. The terms and conditions will include any right or obligation of the parties to a residential mortgage loan, except the amount of credit extended if the compensation is based on a fixed percentage. The Rule provides clarification regarding what constitutes a proxy. A factor will be a proxy if it consistently varies a term or terms over a significant number of loans and the loan originator has the ability to add, drop, or change the factor.

Consistent with prior informal interpretations of Regulation Z, the Rule clarifies that the prohibition includes not only compensation based on the terms or conditions of a single transaction, but also compensation based on the terms of multiple transactions by a single loan originator or multiple loan originators. Because the prohibition includes the terms or conditions of multiple loans by multiple originators, loan originator compensation cannot be based on the profits of a residential mortgage loan-related business. The Rule adopts this interpretation, but creates two exceptions. First, contributions to or benefits paid from designated tax-advantaged plans are permissible if they are not based on the terms of the individual loan originator’s transactions. Second, payments pursuant to certain non-deferred profits based compensation plans, as set forth in the Rule, could be permissible if they meet additional requirements, such as being limited to 10 percent or less of the loan originator’s total compensation or if the individual was the loan originator for 10 or fewer residential mortgage loans during the 12 months preceding the compensation determination date.

The Rule, similar to current Regulation Z, will generally prohibit reductions to loan originator compensation to offset costs if the terms of a transaction change. The reductions are prohibited because they are based on a term or condition of the transaction. However, the Commentary to the Rule states that reductions to compensation to offset unanticipated increases in certain settlement charges are permitted.

The Rule creates an exception to the Regulation Z prohibition on dual compensation. The Rule will allow a mortgage broker that receives compensation from the consumer to pay its employees or contractors commissions under certain circumstances.

For some, what is not in the Rule may be as important as what is in it. The Dodd-Frank Act would have prohibited certain loan originator compensation if the borrower paid upfront points and fees. For example, the Dodd-Frank Act would have generally prohibited a lender from paying individual loan originators certain commissions and other compensation in connection with a mortgage loan if the borrower paid up front points and fees. The Bureau had proposed creating a partial exemption. The proposal would have allowed a lender to charge up front points and fees and pay commissions and other compensation if the lender offered the borrower an alternative loan that did not include upfront points and fees. Rather than adopt this partial exemption, the Bureau decided to adopt a complete exemption to the statutory ban on upfront points and fees. The Bureau intends to assess the effects of the complete exemption and may take future action, including narrowing the exemption.

The Rule imposes obligations on creditors and mortgage brokers to ensure that the individual loan originators who work for them (i.e., employees, agents, contractors) are licensed or registered under other applicable laws, such as the Secure and Fair Enforcement for Mortgage Licensing Act of 2008. The Rule requires creditors and mortgage brokers that employ individual loan originators who are not required to be licensed or registered to ensure that these loan originator employees meet character, fitness, and background standards and receive training similar to licensed and registered loan originators. The Rule also requires that creditors and mortgage brokers include their unique identifiers and names on certain loan documents. The creditor or broker also must list the name and identifier of the individual loan originator primarily responsible for the origination of the loan.

The Rule prohibits loan terms that require the borrower to submit a dispute about a residential mortgage loan or certain home equity lines of credit (HELOCs) to binding arbitration. Additionally, under the Rule, no agreement relating to a residential mortgage loan or certain HELOCs could be applied to bar a borrower from bringing a court claim regarding an alleged violation of federal law. However, the parties could agree to arbitrate or otherwise settle a claim after a dispute arises.

The Rule prohibits the financing of any premiums for credit insurance in connection with a residential mortgage loan or certain HELOCs, but will permit premiums that are calculated and paid in full on a monthly basis.

The Rule expands recordkeeping requirements regarding loan originator compensation. The recordkeeping requirements apply to loan originator organizations, including both creditors and mortgage brokers. They will be required to keep evidence of compliance for three years. The increased time period will match the longer statute of limitations that will apply to claims for violations of the loan originator compensation requirements.

In conclusion, the Rule could affect several different aspects of a mortgage lender’s or broker’s operations, including hiring, employee training, compensation structures, referral activities, loan forms, litigation budgets, record retention schedules, and other policies and procedures. Going forward, lenders and brokers may be able to revise compensation structures. If they do so, they may need to consider other recently published rules that could affect loan originator compensation (e.g., Ability-to-Repay Rule). Depository institutions will have to provide additional training and background screening. Lenders and brokers will likely need to revise loan documents to provide identification information and revise their record retention schedules and other policies and procedures so that they are able to demonstrate compliance. The Rule is an example of the importance of reviewing not only the regulation but also the commentary and supplementary information. In this case, the Rule does not cover everything that one must know about upcoming loan originator compensation issues, but the commentary and supplementary information as well as the regulation clarify several important points from current Regulation Z’s requirements and cover several other issues on which mortgage lenders and brokers will need to be advised.

Recent Changes to HOEPA

Posted on April 2, 2013 by - Uncategorized

On January 10, 2013, the Bureau of Consumer Financial Protection (Bureau) issued a final rule amending Regulation Z by expanding the types of transactions subject to the Home Ownership and Equity Protection Act of 1994 (HOEPA), revising and expanding HOEPA thresholds, and imposing additional requirements on HOEPA loans. The final rule also amends Regulation Z and Regulation X (RESPA) by imposing homeownership counseling requirements. These changes are effective for all loans applied for on and after January 10, 2014.

This article focuses on the final rule’s expanded coverage, thresholds, requirements, and its impact on creditors, brokers, purchasers, and consumers.

Expanded Coverage

Transactions eligible for HOEPA coverage now include purchase-money loans and home-equity lines of credit (HELOCs). Transactions excluded from coverage include: reverse mortgage loans, loans to finance the initial construction of a dwelling, loans originated by a Housing Finance Agency, and loans under USDA’s Section 502 Direct Loan Program. While this expanded coverage may improve consumers’ understanding of the terms and features of a high-cost mortgage, it also may limit their access to credit, since most lenders are reluctant to make high-cost mortgages. Further, creditors will incur additional costs in identifying these types of loans, including, but not limited to, those costs related to changing or upgrading automated systems and disclosures, legal and compliance review, and staff training. Creditors also may lose revenue as a greater number of their loans are subject to HOEPA, and there is limited secondary market demand for high-cost mortgages.

What is a High-Cost Mortgage?

A “High-Cost Mortgage” is a consumer credit transaction secured by a consumer’s 1-4 unit principal dwelling, including purchase and non-purchase money closed-end credit transactions and HELOCs, in which

  1. The annual percentage rate (APR) exceeds the average prime offer rate (APOR) for a comparable transaction by more than:
    1. 6.5 percentage points for first liens;
    2. 8.5 percentage points for first liens less than $50,000 secured by a dwelling that is personal property (e.g., manufactured home); or
    3. 8.5 percentage points for junior liens;
  2. The total points and fees exceed:
    1. 5 percent of the total loan amount if the loan amount is $20,000 or more; or
    2. The lesser of 8 percent of the total loan amount or $1,000 for a loan amount less than $20,000 (the $1,000 and $20,000 figures are adjusted annually); or
  3. A prepayment penalty may be charged more than 36 months after consummation or account opening, or may exceed, in total, more than 2 percent of the amount prepaid.

Although the thresholds seem straight-forward, the devil is in the details. Let’s dive into those details.

New High-Cost APR and Index

Creditors may use one of three methods to determine the interest rate for the APR calculation. For a fixed-rate transaction, a creditor must use the interest rate in effect as of the date the interest rate for the transaction was set. For a variable-rate transaction which varies according to an index, a creditor must use the higher of the index plus margin or the introductory interest rate in effect as of the date the interest rate for the transaction is set. For a variable-rate transaction which does not vary according to an index (e.g., step-rate mortgage), a creditor must use the maximum interest rate that may be imposed during the term of the transaction.

In order to determine the applicable rate threshold, a creditor must now use the APOR index for a comparable transaction. APOR tables and guidance are available at www.ffiec.gov/ratespread/aportables.htm and www.ffiec.gov/ratespread. There are three factors to consider when determining a “comparable transaction”: (1) whether the transaction is a fixed-rate or variable-rate, (2) the date the interest rate for the transaction was set, and (3) the term of the transaction. The “date the interest rate was set” means the date on which the loan’s interest rate is set for the final time before closing. If there is a rate lock agreement, it is the lock date specified in the agreement. If a rate is reset after execution of a rate lock agreement (e.g., float-down option exercise date), then the relevant date is the date the rate is re-set for the final time before closing. If there is no rate lock agreement, the relevant date is the date on which the rate is set for the final time before closing. In the case of a fixed-rate transaction, the “term of the transaction” is the transaction’s term to maturity. In the case of a variable-rate transaction, the “term of the transaction” is the initial fixed-rate period, rounded to the nearest number of whole years (or, if the initial fixed-rate period is less than one year, one year). A creditor originating a fixed-rate, evergreen HELOC should use a term of 30 years.

What is the potential impact of the revised APR threshold? First, the Bureau estimates a 20 percent increase in refinance and home improvement loans that will be High-Cost Mortgages. Second, FHA recently extended its monthly mortgage insurance premium requirement. This will cause the APR for FHA loans to be higher, since the APR reflects costs other than interest on closed-end transactions, which in turn could make more FHA loans High-Cost Mortgages. Third, the APR calculated from a fully-indexed rate will be higher than the composite APR calculated according to Regulation Z Section 1026.17.

New High-Cost Points and Fees Threshold and Definition

Which points and fees threshold applies depends on whether the face amount of the note, in a closed-end transaction, or the credit limit, in an open-end transaction, is $20,000 or more. In contrast, for the points and fees threshold calculation, the final rule uses a “total loan amount.” In a closed-end transaction the “total loan amount” is calculated by starting with the amount financed and subtracting (1) any financed item listed in 1026.4(c)(7) which is unreasonable or is paid to the creditor or an affiliate; (2) any upfront financed credit insurance premium; and (3) the prior loan’s prepayment penalty if it is financed, subject to certain limitations. The HELOC “total loan amount” is the credit limit.

The final rule also amends the definition of points and fees to remove certain items previously included (e.g., certain upfront mortgage insurance premiums and bona fide discount points) and to add other items (e.g., the maximum prepayment penalty). Under the final rule, “points and fees” mean the following fees or charges that are known at or before consummation:

  1. All items included in the finance charge under 1026.4(a) and (b).
  2. All compensation paid directly or indirectly by a consumer or creditor to a loan originator that can be attributed to the transaction at the time the interest rate is set. This requirement, as currently drafted, would double-count loan originator compensation under certain circumstances. There is a Concurrent Proposal that would address this issue. Stay tuned.
  3. All items listed in 1026.4(c)(7) if unreasonable, or the creditor or its affiliate receives compensation, direct or indirect, in connection with the charge.
  4. Upfront credit life, disability, unemployment insurance premiums.
  5. The maximum prepayment penalty. (Note: The following state high cost points and fees calculations also may include some or all of the prepayment penalty amount: Arkansas, Georgia, Massachusetts, New Jersey, New Mexico, North Carolina, and South Carolina.)
  6. The prior loan’s prepayment penalty, subject to certain limitations. (Note: Georgia, Massachusetts, New Jersey, and New Mexico have a similar requirement.)
  7. For HELOCs only, any participation fee payable at or before account opening and any minimum or per-transaction fee (assume at least one draw).

The following items known at or before consummation are excluded from the calculation of “points and fees”:

  1. Interest or time-price differential
  2. Any premium or similar charge imposed in connection with a federal or state agency program (i.e., FHA Mortgage Insurance, VA Funding Fee, or USDA RHS Upfront Guarantee Fee).
  3. Any premium or similar charge that protects the creditor against the consumer’s default or other credit loss (e.g., private mortgage insurance), but only to the extent the upfront amount does not exceed the FHA upfront mortgage insurance premium for a comparable loan and the upfront guarantee or premium is automatically refundable on a pro rata basis upon satisfaction of the mortgage.
  4. Any bona fide third-party charge not retained by the creditor, loan originator, or an affiliate of either, unless the charge is required to be included;
  5. Up to 2 bona fide discount points, if the undiscounted interest rate does not exceed the comparable APOR by more than 1 percentage point, or up to 1 bona fide discount point if the undiscounted interest rate does not exceed the APOR by more than 2 percentage points. For transactions secured by personal property, a creditor would use the average rate for a loan insured under Title I of NHA. A discount point is considered bona fide if it reduces the undiscounted rate by at least .25 basis points. (The following states have some form of bona fide discount point exclusion in their high cost thresholds: Indiana, New Jersey, New Mexico, North Carolina, South Carolina, and Tennessee.)

Based upon the lower points and fees threshold, smaller loan amounts may easily exceed the 5 percent threshold. If this occurs, access to small loan credit may be limited, as creditors and the secondary market have little appetite for High-Cost Mortgages.

New Prepayment Penalty Threshold

The new threshold limits when a penalty may be imposed to the first 36 months of the transaction, and limits the penalty amount to 2 percent of the amount prepaid. For purposes of this threshold, a prepayment penalty does not include (1) certain conditionally-waived upfront bona fide third-party closing costs; and (2) until January 21, 2015, interest charged consistent with the monthly interest accrual amortization method for FHA insured transactions.

The Bureau believes the number of transactions affected by the prepayment threshold will be small, since the maximum prepayment penalty is included in the points and fees calculation, and a creditor would have to forgo some or all of the other charges included in the points and fees calculation, in order to originate a “qualified mortgage” which caps points and fees at 3 percent. In addition, limiting the penalty to the first 36 months will impact lenders in California, Louisiana, Minnesota, New Hampshire, and Ohio, all of which allow prepayment penalties to be charged for a longer period (60/84, 60, 42, 60, and 60 months respectively). This threshold also impacts the allowable prepayment penalty amount in Illinois, 3 percent, and Louisiana, which allows a 5 percent penalty in the first year.

New High-Cost Mortgage Restrictions

Sections 1026.32 and 1026.34 provide that once a transaction is a High-Cost Mortgage:

  • Balloon payments are generally prohibited.
  • Prepayment penalties are prohibited.
  • Financing points and fees are prohibited.
  • Late fees cannot exceed 4 percent of the past due payment or be imposed until after 15 days past due.
  • Payoff statement must be provided within 5 days of request and fees are restricted.
  • Modification and Deferral Fees are prohibited.
  • Ability-to-Repay assessment is required for HELOCs. Closed-end loans must meet the 2013 Ability-to-Repay Final Rule requirements.
  • No default may be recommended or encouraged.

Revised High-Cost Mortgage Disclosures

Section 1026.32(c) revises the High-Cost Mortgage disclosure and distinguishes closed-end and HELOC requirements. A creditor must provide the disclosure to the consumer not less than 3 business days prior to consummation or account opening. “Business day” has the same meaning as the Regulation Z rescission rule. If the disclosure becomes inaccurate, a creditor must provide new disclosures and begin a new 3-day waiting period. A consumer may waive the waiting period to meet a bona fide personal emergency. A creditor may provide new disclosures by telephone if the consumer initiates the change and if, prior to or at consummation or account opening (1) the creditor provides new disclosures, and (2) the consumer and creditor sign a statement concerning the delivery and timing of telephone disclosures.

Corrections of Unintentional Violations

New Section 1026.32(h) allows a creditor or assignee, who, when acting in good faith, fails to comply with any Section 1026.32 requirement, to take steps to cure the “violation” by providing written notice of available choices. For notice to be adequate, the consumer should have at least 60 days to consider the options and communicate a choice. The creditor or assignee must satisfy either of the following sets of conditions:

  1. Within 30 days of consummation or account opening and prior to the institution of any action, the consumer discovers the violation or the creditor or assignee notifies the consumer, and the creditor or assignee (a) provides appropriate restitution within 30 days; (b) adjusts the transaction’s terms, within 30 days, by either, at the choice of the consumer (i) making the transaction satisfy Section 1026.32 requirements; or (ii) Changing the transaction’s terms so it will no longer be a High-Cost Mortgage.
  2. Within 60 days of the creditor’s discovery or receipt of notification of an unintentional violation or bona fide error and prior to the institution of any action, the creditor (a) notifies the consumer of the compliance failure; (b) provides appropriate restitution within 30 days; and (c) adjusts the transaction’s terms, within 30 days, by either, at the choice of the consumer (i) making the transaction satisfy Section 1026.32 requirements; or (ii) changing the transaction’s terms so it will no longer be a High-Cost Mortgage.

Regulation X (RESPA) Homeownership Counseling Organization List

12 CFR 1026.20 requires a lender to provide a written list of homeownership counseling organizations (the List) to the applicant of a federally related mortgage loan, which includes a loan (other than temporary financing, e.g., construction loan) secured by a 1-4 unit dwelling, including purchase and non-purchase money closed-end credit and HELOCs. The creditor must retrieve the List information from the Bureau’s website or from data made available by the Bureau or HUD no more than 30 days prior to delivery.

A lender must provide the List no later than 3 business days after the lender or mortgage broker receives an application. If there is more than one applicant, the lender may provide the List to the applicant with primary liability. If the lender does not provide the List in person, the lender must mail or deliver it by other means, including electronically, subject to the E-Sign Act. Although the lender is ultimately responsible for compliance, a mortgage broker or dealer also may provide the List. If there is more than one lender, only one List is required. Unless otherwise prohibited, the lender may provide the List with other required disclosures. For a HELOC subject to Regulation Z, a lender that provides the applicant with the List may comply with the timing and delivery requirements of either 1024.20(a) or 1026.40(b).

A lender does not need to provide the List if before the end of the 3 business days, the application is denied or withdrawn, or the application is for a reverse mortgage or loan secured by a timeshare.

High-Cost Mortgage Counseling Requirements

Section 1026.34(a)(5) requires a creditor, prior to making a High-Cost Mortgage, to receive written certification from an unaffiliated HUD-certified or -approved or state housing finance authority-certified or -approved counselor that the consumer received counseling on the advisability of the transaction. The certification must contain the elements specified in 1026.34(a)(5). The creditor may receive the certification by mail, e-mail, or facsimile. A creditor may process the application, order the appraisal or title search, prior to receiving the certification.

A consumer may not obtain counseling until after receiving the initial good faith estimate on a closed-end transaction or the initial HELOC disclosures required by Regulation Z. A creditor cannot direct a consumer to a particular counselor or organization. A consumer may pay a bona fide third-party counseling fee and it may be financed. A creditor may pay the fee, but cannot condition payment on loan consummation or account opening. A creditor may confirm counseling prior to paying the fee; however, if the consumer withdraws the application, a creditor may not condition the payment on receipt of the certification.

Negative Amortization Counseling Requirements

Section 1026.36(k) requires a creditor, prior to making a closed-end loan secured by a 1-4 unit dwelling which may result in negative amortization, to obtain confirmation that a first-time borrower received counseling on the risks of negative amortization from a HUD-certified or -approved counselor or counseling organization. Acceptable confirmation includes a certificate, letter, or e-mail. This requirement does not apply to reverse mortgages or loans secured by a timeshare. A creditor cannot direct a consumer to choose a particular counselor or organization. Although a creditor cannot make the loan prior to receiving this confirmation, a creditor may engage in other activities, such as processing the application or ordering the appraisal or title search.

Conclusion

Although originations of High-Cost Mortgages are a small percentage of the market as a result of special disclosure requirements, restrictions, enhanced borrower remedies, and assignee liability, the expansion of HOEPA coverage will increase the number of loans subject to HOEPA and the new and lower thresholds will increase the number of loans classified as High-Cost Mortgages. What percentage of loans this will include is difficult to determine.

This article just begins to scratch the surface of the issues this final rule raises for lenders, brokers, and their compliance or legal experts. Lenders will want to review 30 state and local high cost coverage and threshold requirements to determine any necessary changes. Lenders will want to review rates and fees on smaller loans, in order to determine how to price these loans appropriately to avoid a High-Cost Mortgage designation. Lenders and brokers will want to review their loan originator compensation policies. Lenders will want to review state prepayment penalty riders to ensure compliance with federal and state law. Lenders will want to consider creating new procedures to handle unintentional Section 32 violations, to meet the timing and other cure requirements. Finally, lenders will need to plan for the additional costs they will incur in updating automated systems, disclosures and documents, employee training, and outside legal advice. Will these HOEPA changes ultimately help consumers or reduce access to credit? Only time will tell.

 

The Future of Tribal Lending Under the Consumer Financial Protection Bureau

Posted on March 13, 2013 by - Uncategorized

Some Indian tribes – particularly impecunious tribes located remotely from population centers, without sufficient traffic to engage profitably in casino gambling – have found much-needed revenue from consumer lending over the Internet.

In a typical model, the tribe forms a tribal lending entity (TLE) that is financed by a third party. The TLE then makes loans over the Internet to consumers nationwide, usually on terms that are unlawful under the internal laws of the states where the borrowers reside. Because the TLE is deemed an “arm” of the tribe, the TLE benefits from the tribe’s sovereign immunity. As a result, the TLE may be sued only under very limited circumstances; and, perhaps even more importantly, the TLE is exempt from most state-court discovery intended to unearth the economic relationship between the TLE and its non-tribal financier.

Because this model has, at least to date, provided a relatively bulletproof means to circumvent disparate state consumer-protection laws, the model has attracted Internet-based payday and, to a lesser extent, installment lenders. Although data are spotty, it is likely the fastest-growing model for unsecured online lending. Tribal sovereign immunity renders this model the preferred legal structure for online lenders desirous of employing uniform product pricing and terms nationwide, including for loans to borrowers who reside in states that prohibit such lending entirely.

The tribal model is increasingly being adopted by online lenders who had formerly employed other models. Yet the legal risks of the model to those who would “partner” with TLEs are rarely emphasized.

Introduction to the Tribal Model

Payday loans are designed to assist financially constrained consumers in bridging small ($100 to $1,000) cash shortages between loan origination and the borrower’s next payday. The permitted interest rates for such loans, where they are allowed, are high – generally in the APR range of 400 percent. Such permitted rates are, perhaps incredibly, less than the economic equilibrium price for such credit. A borrower who desires to extend a loan, or who is unable to repay a loan on the due date, may refinance, or “roll over,” the loan. State laws and the “best practices” of the storefront payday lenders’ trade association frequently limit such “rollovers” and permit a borrower with payment difficulties to demand an interest-free extended repayment plan.

TLEs are customarily tribally chartered. In the best embodiment, the TLEs have offices on tribal lands, operate payday-loan-decisioning computer servers there, and employ tribal personnel in various stages of the loan-origination process. But TLEs generally make extensive use of non-tribal subcontractors and typically receive substantially all of their financing from non-tribal financiers. As a result, the economic benefits of TLEs’ lending operations frequently flow primarily to the financiers and not to the tribes.

The principal benefit of the tribal model to the TLE is the ability to charge – at least to date, with relative impunity – market rates for payday loans, typically in excess of $20 per $100 advanced for a two-week loan (equivalent to an APR of 520 percent). These rates generally exceed permissible charges in borrowers’ states. Thirty-two states permit payday loans to their residents, but in most cases with maximum finance charges of $15 or less; the remaining states and the District of Columbia have applicable usury laws that either expressly or impliedly bar payday lending altogether.

Because TLEs deem themselves exempt from compliance with all borrower-state laws, a TLE engaged in payday lending usually charges a single rate nationwide and generally does not comply with state-law limitations on loan duration or rollovers. Online lenders generally seek to comply with federal laws applicable to consumer loans (e.g., TILA and ECOA).

Commercial payday lenders have entered into collaborations with Indian tribes in order to seek to benefit from the tribes’ sovereign immunity. As noted above, in many cases the non-tribal participant may preponderate in the finances of the TLEs, causing regulators and some scholars to call into question the bona fides of the arrangements. The popular press often refers to these arrangements as “rent-a-tribe” ventures, similar to the “rent-a-bank” payday lending ventures formerly in use until the latter were effectively ended by federal bank regulators in 2005.

Following President Obama’s putative recess appointment on January 4, 2012, of Richard Cordray as director of the Consumer Financial Protection Bureau (CFPB) – thereby enabling supervision of non-depository institutions – the CFPB is likely to subject the tribal model to increased scrutiny.

Tribal Sovereign Immunity

Indian tribes were sovereign nations prior to the founding of the United States. Thus, rather than grant sovereignty to tribes, subsequent treaties and legislative and juridical acts have served to recognize this inherent preexisting sovereignty. Because they are separate sovereigns, recognized Indian tribes are subject to suit only under limited circumstances: specifically, when the tribe has voluntarily waived its immunity, or when authorized by Congress. Kiowa Tribe of Oklahoma v. Manufacturing Tech., Inc., 523 U.S. 751, 754 (1998).

The extent of immunity is governed largely by the Supreme Court’s decision in California v. Cabazon Band of Mission Indians, 480 U.S. 202 (1987). Concepts of tribal immunity have been addressed extensively in prior articles and will not be belabored here. In brief summary, state and local laws may be applied to on-reservation activities of tribes and tribal members only under very limited circumstances generally inapplicable to tribal lending.

As recent examples of these principles, the appellate courts of California and Colorado were confronted with the assertion that tribal sovereign immunity prevents the use of state-court discovery methods to determine whether a tribe-affiliated Internet payday lender had a sufficient nexus with the tribe to qualify for sovereign immunity and, secondarily, to pursue discovery of the alleged sham relationship between the TLE and its financial backer. Relying in each case on the Supreme Court’s determination that tribal sovereign immunity prevents compelled production of information to assist a state in investigating violations of and enforcing its laws, both of those courts denied meaningful discovery.

Sovereign immunity applies not only to tribes themselves but also to entities that are deemed “arms” of the tribe, such as tribally chartered TLEs.

Because the immunity of TLEs is substantially beyond cavil, the “action” in litigation over the tribal model has moved on from the tribes and their “arms” to non-tribal financiers, servicers, aiders, and abettors. Discovery of the details of the financial relationships between TLEs and their financiers has been a key aim of these state-court proceedings by regulators, since the non-tribal “money partners” of the TLEs almost certainly cannot assert tribal immunity. The principal risk to such financiers is recharacterization as the “true” lender in one of these arrangements.

Pre-CFPB Federal Regulation of Payday Lending

Prior to the enactment of the Dodd-Frank Act (the Act), federal enforcement of substantive consumer lending laws against non-depository payday lenders had generally been limited to civil prosecution by the Federal Trade Commission (FTC) of unfair and deceptive acts and practices (UDAP) proscribed by federal law. Although it could be argued that unfair practices were involved, the FTC did not pursue state-law usury or rollover violations. Because of the relative novelty of the tribal lending model, and perhaps more importantly because of the propensity of FTC defendants to settle, there are no reported decisions regarding the FTC’s assertion of jurisdiction over TLEs.

The FTC’s most public (and perhaps its first) enforcement action against a purported tribal-affiliated payday lender was not filed until September 2011, when the FTC sued Lakota Cash after Lakota had attempted to garnish consumers’ wages without obtaining a court order, in order to collect on payday loans. The FTC alleged that Lakota had illegally revealed consumers’ debts to their employers and violated their substantive rights under other federal laws, including those relating to electronic payments. The case, as with nearly all of the other FTC payday-lending-related cases, was promptly settled. Thus, it provides little guidance to inform future enforcement actions by the FTC or the CFPB.

The Looming Battle Over CFPB Authority

Article X of the Act created the Consumer Financial Protection Bureau with plenary supervisory, rulemaking and enforcement authority with respect to payday lenders. The Act does not distinguish between tribal and non-tribal lenders. TLEs, which make loans to consumers, fall squarely within the definition of “covered persons” under the Act. Tribes are not expressly exempted from the provisions of the Act when they perform consumer-lending functions.

The CFPB has asserted publicly that it has authority to regulate tribal payday lending. Nevertheless, TLEs will certainly argue that they should not fall within the ambit of the Act. Specifically, TLEs will argue, inter alia, that because Congress did not expressly include tribes within the definition of “covered person,” tribes should be excluded (possibly because their sovereignty should permit the tribes alone to determine whether and on what terms tribes and their “arms” may lend to others). Alternatively, they may argue a fortiori that tribes are “states” within the meaning of Section 1002(27) of the Act and thus are co-sovereigns with whom supervision is to be coordinated, rather than against whom the Act is to be applied.

In order to resolve this inevitable dispute, courts will look to established principles of law, including those governing when federal laws of general application apply to tribes. Under the so-called Tuscarora-Coeur d’Alene cases, a general federal law “silent on the issue of applicability to Indian tribes will . . . apply to them” unless: “(1) the law touches ‘exclusive rights of self-governance in purely intramural matters’; (2) the application of the law to the tribe would ‘abrogate rights guaranteed by Indian treaties’; or (3) there is proof ‘by legislative history or some other means that Congress intended [the law] not to apply to Indians on their reservation . . . .'”

Because general federal laws governing consumer financial services do not affect the internal governance of tribes or adversely affect treaty rights, courts seem likely determine that these laws apply to TLEs. This result seems consistent with the legislative objectives of the Act. Congress manifestly intended the CFPB to have comprehensive authority over providers of all kinds of financial services, with certain exceptions inapplicable to payday lending. Indeed, the “leveling of the playing field” across providers and distribution channels for financial services was a key accomplishment of the Act. Thus, the CFPB will argue, it resonates with the purpose of the Act to extend the CFPB’s rulemaking and enforcement powers to tribal lenders.

This conclusion, however, is not the end of the inquiry. Since the principal enforcement powers of the CFPB are to take action against unfair, deceptive, and abusive practices (UDAAP), and assuming, arguendo, that TLEs are fair game, the CFPB may have its enforcement hands tied if the TLEs’ only misconduct is usury. Although the CFPB has virtually unlimited authority to enforce federal consumer lending laws, it does not have express or even implied powers to enforce state usury laws. And payday lending itself, without more, cannot be a UDAAP, since such lending is expressly authorized by the laws of 32 states: there is simply no “deception” or “unfairness” in a somewhat more pricey financial service offered to consumers on a fully disclosed basis in accordance with a structure dictated by state law, nor is it likely that a state-authorized practice can be deemed “abusive” without some other misconduct. Congress expressly denied the CFPB authority to set interest rates, so lenders have a powerful argument that usury violations, without more, cannot be the subject of CFPB enforcement. TLEs will have a reductio ad absurdum argument: it simply defies logic that a state-authorized APR of 459 percent (permitted in California) is not “unfair” or “abusive,” but that the higher rate of 520 percent (or somewhat more) would be “unfair” or “abusive.”

Some Internet-based lenders, including TLEs, engage in specific lending practices that are authorized by no state payday-loan law and that the CFPB may ultimately assert violate pre-Act consumer laws or are “abusive” under the Act. These practices, which are by no means universal, have been alleged to include data-sharing issues, failure to give adverse action notices under Regulation B, automatic rollovers, failure to impose limits on total loan duration, and excessive use of ACH debits collections. It remains to be seen, after the CFPB has concluded its research with respect to these lenders, whether it will conclude that these practices are sufficiently harmful to consumers to be “unfair” or “abusive.”

The CFPB will assert that it has the power to examine TLEs and, through the examination process, to ascertain the identity of the TLEs’ financiers – whom state regulators have argued are the real parties in interest behind TLEs – and to engage in enforcement against such putative real parties. This information may be shared by the CFPB with state regulators, who may then seek to recharacterize these financiers as the “true” lenders because they have the “predominant economic interest” in the loans, and the state regulators will also be likely to engage in enforcement. As noted above, these non-tribal parties will generally not benefit from sovereign immunity.

The analysis summarized above suggests that the CFPB has examination authority even over lenders completely integrated with a tribe. Given the CFPB’s announced intention to share information from examinations with state regulators, this scenario may present a chilling prospect for TLEs.

To complicate planning further for the TLEs’ non-tribal collaborators, both CFPB and state regulators have alternative means of looking behind the tribal veil, including by conducting discovery of banks, lead generators and other service providers employed by TLEs. Thus, any presumption of anonymity of TLEs’ financiers should be discarded. And state regulators have in the past proven entirely willing to assert civil claims against non-lender parties on conspiracy, aiding-and-abetting, facilitating, control-person or similar grounds, without suing the lender directly, and without asserting lender-recharacterization arguments.

The Future

Given the likelihood of protracted litigation regarding the CFPB’s authority over TLEs, it is not unthinkable that the CFPB will assert that authority in the near future and litigate the issue to finality; the CFPB cannot be counted on to delay doing so until it has concluded its economic research with respect to payday lending (in which TLEs cannot be expected to rush to cooperate) or until litigation over the recess appointment of Director Cordray has been resolved.

TLEs, anticipating such action, will wish to consider two distinct strategic responses. On the one hand, hoping to insulate themselves from direct attacks by the CFPB under the “unfair” or “abusive” standards, TLEs might well amend their business practices to bring them into line with the requirements of federal consumer-protection laws. Many TLEs have already done so. It remains an open question whether and to what extent the CFPB may seek to employ state-law violations as a predicate for UDAAP claims.

On the other hand, hoping to buttress their immunity status against state attacks (possibly arising from shared CFPB-generated information about their relationships with tribes), TLEs might well amend their relationships with their financiers so that the tribes have real “skin in the game” rather than, where applicable, the mere right to what amounts to a small royalty on revenue.

There can be no assurance that such prophylactic steps by TLEs will serve to immunize their non-tribal business partners. As noted below with respect to the Robinson case, the “action” has moved on from litigation against the tribes to litigation against their financiers. Because the terms of tribal loans will remain illegal under borrower-state law, non-tribal parties who are deemed to be the “true” lenders-in-fact (or even to have conspired with, or to have aided and abetted, TLEs) may find themselves exposed to significant liability. In the past, direct civil proceedings against “true” lenders in “rent-a-bank” transactions have proven fruitful and have resulted in substantial settlements.

To be clear, state regulators do not need to join TLEs as defendants in order to make life unpleasant for TLEs’ financiers in actions against such financiers. Instead, they may proceed directly against the non-tribal parties who finance, manage, aid, or abet tribal lending.

Nor does the private plaintiffs’ class action bar need to include the tribal parties as defendants. In a recent example, a putative class plaintiff payday borrower commenced an action against Scott Tucker, alleging that Tucker was the alter ego of a Miami-nation affiliated tribal entity – omitting the tribal entity altogether as a party defendant. Plaintiff alleged usury under Missouri and Kansas law, state-law UDAP violations, and a RICO count. He neglected to allege that he had actually paid the usurious interest (which presumably he had not), thereby failing to assert an injury-in-fact. Accordingly, since Robinson lacked standing, the case was dismissed. Robinson v. Tucker, 2012 U.S. Dist. LEXIS 161887 (D. Kans. Nov. 13, 2012). Future plaintiffs are likely to be more careful about such jurisdictional niceties.

In the past, online lenders have been able to count on some degree of regulatory lassitude, as well as on regulators’ (and the plaintiff bar’s) inability to differentiate between lead generators and actual lenders. Under the CFPB, these factors are likely to fade.

Perhaps the prediction of the CFPB’s early assertion of authority over TLEs is misplaced. Nevertheless, it is likely that the CFPB’s influence over the long term will cause tribal lending and storefront lending to converge to similar business terms. Such terms may not be profitable for TLEs.

Finally, because the tribal lending model relies on continued Congressional tolerance, there remains the possibility that Congress could simply eliminate this model as an option; Congress has virtually unfettered power to vary principles of tribal sovereign immunity and has done so in the past. While such legislative action seems unlikely in the current fractious environment, a future Congress could find support from a coalition of the CFPB, businesses, and consumer groups for more limited tribal immunity.

 

 

Recent Developments in Charging Orders

Posted on February 22, 2013 by - Uncategorized

The economic crises sparked in 2008 have driven significant interest in the charging order. The 1990s saw the rise of the LLC as a preferred form for the organization of new business ventures across the country. In turn, the LLC, reflecting its roots in partnership law, incorporated the “charging order,” a mechanism by which the judgment-creditor of a member may make a claim on the distributions to be made by the LLC as a means of satisfying the judgment-debtor’s obligation. With the Great Recession, more and more creditors have dealt with judgment-debtors who were themselves members of LLCs. Hence, the newfound attention to these otherwise obscure statutes.

The three of us, at the 2012 LLC Institute sponsored by the Section of Business Law’s Committee on LLCs, Partnerships and Unincorporated Entities, were able to discuss a variety of issues of current currency involving LLCs, thoughts and comments here digested.

By way of background, although the statutory formulae are somewhat different between the various states, the charging order is a remedy provided to the judgment-creditor of a member or assignee of a member by which that creditor may attach the distributions (interim and liquidating) made to the member-assignee, thereby diverting that income stream to the satisfaction of the judgment. Essentially, the charging order is a lien attaching to any distributions that might be made to the member or assignee that is as well the judgment-debtor. The objective of the charging order is to secure the judgment-creditor’s receipt of those distributions while at the same time precluding that judgment-creditor from interfering with the activities of the LLC as a going concern. Precluding a claim by the judgment-creditor that it may somehow directly attach the assets of the LLC, the charging order buttresses the asset partition function of the LLC as a legal entity distinct from its members. Under most state formulae, the charging order is subject to redemption, and a lien upon the LLC interest created by the charging order is subject to foreclosure.

For a more comprehensive review of the charging order generally, see, e.g., Thomas E. Rutledge and Sarah S. Wilson, An Examination of the Charging Order Under Kentucky’s LLC and Partnership Acts (Part I), 99 Kentucky Law Journal Online 85 (2011); (Part II), 99 Kentucky Law Journal Online 107 (2011). Professor Bishop publishes a pair of resources regularly updated, that are particularly helpful with respect to remaining current with respect to developments in LLCs. The first is a tabular review of the charging order provisions that exist in the various LLC Acts, namely Fifty State Series: LLC Charging Order Statutes, available on SSRN.com. The second table, also available on SSRN, is titled Fifty State Series: LLC Charging Order Case Table, an invaluable resource in knowing the status of the law both in any individual state and across the country.

The Taxation of Distributions Diverted to the Judgment-Creditor

One of the more contentious issues with respect to charging orders, and a topic on which there has been published a great deal of misinformation, is taxation. It has been asserted by some that the judgment-creditor holding a charging order will bear the tax liability with respect to allocations and distributions made with respect to the judgment-debtor’s interest in the LLC, the net effect of which is to expose the judgment-creditor to the risk of phantom income should the LLC not make any distributions. Simply put, this is false.

Under Revenue Ruling 77-137, until such time as the judgment-creditor might foreclose on the charged LLC interest, thereby becoming an assignee thereof, it is the judgment-debtor who remains, for tax purposes, the member in the LLC. It is to the judgment-debtor who is the member in the LLC that the allocation of profits, losses, and other tax items on Form K-1 will be reported, and not the account of the judgment-creditor. This outcome is consistent as well with the principle that the judgment-debtor should satisfy the judgment with after-tax dollars; if the judgment-debtor were able to shift to the judgment-creditor the tax liability with respect to the funds ultimately distributed, the judgment-debtor could, effectively, satisfy the debt with pre-tax dollars. Whether the judgment-creditor will need to report as income the payments received pursuant to the charging order is a matter resolved elsewhere in the Code. For example, if the judgment involved the judgment-debtor’s personal injury of the judgment-creditor, under Code Section 104(2) the payments may not be taxable income.

Turning from tax law, a variety of decisions on charging orders have been released in the last year or so, and they illustrate the many ambiguities that exist. For example, the decision of the Federal District Court for Kansas rendered in Meyer v. Christie, 2011 WL 4857905 (Oct. 13, 2011), illuminates that court’s confusion regarding the status of the holder of an assignee interest in an LLC and the holder of a charging order. The court incorrectly conflated the two positions, an outcome especially pernicious in Kansas as that state has an atypical statute, it providing that the assignee of the sole member of an LLC has the right to participate in the LLC’s management and affairs.

The decision of a Montana bankruptcy court rendered in In re Jonas, No. 10-60248-11, 2012 WL 2994724 (July 3, 2012), reviewed the authority of a receiver appointed to enforce a charging order. Almost every statute allows the court issuing a charging order to appoint a receiver to receive the proceeds thereof. In the Jonas decision, it was unclear whether the charged judgment-debtors held 50 percent or 100 percent of the interest in the subject LLC, but it is clear that a receiver was appointed with respect thereto. However, the court went on to discuss the receiver taking control of the LLC and its assets, rather than simply receiving the distributions as made. In the context of a single member LLC, if in fact that is what was the situation, the court may have, at least subconsciously, applying the rule set forth in In re Albright. See also Thomas E. Rutledge and Thomas Earl Geu, The Albright Decision, Why an SMLLC is not an Appropriate Asset Protection Vehicle, 5 Bus. Ent. 16 (Sept./Oct. 2003). If, on the other hand, the LLC had another member, the charging order receiver taking control of the LLC itself was clearly inappropriate.

Turning to the decision of the Iowa Court of Appeals rendered in Wells Fargo Bank, N.A. v. Continuous Control Solutions, Inc., No. 2-431/11-1285 (Aug. 8, 2012), the court determined that the holder of a charging order does not, in that capacity, have the right to compel the LLC to disclose its books and records. In that an assignee of an interest in an LLC does not have document inspection rights, the holder of a charging order, being one step further removed from the LLC, will have no inspection rights. In a similar vein was the decision of the Nevada court rendered in Waddell v. H2O, Inc., 128 Nev. Adv. Op. No. 9 (March 1, 2012), to the effect that an entry of a charging order does not divest the judgment-creditor of the right to participate in the LLC’s management. Rather, in that the charging order does not transfer title to the charged interest, it is retained by the judgment-debtor and they may continue to exercise the rights of a member.

Leonard v. Leonard, 2012 WL 4558390 (N.J. J. super A.D. June 13, 2011), is a most curious decision in which the court directed that a “writ of execution” be issued in support of a charging order. Those who are regularly involved with charging orders found this decision most confusing in that it was not clear what was added to a charging order by a writ of execution. Having consulted with several practitioners in New Jersey, it became clear that, in light of the lack of familiarity with the charging order as compared with the effect of a writ of execution, the latter was entered as a “belt and suspenders” to the comparatively obscure charging order.

In a recent decision by the Federal District Court for the Central District of Illinois, it considered the rights of the receiver over limited partnerships controlled by, apparently, married taxpayers. Its reasoning, however, may lead to the conclusion that the charging order is ineffective in a single-member LLC in Illinois. United States v. Zabka, ___ F. Supp. 2d ___, 2012 WL 5246918 (C.D. Ill. Sept. 11, 2012).

Federal tax liens were assessed against Robert and Deborah Zabka for numerous years of their personal tax liability. Judgment having been entered in favor of the government, the matter before the court involved the appointment of a receiver to collect, manage, and ultimately sell the Zabka’s property in order to satisfy the federal tax liens. One argument made by the Zabkas was that the federal receiver must comply with the Illinois charging order statute under the Limited Partnership Act, namely 805 Ill. Comp. Stat. 215/703. This statute expressly provides that it is the “exclusive remedy” of a judgment-creditor.

In rejecting that argument, the court noted that the government’s lien attached to all of the Zabka’s property, which “property and rights to property included their 100 percent ownership interest in the Limited Partnerships.” 2012 WL 5246918, *5. The court went on to note that the statutory language addresses the rights of a judgment-creditor of “a” (i.e., a singular) partner or transferee. From there, the court wrote:

The plain language of that statute – which refers to a judgment-creditor of an individual partner – demonstrates that it was designed to protect other partners in a partnership when one, but perhaps not all of the partners, have become encumbered with a judgment-creditor. In that respect, the Court finds that the state statute is irrelevant to the circumstances of the instant case because the Government’s federal tax lien attached to the Zabka’s 100 percent ownership interest of the Limited Partnerships.

By this reasoning, if a judgment-debtor is the sole member of an LLC, the judgment-creditor is not restricted to a charging order. Whether, in that situation, the judgment-creditor is able to seize the entirely of the LLC transferable interest, thereby becoming an assignee of all the economic benefits of the venture, and seize as well the management rights in the company or something else, is left to be determined. What is clear, however, is that the dangerous step of eliminating the charging order in the single-member LLC, simply because it is a single-member LLC, appears to have been taken.

Bay Guardian and Choice of Law

Bay Guardian Company, Inc. v. New Times Media LLC is an important charging order decision in that the primary question involved in this litigation is whether it is the law of the jurisdiction in which a judgment is entered against a member of a LLC that will govern the scope and effect of the charging order versus a requirement that there be applied the law of the jurisdiction of the LLC’s organization. This choice of law question arises because there are, between the charging order provisions of the various states, important differences. For example, under the law of many states, it is provided that the judgment-creditor may foreclose on the charging order lien, thereby converting their lien interest into a title interest (assuming, of course, it is the judgment-creditor who purchases the lien upon the foreclosure sale). Other states expressly provide that there may not be a foreclosure on the charging order lien.

Memorably, at the LLC Institute, Mr. Adkisson suggested that the charging order bears the burden of illegitimacy (he actually utilized a somewhat more flowery term), and was able to share with the group some illuminating information. The charging order first arose under the British Partnership Act, there created as a mechanism to avoid the judgment-creditor invading the partnership and seizing certain of its assets in satisfaction of the judgment. As expertly reviewed in J. Gordon Gose, The Charging Order Under the Uniform Partnership Act, 28 Wash. L. Rev. & St. B. J. 1 (1953), the charging order was created to preclude the judgment-creditor invading the partnership and seizing all or a portion of its assets in order to satisfy the claim against only an individual partner. It is this concept that was then carried forward into American law and most notably the Uniform Partnership Act. But here, Jay suggests, it where the mistake was made. According to his research, at the time the charging order was incorporated into the English Partnership Act, the English law did not otherwise provide for a lien upon the distributional interest in the partnership. Hence, the charging order was created to fill that gap. When the charging order was incorporated into the American Uniform Partnership Act (and from that act into all of the subsequent unincorporated entity laws including those of LLCs), it was not recognized that American law already provided for a lien on the distributional interest. Consequently, there existed no lacuna in American law requiring that the charging order be created. Consequently, it would be possible to delete the charging order’s provisions from all of these various acts and rely upon generally available remedies law to address the rights of the judgment-creditor of a judgment-debtor who is either a member in an LLC or a partner in a partnership.

Turning from that point, the charging order is a remedy; for example, the Delaware LLC Act provides that “a charging order is the exclusive remedy by which a judgment-creditor. . . .” Del. Code Ann. tit. 6, § 18-703(d). Hence, the charging order is a question of the law of remedies and “the law of remedies is always local.” Applying this rule, the conflicts question is resolved, and it is appropriate for the court to apply the law of the jurisdiction in which it sits in determining what remedies, including the characteristics of any charging orders that may be entered, will apply irrespective of the law of the jurisdiction of organization. Assume a Delaware LLC with a member resident in Kentucky; Delaware does not allow for foreclosure on the charging order while Kentucky does. A judgment is entered in Kentucky against the member and a charging order is to be issued against the interest in the Delaware LLC. Is the Kentucky court justified in applying Kentucky law to the question of whether there may be foreclosure? Under the principle that all remedies law is local, the answer is “yes.”

Following from that path of analysis, efforts by various states to increase their rankings with respect to asset protection are somewhat misleading. While a state may gain an increased ranking by, for example, precluding the foreclosure on the charging order lien, that statutory limitation will be effective only in that individual state. If there is judgment against a member in another state, and that other state has more liberal laws, the asset protection objectives may be thwarted.

As charging orders exist in almost every state’s partnership, limited partnership and LLC acts, irrespective of distinctions between the various states, there likely is no policy basis for having different statutory formulae for the charging orders in a single state. Rather, in order to avoid judicial distinctions based upon what are likely unintended language distinctions, it would serve state drafting committees to provide a single formula that is used by each state. The exception to this might be additional language addressing single member LLCs used for asset protection purposes that are deemed abusive; of course, as the partnership or limited partnership require at least two owners, that language may be unique to the LLC Act.

Conclusion

The problem for practitioners is that numerous unresolved issues exist as to the application of charging orders. The courts are just beginning to scratch the conflicts-of-law issues, creditors are with mixed success are utilizing other theories of relief such as alter ego law to circumvent charging order protection, and the effectiveness of charging order protection in a bankruptcy proceeding is still less than certain. However, these challenges seem to be most successful in the single-member (or effectively single-member) context, and less successful in true multiple-member situations where the interests of the other, non-debtor members are substantial.

In other words, this area is still ripe for litigation, and planners for the time being should err on the side of the conservative use of partnerships and LLCs to the extent one is concerned about future creditor challenges to a member of such an entity. At the same time, there exists great opportunity to forestall these questions, at least to the degree they are dependent upon state law, by careful redrafting of the charging order provisions of the various acts.

 

 

 

 

Series LLCs: What Happens When One Series Fails? Key Considerations and Issues

Posted on February 22, 2013 by - Uncategorized

A handful of states permit companies to operate multiple businesses under a common organizational umbrella, referred to as a series LLC. These states are Delaware, Illinois, Iowa, Kansas, Nevada, Oklahoma, Tennessee, Texas, Utah, and Wisconsin. Both the District of Columbia and Puerto Rico have series LLC statutes as well.

The series LLC typically features a master or “parent” limited liability company (master LLC), with one or more separate businesses organized as limited liability companies (each a “series”) under the master LLC. The relationships between the master and the series LLCs are determined by the limited liability company agreement and may be referenced in the articles of organization or certificate of formation filed with the state where the entity is organized. If certain statutory requirements are met, each series is liable only for obligations of that particular series and shielded from the liability of the master LLC and the other series. For example, Delaware Code title 6 § 18-215(b) sets forth requirements in the establishment of a series LLC, including notations in the operating agreement, the maintenance of records, accounting for the assets from other assets of the master limited liability company, and providing notice concerning the limitation of liabilities in the certificate of formation. Illinois additionally requires the entity to file a certificate of designation for each series. 805 Ill. Comp. Stat. § 180/37-40(b) (2012).

The nuances of the series LLC structure are beyond the scope of this article. Rather, this article focuses on a few of the key issues that arise when one series or the master LLC experiences financial distress and elects to file a petition for relief under the U.S. Bankruptcy Code. As discussed below, this scenario poses several challenging issues, many of which remain unresolved and open to interpretation.

Overview of Basic Issues

The Bankruptcy Code provides two principal options for resolving the financial distress of business organizations – i.e., liquidation under Chapter 7 and reorganization under Chapter 11. Sections 109(b) and (d) of the Bankruptcy Code identify the category of “person” who may be a debtor in a Chapter 7 or Chapter 11 case. Those persons include “individuals, corporations and partnerships,” and the term “corporation” includes, among others, “unincorporated organizations and associations.” 11 U.S.C. §§ 101(9), (41). Courts have characterized LLCs as corporations under the Bankruptcy Code that generally are eligible to file a Chapter 7 or Chapter 11 case.

The primary challenge with a series LLC stems from the differing treatment of the structure under state law. For certain purposes, state law views the master LLC and the multiple series as one entity. Yet, for other purposes – primarily asset ownership and liability allocation – state law treats the master LLC and each series as separate and distinct entities. “For Secretary of State filing purposes, the series LLC is considered one entity that files a single annual report and pays a single fee. . . In other words, a series LLC is comparable to a structure with a parent LLC having multiple subsidiary LLCs except that the series LLC is considered one legal entity (at least for the Secretary of State filing purposes). . . .” Nick Marsico, Current Status of the Series LLC: Illinois Series LLC Improves Upon Delaware Series LLC but Many Open Issues Remain, J. Passthrough Entities, Nov-Dec. 2006, at 35. Whether courts will respect this united but separate characterization of the series LLC structure remains unclear.

The master LLC should qualify as a debtor under Sections 101 and 109 of the Bankruptcy Code. What then happens to the series if the master LLC seeks bankruptcy protection? Does each series remain a non-debtor entity, unaffected by the master LLC’s bankruptcy case? Alternatively, is each series part of the master LLC’s bankruptcy case but shielded from the debts of the master LLC and other series under applicable state law and the terms of their respective operating agreements? Or are the assets and liabilities of the master LLC and each series consolidated in one bankruptcy estate?

Similar questions exist with respect to the filing of a bankruptcy case by just one series. In addition, courts may raise the more basic question of whether a series is eligible to file independently from the master LLC. Relevant case law is limited, but some basic bankruptcy concepts may help guide the series LLC through these complex issues.

Eligibility to File Bankruptcy

As noted above, most courts characterize LLCs as corporations for purposes of Sections 101(9), 101(41), and 109(b) of the Bankruptcy Code. This characterization, in turn, permits an LLC to be a debtor in a Chapter 7 or a Chapter 11 case. Whether a master LLC or a series can file independently appears to be an open question.

Courts use different approaches in analyzing eligibility under Section 109 of the Bankruptcy Code. These approaches include the “state classification” approach, the “independent classification” approach, and the “alternative relief” approach. Although these approaches typically are used to determine if an entity is excluded from seeking federal bankruptcy relief, they are helpful in evaluating the potential treatment of series LLCs.

The state classification test turns largely on the treatment and characterization of the entity under applicable state law. In re Auto. Prof’ls, Inc., 379 B.R. 746, 752 (N.D. Ill. 2007). Consequently, this test may produce different results depending on the state of organization. For example, in Illinois, the series LLC statute specifically states that each series is separate, providing that “[a] series with limited liability shall be treated as a separate entity to the extent set forth in the articles of organization.” 805 Ill. Comp. Stat. § 180/37-40(b) (2012). The Illinois statute also provides that “[e]ach series with limited liability may, in its own name, contract, hold title to assets, grant security interests, sue and be sued and otherwise conduct business and exercise the powers of a limited liability company under this Act.” If a series follows all of the mandates under Illinois state law to garner the series qualification, a bankruptcy court may follow the direction of the state and treat the master LLC or the series as eligible to file a bankruptcy case in its own right.

Other state statutes are silent on the classification of the master LLC or series as separate entities for all purposes. For example, the Delaware series LLC statute does not contain language similar to the Illinois statute on entity classification. It does, however, provide that “[a]ny such series may have separate rights, powers or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations, and any such series may have a separate business purpose or investment objective.” Del. Code Ann. title 6 § 18-215(a) (2012). Also, like Illinois, the Delaware statute recognizes that a properly formed series “shall have the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interests, and sue and be sued.” Del. Code Ann. title 6 § 18-215(c) (2012). The existing case law does not address whether these provisions are sufficient to designate each series eligible to file bankruptcy in its own right.

The independent classification and alternative relief approaches to eligibility under Section 109 of the Bankruptcy Code may overlap in the context of series LLCs. Both approaches focus on the court’s interpretation of the Bankruptcy Code and its underlying purposes. “The ‘independent classification test’ is basically a statutory construction analysis by the bankruptcy courts ‘based upon their own definitions of the words of the Bankruptcy Code.'” Beacon Health, 105 B.R. 178, 180 (Bankr. D. N.H. 1989). Likewise, the alternative relief approach considers whether there is a state or another federal insolvency scheme already in place to address the financial distress of the entity seeking relief. Under both approaches, a court could determine that a series is an “unincorporated organization or association” eligible to file bankruptcy on an independent basis.

At least one pending Delaware bankruptcy case involves a series LLC structure. Dominion Ventures, LLC, filed a Chapter 11 case on July 19, 2011. In re Dominion Ventures, LLC, No. 11-12282 (Bankr. D. Del.). Its filing with the bankruptcy court states, “The Debtor serves as a management company and holds varying degrees of interest in five (5) other series LLCs (collectively, the ‘Series LLCs’). The Series LLCs each own and operate (or once owned and operated) a single property.” Although the bankruptcy petition seeks only to name the management company LLC as a debtor, several equity holders and members have contested the debtor’s activities in the bankruptcy case. In their pleadings, these parties argue, among other things, that the debtor seeks “to sell Dumont Creek Estates Series, LLC, and Northwood Series LLC, to pay the ‘debts’ of ‘Dominion Venture, LLC’ . . . in clear violation of the provisions of the Dominion Ventures, LLC and each separate and distinct Dominion Venture LLC Series LLC operating agreement.” The bankruptcy court, at the request of the equity holders and creditors and with the consent of the debtor, appointed a Chapter 11 trustee in the Dominion Ventures case. The ultimate conclusion of this case may provide some insights into the treatment of series LLCs in bankruptcy.

Regardless of whether a series can file bankruptcy on an independent basis or whether it is deemed part of the master LLCs bankruptcy case, the more important question may be what happens to the assets and liabilities of each series. Will the bankruptcy court enforce the contractual limitations on liability? This question is at the heart of the disputes in the Dominion Ventures case, and it likely will be the focus of other cases, as well as in planning discussions in entity choice matters. Some of these issues are addressed below.

Substantive Consolidation

At its core, the key issue presented by the series LLC – whether a related company’s assets are available to satisfy a debtor’s obligations – is not novel. Courts have long struggled with the issue: under what circumstances should one company’s assets be available to the creditors of another company? Under state law, this issue is often addressed in the context of veil piercing and whether one company is operating another company as its alter ego. (Veil piercing also is used to reach the assets of individual shareholders and frequently is a creditor-specific remedy.) In bankruptcy, these types of issues are commonly addressed under the equitable doctrine of substantive consolidation. For a general discussion of substantive consolidation and its relation to veil piercing and the alter ego doctrine, see Seth D. Amera and Alan Kolod, Substantive Consolidation: Getting Back to Basics, 14 Am. Bankr. Inst. L. Rev. 1 (2006).

Substantive consolidation essentially combines the assets and liabilities of the debtor’s bankruptcy estate with the assets and liabilities of another company or group of companies. The result is a larger, consolidated pool of assets to pay the obligations of all of the companies’ collective creditors. Although substantive consolidation typically is used to combine the bankruptcy estates of two debtors, it also can be used to combine the assets and liabilities of a debtor with non-debtor companies. Some courts have maintained that the sole purpose of substantive consolidation is to ensure the equitable treatment of all creditors. In re Augie/Restivo Baking Company, Ltd., 860 F.2d 515 (2d Cir. 1988).

Different courts articulate and apply the substantive consolidation doctrine in different ways. Some courts consider “two critical factors” in assessing a motion for consolidation: “(i) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or (ii) whether the affairs of the debtors are so entangled that consolidation will benefit all creditors.” In re Gordon Properties, LLC, 478 B.R. 750, 757-758 (E.D. Va. 2012) (explaining various approaches to substantive consolidation analysis) (citations omitted). Other courts require a finding that “consolidation is necessary to avoid some harm or to realize some benefit.” Still others follow an equities of the case approach by “focusing on equity to creditors and refusing to be blinded by corporate forms.”

The factors considered by courts under the substantive consolidation doctrine often resemble those considered by courts in the alter ego/veil piercing doctrine. Thus, substantive consolidation is a case-by-case analysis. In the series LLC context, a substantive consolidation analysis may not only consider the applicable state statute and relevant operating agreements but also how the master LLC and the series conduct themselves in practice.

Notably, many of the factors considered by courts in the substantive consolidation context correspond with the requirements for limited liability established under state series LLC statutes. For example, series LLC statutes require each series to maintain separate books and records with separate accounting of their assets and liabilities. This often is a factor considered under substantive consolidation. Moreover, the Illinois series LLC statute requires the master LLC to file a series designation for each series and that “the name of the series with limited liability must contain the entire name of the limited liability company and be distinguishable from the names of the other series set forth in the articles of organization.” 805 Ill. Comp. Stat. § 180/37-40(c) (2012). These provisions, if followed, might mitigate the concern of creditors’ reliance and expectations, which often is a focus of the substantive consolidation analysis. Nevertheless, parties must recognize the potential of substantive consolidation even where organizational forms are respected. Gordon Props, 748 B.R. at 758-760 (remanding for bankruptcy court to re-evaluate equities of the case from the creditors’ perspective).

Parties establishing a series LLC should evaluate the substantive consolidation case law in their jurisdiction and consider the doctrine in forming and operating their business venture. Although there is no certainty in this analysis, it can inform the process in a meaningful way.

Conclusion

The law governing the rights and remedies of a financially-troubled series LLC is still developing. Parties using, or contemplating using, the series LLC structure should recognize the lingering uncertainty concerning the treatment of a master LLC and its series under federal bankruptcy law and proactively consider alternative structures and exit strategies in the planning stages. Although parties cannot necessarily avoid bankruptcy with advance planning, they can strengthen certain aspects of the series LLC structure with state law tools. For example, parties should clearly designate the allocation of asset ownership, liabilities, and the assets available to satisfy those liabilities; ensure that creditors’ interests are properly perfected against the correct assets; and comply in all respects with the applicable series LLC statute.

In addition, parties should consider ways to use state LLC and commercial law to enhance the likelihood that the parties’ intentions regarding the state law structure are respected in any subsequent bankruptcy case. For example, parties might endeavor to foster greater protection for the equity value of healthy series through contractual provisions – both in the operating agreement – concerning types and amount of debt that series may incur – and in creditor contracts – through acknowledgements of the assets available to pay obligations, waivers of deficiencies in the context of secured debt, and limiting the use of cross-collateralization and cross-acceleration provisions. These steps will not guarantee the protection of the series LLC structure in bankruptcy, but they will help all parties dealing with the series understand the construct and may foreclose certain arguments based on parties’ expectations.

Similarly, sponsors and managers should evaluate their disclosure obligations to investors under applicable law and consider what information concerning insolvency risks might be required to satisfy such obligations. Although disclosing uncertainty in the series LLC structure might hold negative implications, those must be weighed against potential litigation involving sponsors and managers premised on inadequate disclosures. Moreover, lawyers should consider the effect of this uncertainty on the parameters and content of opinion letters.

Given the operational and financing advantages to the series LLC for some businesses, the uncertainty surrounding bankruptcy and series LLCs becomes part of the cost-benefit analysis. Parties should not necessarily avoid the structure because of this uncertainty, but they should consider its overall impact, including potential negative consequences on the rights and remedies of owners and certain creditors and on the cost of capital.

 

 

Rule 10b5-1 Trading Plans in the Current Environment: The Importance of Doing it Right

Posted on February 22, 2013 by - Uncategorized

Rule 10b5-1 under the Securities Exchange Act of 1934 allows officers, directors and other insiders of public companies to purchase and sell their company’s stock while they are in possession of material non-public information, provided that the transaction is made pursuant to a trading plan previously established at a time when the insider was not aware of material non-public information. Critics have long viewed the rule as creating an opportunity for abuse, claiming that some insiders may in fact be aware of material non-public information at the time plans are established and that the rule can be used to provide cover for improper trades. The critics’ voices have grown much louder recently, due to a series of Wall Street Journal articles published in late 2012 that highlighted suspiciously fortuitous trading patterns under Rule 10b5-1 plans adopted by insiders at certain companies. Several of these insiders are now reportedly being investigated by the Securities and Exchange Commission (SEC) and federal prosecutors.

Although Rule 10b5-1 trading plans may be in the enforcement spotlight, when properly designed and administered, they remain a generally safe and effective way for insiders to purchase and sell securities without concern for insider trading liability. Set forth below is a brief background of Rule 10b5-1, followed by suggestions on the implementation and administration of trading plans in the current environment.

Background

Rule 10b5-1 was adopted by the SEC in 2000 (the adopting release is available at www.sec.gov/rules/final/33-7881.htm) in order to address the previously unsettled issue in insider trading law of whether insider trading liability requires proof that the insider “used” material non-public information in connection with a purchase or sale of a security, or whether the insider need only have “knowingly possessed” such information at the time of the transaction. Rule 10b5-1 addresses this issue by providing that “a purchase or sale . . . is ‘on the basis of’ material non-public information . . . if the person making the purchase or sale was aware of the . . . information when the person made the purchase or sale.” In other words, knowing possession may be sufficient for insider trading liability to be found.

Rule 10b5-1 also established an affirmative defense which, if the following three conditions are satisfied, will result in the insider being deemed not to have traded “on the basis of” material non-public information, even if the insider was aware of material non-public information at the time of the purchase or sale:

  • First, before becoming aware of material non-public information, the insider must enter into a binding contract to purchase or sell the security, instruct another person to purchase or sell the security for the insider, or adopt a written trading plan. For the sake of simplicity, a contract, instruction, or plan is referred to in this article as a “plan.”
  • Second, the plan must:
    • specify the amount of securities to be purchased or sold, and the price(s) at which and the date(s) on which the securities are to be purchased or sold;
    • include a written formula or algorithm, or computer program, for determining the amounts, prices, and trade dates; or
    • not permit the insider to exercise any subsequent influence over how, when, or whether to effect purchases or sales, and any other person who does exercise such influence (such as the insider’s broker) must not be aware of the material non-public information when doing so.
  • Third, the purchase or sale in question must actually occur pursuant to the plan and not deviate from it.

The plan must have been entered into in good faith and not as part of a plan or scheme to evade the insider trading laws.

Suggestions on Adoption and Administration of Trading Plans

Confirm that the company’s insider trading policy permits Rule 10b5-1 trading plans and obtain any necessary company approvals. Before a Rule 10b5-1 trading plan is established for a company’s insider, it must first be confirmed that the company’s insider trading policy permits Rule 10b5-1 trading plans. The insider also must obtain any approvals of the plan required under the insider trading policy, such as a sign-off by the company’s general counsel.

Assess whether the contemplated trades are right for a Rule 10b5-1 trading plan. If the insider wants to purchase or sell relatively small amounts of shares at regular intervals over an extended period of time, then a Rule 10b5-1 trading plan would likely make sense. Such trading under a Rule 10b5-1 trading plan does not usually arouse suspicion that the insider was aware of material non-public information at the time the plan was adopted. Rule 10b5-1 trading plans also can be useful where the insider knows well in advance that he or she will need to sell shares at a particular time or times in order to generate cash – for example, to pay a child’s college tuition prior to the start of a semester or to pay the exercise price and taxes for expiring stock options by selling a portion of the option shares.

If the insider wants to make a single trade or a small number of trades over a short period of time, it generally would be better to do so during an open trading window under the company’s insider trading policy. Most companies open the trading window shortly after the public release of earnings and close it near or at the end of each quarter. Sometimes the window must close prematurely or not be opened at all even after the public release of earnings, if another potentially material event is on the horizon (such as a possible merger or acquisition). In addition, if the insider is aware of material non-public information (even if the issuer’s trading window is not closed), the insider would be prohibited from purchasing or selling securities until such information is publicly disclosed or no longer relevant.

Put it in writing. Although Rule 10b5-1 technically permits trades to occur pursuant to oral contracts or instructions, best practice would be to put all such plans in writing.

Keep it simple. The method of determining the number of shares to be purchased or sold can be as simple or as complex as desired. Of paramount importance is that both the insider and the executing broker clearly understand how the formula is intended to operate. Avoid adopting plans that are extremely complex or that cannot be easily understood by a third party reviewing the plan after the fact, as the SEC or a federal prosecutor could claim that the complexities or ambiguities of the plan do not satisfy the requirements of Rule 10b5-1.

No subsequent influence over trades. Any subsequent influence by the insider over a decision to purchase or sell securities could eliminate the protections of the rule. The trading plan itself should specifically prohibit the insider from exerting such influence. While not required by Rule 10b5-1, as an additional safeguard, it may be prudent for an insider to specify that an independent third party, rather than the insider’s regular broker (for example, a separate department within the brokerage firm) handle all trades under the Rule 10b5-1 trading plan, and that the broker establish and maintain a separate account for plan transactions. If the insider’s regular broker is used, extensive communications by the insider with the broker, even those relating to other securities holdings in the insider’s account, could raise questions as to whether the insider exerted subsequent influence over the execution of the plan transactions.

Waiting period before first trade. Insiders should only be permitted to adopt Rule 10b5-1 trading plans during an open trading window under the company’s insider trading policy. This will help to establish that the insider was not aware of material non-public information at the time the plan was adopted. In addition, the plan should contain a reasonable “cooling off” period after adoption (perhaps 30-60 days) during which trades will not occur. The occurrence of purchases or sales shortly after the adoption of a plan could raise questions as to whether the insider was aware of material non-public information when the plan was adopted.

Amending plans. The SEC has indicated that a trading plan may be modified so long as the modification is made in good faith and at a time when the insider is not aware of material non-public information. The altered plan is deemed to be a new plan for purposes of Rule 10b5-1. As with the initial adoption of a plan, modifications to a plan should only be made during an open trading window under the company’s insider trading policy and the effectiveness of the modification should be delayed for a reasonable period of time. Insiders should also avoid frequent modifications, as these may lead the SEC or a federal prosecutor to question whether the plan was entered into in good faith and not as part of a plan or scheme to evade the insider trading laws.

Terminating plans. Early termination of a plan by the insider is permissible, even, according to the SEC, when the insider is in possession of material non-public information. The SEC has cautioned, however, that early termination at a time when the insider is aware of material non-public information can result in a loss of the Rule 10b5-1 affirmative defense for prior transactions if the termination calls into question whether the insider originally entered into the plan in good faith and not as part of a scheme to evade the insider trading laws. Repeat adoptions and early terminations of Rule 10b5-1 trading plans will likely raise doubts as to the good faith of the insider and therefore should be avoided. For this reason, the plan should provide for termination upon the occurrence of any one or more of several specified events, such as the purchase or sale of a maximum number of shares, the completion of a merger or similar transaction, the death or disability of the insider and the occurrence of a specified date (typically one to two years after adoption). Be sure that the plan broker is aware of these provisions so that trading does not occur beyond the expiration date, which would leave the insider without the protections of Rule 10b5-1.

Discourage trading outside of adopted plans. Rule 10b5-1 does not prohibit a person who establishes a trading plan under the rule from trading outside of the plan, though it does prohibit non-plan, corresponding, or hedging transactions or positions with respect to the company’s stock. Non-plan trading will not be covered by the rule’s affirmative defense, however, and must not occur at a time when the insider is aware of material non-public information. Once a trading plan is in place, non-plan trading should be kept to a minimum or avoided altogether, as parallel trading could be viewed with suspicion. For example, in the case of a Rule 10b5-1 trading plan to sell securities, the SEC or a federal prosecutor challenging non-plan sales by the insider might argue that because the insider already had a trading plan, presumably to diversify the insider’s investment portfolio, the insider was seeking to take advantage of material non-public information in making the non-plan sales.

Avoid multiple plans. While Rule 10b5-1 does not prohibit an insider from having multiple trading plans with the same company, doing so could be problematic. At a minimum, it may create confusion and cause administrative headaches for the insider, the insider’s broker(s) and the company. Of greater concern is that maintaining multiple plans with different trading schedules and pricing parameters may lead to accusations that the insider is engaged in manipulative behavior and trying somehow to evade the requirements of Rule 10b5-1.

Allow for necessary suspensions. A Rule 10b5-1 trading plan should allow for the suspension of trading activity during periods when the insider should not be trading, such as any specific blackout periods under the SEC’s rules (for example, Regulation M, which generally prohibits a company’s directors and executive officers from purchasing the company’s securities during specified time periods when the company is making a public offering of securities) and lockup periods that may be imposed by underwriters in connection with offerings of the company’s securities, which generally prohibit insiders from selling company securities soon after the completion of an offering. (Underwriters sometimes agree to exempt previously established Rule 10b5-1 trading plans from lockup agreements.)

Determine how much to disclose regarding plans. Under current SEC rules, neither the insider nor the insider’s company is required to make any public disclosures of a Rule 10b5-1 trading plan. If the insider is subject to Section 16 of the Securities Exchange Act of 1934, then at a minimum the Form 4 filed to report the insider’s trade (due within two business days after the trade date) should indicate by footnote that the transaction occurred pursuant to a Rule 10b5-1 trading plan established prior to the trade date. An announcement by the company of the plan shortly after the plan’s adoption also might quell suspicions over the timing of plan trades. Any such announcement should disclose the date the plan was adopted and the number of shares involved. Disclosing additional details, such as the plan trading schedule and pricing parameters, generally should be avoided. If a company chooses to announce an insider’s Rule 10b5-1 trading plan, then any modifications to the plan relating to information previously disclosed (for example, the number of shares to be purchased or sold) also should be disclosed, as should a decision by the insider to terminate his or her plan early.

Changes Afoot?

While companies currently have the flexibility to disclose as much or as little as they want to with respect to their insiders’ Rule 10b5-1 trading plans, the resurgence of criticism surrounding Rule 10b5-1 may soon change this. There is now a push by some in the investment community for the SEC to impose specific disclosure requirements for Rule 10b5-1 trading plans, as well as other restrictions on how trading plans are administered. For example, on December 28, 2012, the Council of Institutional Investors (CII), a pension fund trade association, wrote to the SEC (available at www.sec.gov/rules/petitions/2013/petn4-658.pdf) urging the adoption of interpretive guidance or amendments to Rule 10b5-1 that would permit Rule 10b5-1 trading plans to be adopted only during open trading windows under a company’s insider trading policy, prohibit multiple, overlapping Rule 10b5-1 trading plans, prohibit trades from occurring for at least three months after the adoption of a Rule 10b5-1 trading plan, and prohibit frequent modifications or terminations of Rule 10b5-1 trading plans. CII also is calling for a requirement to immediately disclose the adoption, modification, or termination of any Rule 10b5-1 trading plan and for the imposition of direct responsibility for the oversight of Rule 10b5-1 trading plans on boards of directors.

Regardless of whether any of the proposed reforms to Rule 10b5-1 are implemented, the SEC and federal prosecutors remain as interested as ever in combating illegal insider trading. When used improperly, Rule 10b5-1 trading plans can increase an insider’s liability risk, such as where trades occur too soon after the adoption of a plan, where plans are repeatedly adopted and terminated or where the insider supplements a plan with non-plan trades, each of which may suggest that the insider attempted to take advantage of material non-public information. But when structured and administered properly, Rule 10b5-1 trading plans can provide a safe and effective way for insiders to trade.

 

Tax Aspects of Series LLCs

Posted on February 15, 2013 by - Uncategorized

The series concept arose in Delaware when that state in 1988 adopted its Business Trust Act (changed to Statutory Trust Act in 2001). 12 Del. Code §3801(g). This statute provided a framework for trusts utilized for asset securitization and the organization of investment companies.

Extension of Series Concept to LLCs

Today, the series trust remains actively utilized in the mutual fund and asset securitization applications, and we are seeing the use of the series in other situations. In 1996, a few years after it enacted its Business Trust Act, Delaware enacted the first statutory series LLC provisions at the same time that it added series provisions to its limited partnership statute.

The Delaware LLC Act states:

A limited liability company agreement may establish or provide for the establishment of 1 or more designated series of members, managers, limited liability company interests or assets. Any such series may have separate rights, powers or duties with respect to specified property or obligations of the limited liability company or profits and losses associated with specified property or obligations, and any such series may have a separate business purpose or investment objective. 6 Del. Code §18-215(a).

If notice and record-keeping requirements in the statute are satisfied, the Delaware statute provides:

[T]he debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series shall be enforceable against the assets of such series only, and not against the assets of the limited liability company generally or any other series thereof, and, unless otherwise provided in the limited liability company agreement, none of the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to the limited liability company generally or any other series thereof shall be enforceable against the assets of such series. 6 Del. Code §18-215(b).

Individual Series Generally not a Separate State Law Entity

Generally, the entity for state law purposes is the LLC itself and not the series within the LLC. Stated differently, the series within the LLC is not a separate entity under the laws of the state of Delaware. Although an individual series of a Delaware series LLC has "the power and capacity to, in its own name, contract, hold title to assets (including real, personal and intangible property), grant liens and security interests, and sue and be sued" (6 Del. Code §18-215(c)), a series may not enter into a merger or conversion. Delaware permits a "domestic limited liability company" to enter into a merger or conversion. 6 Del. Code §18-209(a). Further, Delaware defines a "limited liability company" and a "domestic limited liability company" as "a limited liability company formed under the laws of the State of Delaware and having 1 or more members." 6 Del. Code §18-101(6). A series within a series LLC is not "formed" under Delaware law but rather pursuant to the limited liability company agreement of the series LLC. Members are not admitted as members of an individual series but, rather, are members of the series LLC and are "associated" with one or more series and may or may not have any economic interest in the series LLC itself other than an interest in one or more series. 6 Del. Code §18-215(e)-(k). Some states, namely Kansas, Illinois, and Iowa, and the District of Columbia, have considered this issue and have permitted (but not required) that a series within a series LLC to be a separate entity. Six of the current 10 domestic series LLC statutes, however, are like Delaware, in which a series within a series LLC is not a separate entity.

Tax Issues – Background

Before some clarity appeared with the issuance of the Proposed Regulations discussed below, commentators speculated that the eventual federal tax treatment of series LLCs would be to treat the individual series as separate entities. The predicted tax treatment flowed from cases and rulings holding that the separate series of an investment fund or of a business trust were distinct taxable entities. National Securities Series-Industrial Stock Series v. Commissioner, 13 T.C. 884 (1949), acq., 1950-1 C.B. 4. PLR 200803004; PLR 200544018; PLR 200303019; PLR 9847013.

Federal Taxation – the Proposed Regulations

Proposed federal tax regulations would treat each series within a series LLC as a separate entity for federal income tax purposes. Proposed Reg. §30.7701-1, 75 Fed. Reg. 55,699 (2010) (the "Proposed Regulations"). Each series would be classified as a partnership, disregarded, or as an association taxable as a corporation. The Proposed Regulations state a beneficial rule in that they will allow the same income tax classification that would apply if separate juridical LLCs were established. The Proposed Regulations apply to series created by "series organizations" pursuant to "series statutes." Proposed Reg. §301.7701-1(a)(5)(viii)(A) defines these terms such that each of the nine state series LLC statutes and the District of Columbia series LLC statute is a "series statute" within the meaning of the Proposed Regulations.

Classification of the Juridical LLC

The preamble to the Proposed Regulations states:

The proposed regulations do not address the entity status for Federal tax purposes of a series organization. Specifically, the proposed regulations do not address whether a series organization is recognized as a separate entity for Federal tax purposes if it has no assets and engages in no activities independent of its series.

An entity formed under local law is not always recognized as a separate entity for federal tax purposes. Treas. Reg. §30.7701-1(a)(4). Moreover, classification of an organization as an entity separate from its owners is a matter of federal tax law, not local law. Treas. Reg. §301.7701-1(a)(1).

Even if a series LLC has multiple economic members, if all of those members are associated with one or more series and have no economic interest in the LLC apart from their interest in one or more series, the series LLC itself will be treated as having no economic members. For federal tax purposes, the ownership of interests in a series and of the assets associated with a series is determined under general tax principles based on who is entitled to the benefits and burdens of the series or assets. A series organization is not treated as the owner for federal tax purposes of a series or of the assets associated with a series merely because the series organization holds legal title to the assets associated with the series. Proposed Reg. §30.7701-1(a)(5)(vi). As stated in the preamble to the Proposed Regulations:

A series organization is not treated as the owner of a series or of the assets associated with a series merely because the series organization holds legal title to the assets associated with the series. . . . [T]he series will be treated as the owner of the assets for Federal tax purposes if it bears the economic benefits and burdens of the assets under general Federal tax principles. Similarly, for Federal tax purposes, the obligor for the liability of a series is determined under general tax principles.

In general, the same legal principles that apply to determine who owns interests in other types of entities apply to determine the ownership of interests in series and series organizations. These principles generally look to who bears the economic benefits and burdens of ownership [citations omitted]. Furthermore, common law principles apply to the determination of whether a person is a partner in a series that is classified as a partnership for Federal tax purposes under §301.7701-3. See, for example, Commissioner v. Culbertson, 337 U.S. 733 (1949); Commissioner v. Tower, 327 U.S.280 (1946).

The general default rule under the tax classification regulations is that a domestic entity formed under a non-corporate statute will be classified as a partnership if it has two or more owners and will be disregarded if it has only one owner. Such an entity may elect to be taxed as a corporation. Treas. Reg. §30.7701-2. An otherwise disregarded single-owner entity will be regarded for certain employment and excise tax matters, however. Treas. Reg. §30.7701-2(c)(2)(iv) and (v). A special rule provides that an entity will be classified as a corporation if it is a state-chartered bank that is federally insured. Although some states now permit banks to be formed as limited liability companies, the author knows of no state that would allow a series of a series LLC to be a bank.

Reporting as Single Entity Currently Permitted

The Proposed Regulations are only proposed; a series LLC therefore could report now as single entity but would have to switch to separate reporting if the Proposed Regulations are finalized as written unless the transitional rule in the regulations applies. The principal conditions of the transitional rule that will most often apply to a series of a domestic series LLCs are:

  • The series must have been established prior to September 14, 2010;
  • The series (independent of the series organization or other series of the series organization) must have conducted business or investment activity on and prior to September 14, 2010;
  • No owner of the series treats the series as an entity separate from any other series of the series organization or from the series organization for purposes of filing any federal income tax returns, information returns, or withholding documents in any taxable year;
  • The series and series organization had a reasonable basis (within the meaning of IRC §6662) for their claimed classification; and
  • Neither the series nor any owner of the series nor the series organization was notified in writing on or before the date final regulations are published in the Federal Register that classification of the series was under examination (in which case the series’ classification will be determined in the examination).

If otherwise applicable, the transition rule will not apply on and after the date any person or persons who were not owners of the series organization (or series) prior to September 14, 2010, own, in the aggregate, a 50 percent or greater interest in the series organization (or series). For purposes of the preceding sentence, the term interest means:

  1. In the case of a partnership, a capital or profits interest; and
  2. In the case of a corporation, an equity interest measured by vote or value.

Effects of Switching to Reporting as Separate Entitles

The switch from reporting as a single entity would be considered a conversion from a single entity to multiple entities for federal tax purposes. Depending on the single entity tax classification before the switch, the switch could have adverse tax consequences. If the pre-switch single entity was classified as a corporation, the switch could be a taxable liquidation of the corporation. If the pre-switch entity was classified as a partnership, the effect of the switch on partnership liabilities would have to be considered.

Proposed Regulations as Substantial Authority

Even though the Proposed Regulations are only proposed, for a taxpayer who reports in accordance with the Proposed Regulations, however, they are "substantial authority." Treas. Reg. §1.6662-4(d)(3)(iii). Note, however, as discussed below, the Proposed Regulations do not apply for purposes of employment taxes or employee benefits and, therefore, would not be substantial authority for a taxpayer’s treatment of those matters in a series LLC.

Reporting Requirements

The Proposed Regulations contain reporting requirements. Each series (unless disregarded) and series organization (if recognized as an entity for tax purposes and not disregarded) would be required to file the appropriate income tax returns. In addition, Proposed Regulation §301.6011-6(a) would require each series (whether or not disregarded) and each series organization (whether or not disregarded and, apparently, whether or not treated as an entity for tax purposes) to file a statement for each taxable year with respect to the series or series organization as prescribed by the IRS. Proposed Regulation §301.6071-2(a) would require that such statements be filed by March 15 of the year following the period for which the statement is made.

Scope of Proposed Regulations

The Proposed Regulations do not address foreign entities (except for insurance businesses), employment taxes, or employee benefits. The preamble to the Proposed Regulations discusses several perceived problems that could arise if a series is treated as a separate entity for employment tax purposes, including:

  • Substantive and administrative issues that allegedly arise from the treatment of a series as a separate person for federal employment tax purposes.
  • The series structure would make it difficult to determine whether the series or the series organization should be considered the employer with respect to the services provided.
  • The structure of a series organization could also affect the type of employment tax liability – if a series were recognized as a distinct person for federal employment tax purposes, a worker providing services as an employee of one series and as a member of another series would be subject to FICA tax on the employment wages and self-employment tax on the member income.
  • How would the wage base be determined for employees, particularly if they work for more than one series in a common line of business?
  • How would the common paymaster rules apply?

Perceived Problems if a Series is Treated as a Separate Entity for Employment Tax Purposes

It is not clear what exactly the drafters of the Proposed Regulations thought might be necessary "to make [a series] an employer for Federal employment tax purposes." Statutory provisions cited in the preamble use the term "person" in referring to employers. Moreover, the relevant employment tax provisions sometimes use additional terms to describe who can be an "employer." Thus, IRC section 3121(h) defines "American employer" as, inter alia, an "employer which is . . . (3) a partnership, if two-thirds or more of the partners are residents of the United States or (5) a corporation organized under the laws of the United States or of any State." Unless a series is disregarded, under the Proposed Regulations, it will be either a partnership or an association taxable as a corporation for federal tax purposes. Moreover, Treas. Reg. §31.3121(d)-2(b) states that "an employer may be . . . a corporation, a partnership, . . . an association, or a syndicate, group, pool, . . . or other unincorporated organization, group, or entity." It would not appear difficult to fit a series within that definition. Finally, the Internal Revenue Code defines the term "person" to "mean and include . . . a . . . partnership, association, company, or corporation, and provides that "the terms ‘includes’ and ‘including’ when used in a definition contained in this title shall not be deemed to exclude other things otherwise within the meaning of the term defined." IRC §§ 7701(a) (1), 7701(c). Again, it appears that an individual series if not disregarded would be a partnership or corporation within the meaning of the IRC definition of "person."

Although there may be some circumstances in which it is not at first apparent who the employer is, an examination of the facts should almost always lead to a clear result, or at least as clear a result as is obtained in ambiguous employment situations outside of series entities. Moreover, it is unclear how a situation in which a worker would be considered to be the employee of more than one series is any different from the issues that arise if a worker is the employee of two or more separate juridical entities under some degree of common control or the situation that arises when an individual is an employee of one entity and also a member of an LLC that is under common control with the first entity. The U.S. Department of Labor recognizes that whether two or more employers who employ the same individual are jointly liable for all federal wage and hour requirements or each employer is only liable with respect to the employee’s service for that employer is a highly fact-based determination that does not necessarily depend on there being common control among the employers. WH Publication 1297 – United States Department of Labor Employment Standards Administration Wage and Hour Division, "Employment Relationship Under the Fair Labor Standards Act."

It strikes the author as somewhat disingenuous to ask how the common paymaster rules would work. The common paymaster rules allow certain commonly controlled corporations to use one of the corporations to pay employees who work for more than one of the controlled corporations, applying one wage base, etc. Treas. Reg. §31.3121(s)-1. The common paymaster rules apply only to corporations. It seems likely to the author that the great majority of series that are treated as separate entities for federal tax purposes will either be disregarded entities or will be partnerships for tax purposes. The common paymaster rules as currently written would have no application to such series, except possibly to a series that, because disregarded, was treated as a division of a corporation. It would seem to be a useful project for the Treasury Department to revise the common paymaster regulations so that they would apply to all entities that are under common control as defined therein, whether or not incorporated.

Employee Benefit Plans

The preamble to the Proposed Regulations state that to the extent a series may maintain an employee benefit plan, the aggregation rules and employee leasing rules of Internal Revenue Code Section 414 will apply. The author does not see any reason why a series should not be able to maintain an employee benefit plan on its own. As the preamble to the Proposed Regulations states, the analysis whether the series is properly maintaining the plan should be the same analysis that is made when any entity that is under common control with a number of other entities maintains an employee benefit plan.

Federal Taxation – Equity Compensation in Series LLCs

Controversy existed for many years in court decisions and the approach of the IRS with respect to whether the receipt of an interest solely in future partnership profits is a taxable event. The IRS provided some clarity for planning purposes in Rev. Proc. 93-27, 1993-2 C.B. 343, as clarified by Rev. Proc. 2001-43, 2001-34 I.R.B. 1. Rev. Proc. 93-27 declares that the receipt of a profits interest in exchange for services in a partner capacity, or in anticipation of becoming a partner, will not be treated as taxable event to either the recipient partner or the partnership. Rev. Proc. 93-27 provides that a "profits interest" is anything other than a capital interest, and a "capital interest" is "an interest that would give the holder a share of the proceeds if the partnership’s assets were sold at fair market value and then the proceeds were distributed in a complete liquidation of the partnership." However, Rev. Proc. 93-27 does not apply if (a) the profits interest relates to a substantially certain and predictable stream of income from partnership assets; (b) if within two years of receipt the partner disposes of the profits interest; or (c) if the profits interest is a limited partnership interest in a publicly traded partnership.

Series LLCs present unique issues because of Rev. Proc. 93-27’s provision of its applicability:

If a person receives a profits interest for the provision of services to or for the benefit of a partnership in a partner capacity or in anticipation of being a partner, the Internal Revenue Service will not treat the receipt of such an interest as a taxable event for the partner or the partnership (emphasis added).

Assume a Delaware series LLC that has three series. Two of the series are classified as partnerships, and the third is disregarded for income tax purposes. As we know, under the Delaware series LLC statute, a person is not admitted as a member of a series. Membership admission occurs at the series LLC level, and members of the series LLC may be "associated" with one or more series. Any membership interest that is intended to be a profits interest will necessarily have to be issued by the series LLC. If the profits interest is issued to an individual who will have an economic interest only in one of the series, the series LLC presumably may "associate" that profits interest with that series. Fortunately, the Proposed Regulations contain provisions that appear to minimize these possible problems. As noted above, the Proposed Regulations state that "for Federal tax purposes, the ownership of interests in a series and of the assets associated with a series is determined under general tax principles." Prop. Reg. §301.7701-1(a)(5)(vi). In addition, the preamble to the Proposed Regulations also contains several helpful statements, including that "common law principles apply to the determination of whether a person is a partner in a series that is classified as a partnership for Federal tax purposes under §301.7701-3" and "[T]axpayers that establish domestic series are placed in the same position as persons that file a certificate of organization for a state law entity."

Accordingly, if the Proposed Regulations are finalized substantially as proposed, the author believes that the issuance of a profits interest by the juridical LLC that is associated with a series should be treated as the issuance by the series if that series is classified as a partnership. A problematic situation would arise, however, if the holder of the profits interest was the only person with an economic interest in the series. Such series would be disregarded for income tax purposes unless it elected to be taxed as a corporation, and the issuance of that profits interest likely would be viewed as an interest in a sole proprietorship or a corporation and therefore taxable under IRC §83.

State Tax Issues are Evolving

The comptroller of the State of Texas apparently intends to treat a series LLC as a single entity for franchise tax purposes. The state bar Tax Section has recommended that each series be treated as a separate entity for margin tax purposes to avoid causing the difference that would otherwise result with respect to aggregating entities for margin tax purposes. Separate entities that are under common control do not have to file as a combined group unless they are engaged in a unitary business. However, under the comptroller’s approach, all series created under the same series LLC will in effect be combined for margin tax purposes even if the series are not engaged in a unitary business.

The California Franchise Tax Board has announced it will treat each series within a series LLC as a separate LLC, thus subjecting each series to minimum $800 annual franchise tax.

Eliminating Fiduciary Duty Uncertainty: The Benefits of Effectively Modifying Fiduciary Duties in Delaware LLC Agreements

Posted on February 4, 2013 by - Uncategorized

Unincorporated business entities, and in particular limited liability companies, are fast becoming a preferred form of business entity for structuring businesses and transactions. Such legal entities serve a wide range of functions. As with corporations, Delaware is often the jurisdiction of choice for forming unincorporated entities. Delaware limited liability companies are creatures of contract; they afford the parties involved the maximum amount of freedom of contract, private ordering and flexibility. To that end, the Delaware Limited Liability Company Act, 6 Del. C. §§ 18-101, et seq. (the LLC Act), makes certain statutory rules applicable only by default (i.e., only in situations in which members of a Delaware limited liability company (an LLC) have not otherwise provided in their limited liability company agreement (an LLC agreement)). As a result, members of an LLC are free to contract among themselves concerning a myriad of issues, including the management and standards governing the internal affairs of an LLC. Members of an LLC may also choose to govern their relationships exclusively by contract, without regard to corporate-style fiduciary duties of loyalty and care.

Fiduciary Duties and Delaware LLCs

Fiduciary duties generally apply to those who are entrusted with the management or control of another party’s property or assets. See, e.g., In re USACafes, L.P. Litig., 600 A.2d 43, 48 (Del. Ch. June 7, 1991). The LLC Act does not affirmatively establish default fiduciary duties, but the existence of fiduciary duties is contemplated by the LLC Act and such duties have been applied by the Delaware Court of Chancery. In Auriga Capital Corp. v. Gatz Properties, LLC, 40 A.3d 839 (Del. Ch. Jan. 27, 2012), the Court of Chancery applied default fiduciary duties to a manager of an LLC. The court reasoned that the LLC Act contemplates the application of principles of equity, LLC managers are fiduciaries, and fiduciaries owe the fiduciary duties of loyalty and care. The court concluded that the LLC Act provides that managers of LLCs owe default fiduciary duties of loyalty and care. The Delaware Supreme Court affirmed the Auriga decision in Gatz Properties, LLC v. Auriga Capital Corp., ___ A.3d ___, 2012 WL 5425227 (Del. 2012) on the grounds that the LLC agreement at issue imposed fiduciary duties, but noted that the lower court’s reasoning applying default fiduciary duties to managers of LLCs was mere dicta and had no precedential value. The Delaware Supreme Court observed that the LLC agreement in Auriga contractually adopted fiduciary standards and so the issue of whether default fiduciary duties apply in the LLC context should not have been addressed by the Court of Chancery. Notably, the Delaware Supreme Court did not take a position on the existence of default fiduciary duties under the LLC Act, but did indicate that reasonable minds may disagree on the issue. Nevertheless, in Feeley v. NGAOCG, LLC, 2012 WL 5949209 (Del. Ch. Nov. 28, 2012), the Court of Chancery recognized that while the Court of Chancery’s reasoning in Auriga does not represent controlling precedent, it is persuasive and consistent with prior opinions of the Court of Chancery on the issue of default fiduciary duties in the unincorporated entity context. In Feeley, plaintiffs alleged that the managing member of the LLC breached the default fiduciary duties it owed as a manager. The LLC agreement in Feeley did not modify fiduciary duties. Thus, directly at issue in the case was whether default fiduciary duties should apply to the managing member of the LLC. In deciding the issue, the court considered the Court of Chancery’s reasoning in Auriga regarding default fiduciary duties as akin to a law review article informing the court’s decision. Further, the court noted that although the long line of Court of Chancery precedents regarding default fiduciary duties in unincorporated entities does not bind the Delaware Supreme Court, the precedents are viewed as stare decisis by the Court of Chancery. The court concluded that since the Supreme Court has not addressed the issue, and because prior Court of Chancery decisions and the dictum by the Court of Chancery in Auriga were persuasive, default fiduciary duties applied to the managing member of the LLC.

In light of Feeley and prior Delaware Court of Chancery precedents, although the Delaware Supreme Court has not yet decided the question, the authors believe that traditional “corporate” fiduciary duties of loyalty and care are applicable to persons controlling an LLC and its property, unless expressly and clearly modified or eliminated in an LLC agreement. The traditional duty of care essentially requires managers to be attentive and inform themselves of all material facts regarding a decision before taking action. The traditional duty of loyalty generally requires that managers’ actions be motivated solely by the best interests of the LLC and its members and that such actions not further personal interests of the manager at the expense of the LLC and its members.

Modifications of Fiduciary Duties in the LLC Agreement

The traditional fiduciary duties described above may be modified or eliminated by including clear and unambiguous language to that end in an LLC agreement. Until such time as the Delaware Supreme Court decides the issue or the “organs of the bar” (see Gatz at *10) act to clarify the point, the authors will continue to advise parties to LLC agreements that they should clearly and unambiguously supplant traditional fiduciary duties in their LLC agreement if they desire certainty that such duties do not apply. Absent clear and unambiguous modification or limiting language, parties to an LLC agreement may find themselves subject to fiduciary duties.

In construing fiduciary duty modification provisions in the LLC context, Delaware courts have analogized to cases concerning Delaware limited partnerships due to the similarities between the LLC Act and the Delaware Revised Uniform Limited Partnership Act, 6 Del. C. §§ 17-101, et seq. In Miller v. American Real Estate Partners L.P., 2001 WL 1045643 (Del. Ch. Sept. 6, 2001), the Court of Chancery found that the language in a partnership agreement failed to clearly preclude the application of default fiduciary duties. It noted that given the great freedom afforded to drafters of such agreements, it is fair to expect that restrictions on fiduciary duties be set forth clearly and unambiguously. The same principle, in our view, applies to LLCs.

The unpredictability resulting from the potential application of traditional “corporate” fiduciary duties to an LLC agreement may add costs and inefficiencies to an LLC and its operations. Legal uncertainty complicates business planning, promotes costly litigation, and unduly impedes managerial discretion. Expressly overriding any default fiduciary duties in an LLC agreement will help to eliminate the uncertainty stemming from potential challenges based on fiduciary duty violations. In the following sections, we examine scenarios in which modifications or elimination of fiduciary duties may benefit the parties involved in LLCs, and in certain instances, we suggest means for modifying or eliminating such duties.

LLCs as Private Equity/Hedge Funds

Hedge funds and private equity funds are frequently formed as Delaware limited partnerships or LLCs, and are an example of a structure that may have fiduciary duty problems if such duties are not addressed in the governing documents of the fund.

In an LLC fund, a manager typically manages the fund while the investors invest in the fund as non-managing members in a relatively passive role. Under such structure, the manager will owe fiduciary duties to the LLC fund and its investor members. Since the manager or an affiliate is typically managing other similarly situated funds, this structure creates an inherent conflict of interest for such managers.

Accordingly, fund managers benefit from provisions modifying or eliminating fiduciary duties in the governing documents of the fund wherever possible. Such provisions permit fund managers to more efficiently manage the operations of the fund because such persons are able to make investment and other management decisions for the fund without the specter of a breach of fiduciary duties claim impeding their every action. In addition, modifications allow fund managers to mitigate their potential risks and enable them to act in their various capacities in managing multiple funds.

There are several practical ways in which fiduciary duties of fund managers may be effectively modified or eliminated. One way is to simply include a provision in the fund’s governing documents that explicitly eliminates all fiduciary duties of the fund manager and its affiliates to the fund and its investors in a clear and unambiguous manner. However, investors typically resist such an outright provision in a fund agreement.

Another approach involves the use of a “sole discretion” provision. Such provision modifies fiduciary duties only in specified situations when a manager acts in its “sole discretion.” If an LLC agreement contains an appropriate “sole discretion” provision, default principles of fiduciary duty are not applicable to actions of the manager that are subject to a sole discretion standard. An appropriate “sole discretion” provision both defines the term “sole discretion” in a manner inconsistent with traditional fiduciary duties, and contains language that precludes application of traditional duties.

A third option for modifying fiduciary duties in a fund LLC agreement involves providing for advisory committee approval, thus invoking a mechanic similar to that of a “special committee” approval in the corporate context. If properly drafted, this structure permits fund managers to contractually “cleanse” interested transactions and avoid becoming subject to entire fairness review.

Finally, parties to a fund LLC agreement may specifically authorize certain relationships or transactions in the LLC agreement, notwithstanding duties otherwise existing at law or in equity (including fiduciary duties), and so displace fiduciary duties in those specific situations. In so doing, fund managers may at a minimum address specific situations where fiduciary duty issues tend to arise and deal with them upfront in the LLC agreement by specifically authorizing them even if broader modifications of fiduciary duties are not feasible in a particular fund.

Regardless of which approach is pursued, the most important requirement in drafting any such modification or elimination provision is that it is clear and unambiguous as to its intent since the Delaware Court of Chancery narrowly construes provisions that purport to modify fiduciary duties.

Joint Ventures/Multimember LLCs

LLCs are used for structuring joint ventures, start-up companies, large and small businesses (collectively, “Multimember LLCs”) and, as discussed below, even publicly held companies. Modifications of fiduciary duties may be desirable for Multimember LLCs. There are a number of factors to consider when limiting the fiduciary duties within a Multimember LLC, including the duration of such duties, manager versus non-manager duties, duties as among the members, and conflicts of interest. Parties to a Multimember LLC may wish to define the parameters of their relationship in the contract and avoid the uncertainty of having default fiduciary duties apply. Doing so provides more efficiency in management and establishes clear expectations among the parties. Below are a couple of scenarios in which modifications of fiduciary duties may be beneficial to a manager, member, or board of a Multimember LLC.

Conflicts of interest. Usurpation of corporate opportunity, competition and other conflict of interest issues may arise in the course of the operation of a Multimember LLC. For example, parties to Multimember LLCs, especially those involved in joint ventures, may be competitors or have a number of other business ventures. Contractually modifying fiduciary duties promotes economic efficiency in the use of the united resources of the parties in a particular venture. Likewise, conflict situations should be dealt with in the LLC agreement in order to eliminate the risk of a manager or a member unintentionally being subject to duties for which the parties did not bargain.

For example, parties to an LLC agreement may avoid application of the corporate opportunity doctrine by including in the LLC agreement clear provisions on what the business of the LLC will be, what it will accomplish, and what, if any, opportunities the members and managers of the LLC will be able to pursue without having to present them to the LLC. Alternatively, an LLC agreement for a Multimember LLC may eliminate fiduciary duties altogether. The parties may also wish to consider including procedures to address future conflict situations as they arise, such as providing for board or committee approval or establishing a defined standard that displaces the traditional fiduciary standard. By addressing fiduciary duties in the LLC Agreement, compliance, litigation, indemnification, and other costs may be reduced for an LLC.

Management actions and member consents. Modifications of fiduciary duties in an LLC agreement are also desirable because they provide flexibility and certainty for managers or members in making decisions in a management capacity. For example, in Dawson v. Pittco Capital Partners, L.P., 2012 WL 1564805 (Del. Ch. Apr. 30, 2012), the court considered, among other things, a breach of fiduciary duty claim arising out of the merger of LaneScan, LLC (LaneScan), into another LLC. The provisions of the LaneScan LLC agreement clearly eliminated fiduciary duties of the directors and officers of LaneScan to the members of LaneScan. The court dismissed the complaint with respect to the directors’ and officers’ actions taken in connection with the merger. By clearly addressing duties of managers in an LLC agreement, managers of an LLC are able to act with more certainty in managing the affairs of an LLC.

Members acting qua member may find similar benefit from supplanting fiduciary duties. For example, in Related Westpac LLC v. JER Snowmass LLC, 2010 WL 2929708 (Del. Ch. July 23, 2010), the plaintiff, the operating member of two LLCs, sued the other member, alleging breach of the operating agreement and such member’s fiduciary duties for its refusal to agree to fund a capital call or consent to various major decisions. The court dismissed the claims, noting that the defendant member was free to withhold consents to major decisions, unencumbered by any fiduciary duty because the fiduciary duties were inconsistent with the parties’ LLC agreement. As with LLC managers, members of a joint venture LLC are able to act with more certainty in protecting their interests in the venture if the LLC agreement limits or eliminates their fiduciary duties.

Finally, contractual modifications of fiduciary duties also benefit members and managers of board-managed Multimember LLCs. In a board-managed Multimember LLC, board members are often appointed by the members of the LLC. Where default fiduciary duties are applicable, such board members will owe duties to the LLC and all members of the LLC. Modifying fiduciary duties or eliminating them for board members permits the board members to act for the benefit of the member who appointed them without risk of breaching fiduciary duties to the LLC and its other members and affords the members certainty as to the loyalties of their appointees.

Publicly Held LLCs

Managers and controlling members, and their affiliates, of publicly traded LLCs face many of the same thorny fiduciary duty issues as those highlighted above, and the number of potential plaintiffs magnifies their potential effect. Accordingly, the rationales for modifying fiduciary duties in this context are generally the same as those discussed above and, as the number of publicly traded LLCs increases, the authors expect that many of them will have modified fiduciary duties in their LLC agreements.

The means of effecting these modifications vary. For example, an LLC agreement may establish a “special approval” process for potential conflicts transactions that, if obtained, provides that a manager and its affiliates will not be deemed to have breached the LLC agreement or any fiduciary duty. If the specified approval procedures are followed, then a manager of an LLC and its affiliates should prevail with respect to breach of fiduciary duty claims. By providing clear standards, managers, controlling members, and their affiliates can prevail at the motion to dismiss stage of breach of fiduciary duty proceedings. As noted previously, however, parties should exercise caution when drafting such provisions to ensure that they are clear and that they adequately capture the intent to supplant or eliminate default fiduciary duties.

LLCs in Structured Finance Transactions

Finally, fiduciary duties are also routinely modified in structured finance transactions. Structured finance transactions often involve the use of single member LLCs established to own specific assets (SPEs). SPEs are set up as bankruptcy remote entities that have a limited purpose, own no other assets and, among other traits, have an individual with no relationship to the parent member designated as an “independent manager,” who must approve the taking of material actions, including the filing of a voluntary petition in bankruptcy.

The independent manager concept is a key feature in these transactions. There is concern that a manager or board of managers composed only of parent employees or affiliates will follow a parent member’s instructions even in a situation when the SPE is a solvent and financially viable legal entity. This could include instructions to file a voluntary bankruptcy petition for such an SPE. In order to alleviate this concern for lenders to such SPEs, the affirmative vote of the independent manager of an SPE is a prerequisite to the SPE’s voluntarily filing of a bankruptcy petition.

In situations in which the independent managers owe fiduciary duties, lenders, and credit agencies require that such duties are modified so that such independent managers are required to take into account the interests of not only the SPE and the SPE’s parent member, but also the SPE’s creditors with respect to its interest in the SPE when deciding to approve a material action. The rationale for such modification is that the creditors of the SPE may be prejudiced by a voluntary bankruptcy filing by the SPE, and an independent manager owing fiduciary duties to the SPE’s creditors will be less likely to approve an unjustified filing on behalf of the SPE.

Conclusion

Based on existing Delaware case law, the authors believe that traditional fiduciary duties apply with respect to LLCs in the absence of an effective modification or elimination in the LLC agreement. Modifications of fiduciary duties are motivated by different reasons and may be effected in different ways, depending upon the context. The Delaware Court of Chancery construes narrowly any attempted modification or elimination of fiduciary duties. Thus, any LLC agreement provisions modifying or eliminating fiduciary duties must be clear and unambiguous, regardless of the context.

 

Canadian Tax Tips and Traps for U.S. Businesses

Posted on February 2, 2013 by - Uncategorized

In the current economic context, Canada has, so far, come through the recession relatively unscathed. This may tempt U.S.-based enterprises to consider future expansion in Canada. Before implementing any such expansion plans, they should consider some key Canadian tax implications, to avoid potentially costly missteps.

To Incorporate or Not to Incorporate?

One of the first legal considerations faced by U.S. businesses expanding into Canada is whether to do so through an unincorporated branch or a separate legal entity. While the prospects of allowing the flow-through of initial operating losses to the U.S. business might militate in favor of initially setting up a branch operation, a similar outcome may be achieved through the use of a separate legal entity disregarded for U.S. federal income tax purposes, as noted below. Most set-up and maintenance costs, including sales and payroll tax registrations, annual filings with corporate registries, filing of Canadian income tax returns, and preparation of separate financial statements for the Canadian operations, will be incurred irrespective of whether the Canadian business activities are separately incorporated or operated as a branch.

In practice, to the extent such activities are expected to give rise to a taxable presence in Canada, the vast majority of U.S. businesses choose to carry on business in Canada through a Canadian corporation citing, among others, the following reasons:

  • Having a separate legal entity to house the Canadian operations allows the Canadian entity and its U.S. parent to more clearly delineate their respective business functions, as well as the risks each assumes. Having a separate subsidiary affords a U.S. parent the opportunity to have agreements between the U.S. parent and the Canadian subsidiary to provide support for any intended allocation of profits between the Canadian and the U.S. operations (subject to applicable transfer pricing rules);
  • Having a Canadian subsidiary isolates Canadian tax filing obligations and can generally reduce the extent of the Canadian tax authorities’ future enquiries into the U.S. parent’s business operations;
  • To the extent that the Canadian corporate entity is not an unlimited liability company, it affords limited liability to the U.S. parent for risks arising from Canadian business activities; and
  • Where all or any part of the revenues generated by the Canadian operations arise from services rendered physically in Canada, having a separate Canadian subsidiary will prevent the potential application of withholding at source under Canadian federal and provincial income tax regulations.

Withholding Tax on Services Fees

Canadian federal tax regulations provide that a 15 percent withholding must be applied on amounts paid to a non-resident for services rendered physically in Canada (and a further 9 percent withholding must be applied for services in the province of Quebec) and must be remitted to the Canadian tax authorities. This withholding at source is intended to serve as security on account of the payee’s potential Canadian income tax liability and does not represent a final tax. Any excess of the amount withheld over the ultimate Canadian income tax liability of the payee can be refunded after the end of the taxation year of the payee after filing of Canadian income tax returns.

While advance waivers (complete or partial) may be sought and obtained from the Canadian tax authorities prior to payments for services being made to the non-Canadian, a complete waiver of such withholding is generally not available if, among other circumstances, the non-Canadian carries on business in Canada through a permanent establishment, its physical presence in Canada exceeds a specified number of days or the payment is made pursuant to a multi-year contractual arrangement.

U.S. enterprises carrying on business in Canada through an unincorporated branch and providing services in Canada from that branch must consequently resort to seeking partial advance waivers so as to ensure that the withholding effected, which by default would be applied on gross service payments made, will approximate the ultimate tax liability of the recipient. Such partial waivers, also referred to as “income and expense waivers,” will allow an offset against the Canadian service income of certain expenses, other than depreciation and amortization, incurred by the U.S. business in relation to such service income. Graduated rates (similar to those used for residents) will be applied on the resulting “net” Canadian service income.

This withholding regime is, typically, an incentive for U.S. businesses deriving significant revenues from services to incorporate a Canadian subsidiary to carry on business in Canada. While advance waivers may be considered in situations where the proposed Canadian operations involve a limited number of clients and all conditions for eligibility are met, the convenience of this solution is questionable if significant numbers of customers are expected or if significant expenses not eligible for purposes of an “income and expense waiver” are likely to be incurred.

Getting your Money Out Withholding Tax Free

Virtually any U.S. business that establishes a Canadian subsidiary or acquires an existing Canadian corporation will want to maximize so-called “paid-up capital.” The appeal of paid-up capital is that it can be repatriated withholding tax-free to non-Canadian shareholders. “Paid-up capital” for tax purposes uses, as a starting point, stated capital for Canadian corporate law purposes, subject to certain tax-related adjustments (including to take into account any transfers that may have been effected on a partial or complete rollover basis). Paid-up capital for tax purposes may differ significantly from stated capital for accounting purposes. It is normally expressed in Canadian dollars.

Since paid-up capital is in large part derived from legal stated capital, many U.S. acquirers effect the acquisition of a Canadian corporation through a Canadian acquisition vehicle.

This flows from the fact that legal stated capital is generally created in connection with issuances of shares from treasury and reflects the consideration paid for the issuance of such shares. Therefore, irrespective of an acquirer’s tax basis in the shares of a Canadian corporation, the paid-up capital of the acquired shares would, in the absence of the interposition of a Canadian acquisition vehicle, reflect the historical amount initially contributed by previous shareholders to the Canadian corporation for the issuance of its shares. That amount would be the effective limit to what can be withdrawn tax-free by the acquirer.

If, however, a U.S. acquirer sets up a Canadian acquisition vehicle to carry out the acquisition of a Canadian target and subscribes for shares of the acquisition vehicle for a consideration equal to the equity component of the purchase price to be paid, the paid-up capital of the shares of the Canadian vehicle will be equal to that amount, which can in turn be repatriated tax-free. An added benefit of the use of a Canadian acquisition vehicle is the possibility of having all third-party financing required to carry on the acquisition incurred by the Canadian vehicle and, through post-closing amalgamation or winding-up, of having future interest expense on the acquisition debt as a deduction in computing Canadian income.

A mistake to be avoided when contributing additional sums to Canadian subsidiaries is to effect such contributions by way of a capital contribution, without the issuance of additional shares of the Canadian subsidiary. In these circumstances, depending on the Canadian federal or provincial corporate statute relied upon, no legal stated capital, and consequently no paid-up capital, may be created despite any resulting increase in tax basis. While it may be possible in certain circumstances to convert contributed surplus into paid-up capital, this is far from a sure thing, especially where the particular contribution did not result in contributed surplus for accounting purposes.

Capitalizing a Canadian Subsidiary: Debt or Equity?

The choice of capitalizing a Canadian subsidiary with debt and/or equity will have an impact on the return an investor will pocket. Interest payments may reduce the Canadian taxable income and can be free of withholding taxes when paid by a Canadian subsidiary to its U.S. parent to the extent the latter is eligible for the benefits of the Canada-U.S. Treaty (Treaty). On the other hand, dividends are generally subject to a 5 percent withholding tax and are not deductible from the taxable income of a Canadian subsidiary.

U.S. businesses cannot capitalize their Canadian subsidiaries entirely with debt to erode the Canadian tax base. Canada has rules, known as the “thin capitalization rules,” that apply to limit the deductibility of interest on debt owed by a Canadian subsidiary to its foreign parent (or any other “specified non-resident shareholder”). Also, transfer pricing rules (similar to those applying in the United States) and other domestic interest deductibility rules, which are both beyond the scope of this article, may limit the interest deduction that can be claimed by the Canadian subsidiary on debt owed to its U.S. parent.

The Canadian thin capitalization rules deny an interest deduction on debt to a specified non-resident shareholder where the debt:equity ratio of the Canadian subsidiary exceeds a certain threshold. A “specified non-resident shareholder” is in essence any non-resident who owns, together with persons with whom it is not dealing at arm’s length, 25 percent or more of the votes or value of the shares of the capital stock of the Canadian subsidiary. The current maximum debt:equity ratio is 2:1, but such ratio was recently lowered by the 2012 Canadian federal budget to 1.5:1 for taxation years that begin on January 1, 2013, and thereafter. The debt portion of the ratio is represented by the yearly average of the highest amount of debt outstanding to “specified non-resident shareholders” in each month. The equity portion of the ratio is where taxpayers may miss the mark if caution is not exercised. It is the sum of (1) the retained earnings of the Canadian subsidiary (on a non-consolidated basis) at the beginning of the year; (2) the average contributed surplus contributed by a “specified non-resident shareholder” at the beginning of a calendar month that ends in the year; and (3) the average paid-up capital on shares held by a “specified non-resident shareholder” at the beginning of a calendar month that ends in the year. Given that the equity portion is calculated at specific times, a U.S. business must carefully monitor the timing of capitalizing its Canadian subsidiary to avoid exceeding the debt:equity ratio.

As mentioned above, for taxation years beginning on January 1, 2013, and thereafter, the debt:equity ratio for thin cap rules is reduced to 1.5:1, that is 60 percent debt, 40 percent equity. U.S businesses with intercompany debt into their Canadian subsidiaries must consider whether to capitalize or otherwise reduce the portion of such subsidiaries’ “specified non-resident shareholder” debt that is in excess of that ratio.

If the debt:equity ratio is exceeded, in addition to losing the interest deduction on the excess debt, the denied interest will be treated as a deemed dividend subject to a Canadian withholding tax of 5 percent under the Treaty, thereby negatively affecting the after-tax return on their Canadian investment.

Use of Hybrid Entities – Advantageous or Disadvantageous?

Various types of legal entities can be used for investment into Canada by a U.S. person. It is important to identify the proper entity to achieve the desired tax result and to avoid unwanted tax consequences. Canadian unlimited liability corporations (ULCs) and U.S. limited liability companies (LLCs) can be useful because they can be treated as disregarded entities or partnerships for U.S. federal income tax purposes while being taxed as corporations for Canadian income tax purposes. These types of entities, commonly known as hybrid entities, have led to some tax arbitrage and the consequential amendments to the Treaty in 2010 that can trigger burdensome withholding on cross-border payments.

The Treaty now denies a lower withholding rate on certain amounts derived through or received from hybrid entities. Although the stated purposes of these rules was to target certain deductible payments, they could apply in many unforeseen circumstances. For example, dividends paid by a ULC can trigger a 25 percent Canadian withholding tax and business profits generated by a Canadian branch of an LLC can trigger a 25 percent branch tax in Canada. These withholdings can annihilate the tax benefits of having a flow-through structure from a U.S. federal income tax perspective.

The Canadian tax authorities have thus far shown some administrative lenience in interpreting and applying these provisions and Treaty benefits may still be available for hybrid entities. In fact, although caution must be exercised, with proper planning one can mitigate the adverse tax consequences involved with hybrid entities and continue to enjoy some of the benefits they present for U.S. investors into Canada.

Purchasing Assets vs. Shares

Probably one of the first important decisions involved with acquiring a Canadian target is whether the acquisition should be structured as an asset or share deal. Contrary to the United States, Canada has no rule (such as IRC Section 338) that permits a purchaser to treat a stock acquisition as an acquisition of the assets of the target. There is a possible step-up in the tax basis of certain non-depreciable assets up to the fair market value of such assets, but this often has limited value to the purchaser. Thus, except for certain transactions where a Canadian target corporation may have significant net operating losses or other tax attributes to carry-over, the preference for most purchasers of a Canadian business is to buy assets instead of stock, to get a higher tax basis in depreciable assets.

Based on U.S. tax instincts, one might think that a Canadian seller, on the other hand, would invariably prefer to sell stock instead of assets to realize a capital gain treatment (instead of recapture of depreciation) of which only 50 percent is taxable in Canada (versus 100 percent for recapture). However, given the integration system in Canada, this may not necessarily be the case. The aim of the integration system is to ensure that income earned in a Canadian corporation and paid to a Canadian taxable shareholder as a dividend should be subject to similar combined corporate and shareholder taxes than if the income had been earned directly by the shareholder and taxed in its hands only. As a result of integration, where a Canadian corporation sells its assets with most of the gain attributable to goodwill, and then distributes the after-tax proceeds to its Canadian taxable shareholders, the after-tax cash proceeds for the shareholder should not be substantially different from the after-tax cash proceeds such shareholders would have received in a stock transaction, barring a significant discrepancy between inside and outside tax basis, the availability of the lifetime capital gains exemption (for individual shareholders only) or other factors. On the other hand, the purchaser will have the benefit of a step-up in the depreciable assets (including goodwill), in addition to avoiding certain potential legacy liabilities.

Foreign Affiliate Dumping Rules

On October 15, 2012, the Minister of Finance released the final version of the so-called “foreign affiliate dumping” rules initially introduced by the 2012 Canadian Federal budget to curtail certain transactions considered by the Canadian tax authorities to improperly erode the Canadian tax base in favor of foreign jurisdictions. There have already been numerous articles criticizing these rules and their likely application to situations beyond the scope of their intended purpose. The following is a brief overview of these rules and how they may apply to a U.S. business investing in Canada.

In general, the rules apply to an investment in a non-resident corporation made by a corporation resident in Canada where: (1) the non-resident corporation is or becomes, as part of the same series of transactions as the investment, a “foreign affiliate” (very generally, a 10 percent direct or indirect shareholding is required) of the Canadian corporation; and (2) the Canadian corporation is or becomes controlled by a non-resident corporation (the “parent”) at the time of investment. The consequence of the application of these rules is that the amount of the investment gives rise to either a 25 percent Canadian withholding taxes on a deemed dividend (subject to potential reduction under the Treaty) or a reduction of paid-up capital on the shares of the Canadian corporation held by the parent, which may result in future Canadian withholding tax issues.

The broad application of the rules results partly from the extensive definition of what constitutes an investment in a foreign affiliate. Without limitation, an acquisition of shares of, a contribution of capital to, an acquisition of a debt obligation of, and even an extension of the term of an existing debt or of the redemption date of a share issued by the foreign affiliate can be considered an investment in it. The acquisition of shares of another Canadian corporation can also be considered an investment in a foreign affiliate if the other Canadian corporation derives more than 75 percent of its value from foreign affiliates. Thus, in a situation where a U.S. business incorporates a Canadian subsidiary to acquire shares of another Canadian corporation with substantial foreign subsidiaries, a deemed dividend or a reduction of paid-up capital and corresponding present or future withholding tax may arise although no direct investment was made in a foreign entity in the process.

If there is cross-border paid-up capital in the shares of the Canadian corporation, in general, the tax consequences could be temporary and manageable. Also, certain limited exceptions to the rules may apply, such as for investments more closely related to the business activities of the Canadian corporation, for internal reorganizations, and for certain loans that trigger an interest income in Canada. Nevertheless, these proposed rules have a far-reaching application and it remains to be seen how they will be interpreted and applied by the tax authorities. In the meantime, U.S.-controlled Canadian corporations should review the rules carefully every time they intend to make a direct or indirect investment in a foreign entity.

Conclusion

Despite the similarities otherwise existing between Canada and the United States, the Canadian tax system differs, at times significantly, from its U.S. counterpart. The above constitutes only a summary of certain of those differences. In this context, relying on U.S. tax instincts when planning a Canadian expansion may result in unintended adverse Canadian tax consequences that could have been easily avoided. Before entering the Canadian market, prudence would dictate obtaining Canadian tax advice.