Before environmental, social, and governance (ESG) matters became cultural and business movements, the lack of diversity and inclusion within corporate governance structures was noted but not scrutinized. Now, there at least ten pending shareholder derivative lawsuits alleging that a lack of board and management diversity constitutes a breach of fiduciary duty. Organizations that lack diversity in their corporate leadership are also subject to increased regulation and directives in state laws, investment bank requirements, and potential industry edicts. Despite substantial research establishing the social and economic benefits of diverse boards, changing the face of corporate governance remains difficult. This article will:
examine the issues presented by the suits, regulations, and mandates; and
provide simple (but not easy) steps companies can take to begin the diversification of corporate governance.
Board Diversity Lawsuits
The pending shareholder actions, most filed by the same group of firms and targeted at many companies identified in a recent Newsweek article that listed companies without a black director, generally assert that the defendants:
breached their fiduciary duties; and
violated Section 14(a) of the Securities Exchange Act;
by making false or misleading public statements regarding the company’s commitment to diversity even though their boards and management did not include racially diverse – specifically black – directors. To underscore this point, most of the complaints contain photographs of racially homogeneous current board members.
Though the well-established “Caremark” duties – outlined in In re Caremark International Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996) – are not expressly referenced in the complaints, they certainly influence the plaintiffs’ arguments that the boards breached their fiduciary duties when they:
failed to prevent violations of law by allowing discriminatory practices concerning governance;
did not make diverse board appointments; and
authorized false statements about diversity priorities to be made in proxy documents despite a lack of governance diversity.
To address these breaches, the aggrieved shareholders’ suits demand:
quantifiable plans to achieve board diversity and inclusion;
annual diversity reports on hiring, advancement, promotion and pay;
annual diversity and inclusion training;
funds (measured in the hundreds of millions) to hire and promote diversity throughout the corporation;
creation of open seats for new, and appropriately compensated, diverse directors; and
attorneys’ fees.
While the purpose of these suits is laudable, significant threshold legal questions exist. First, the suits typically allege “demand futility” to explain why underlying diversity concerns were not taken to the board as opposed to directly filing suit. Considering the focus on diversity issues in the new ESG environment, and the lack of any detail regarding board processes and deliberation, whether such requests were futile is a crucial issue to be resolved by the courts. Next, statements regarding legal or ESG compliance are not typically actionable. Finally, causation and damages will be high hurdles, since a direct relationship between board diversity/ESG failures and actual shareholder harm must be established. Plaintiffs currently allege that greater board diversity leads to greater profits, relying upon, among other things, a 2018 McKinsey & Company report noting that companies with more diverse boards were more likely to have higher profits. However, correlation is not legal causation, and it will be difficult to convince courts that studies like this justify ignoring the protection of the Business Judgment Rule.
Recognizing many of these defenses, the U.S. District Court for the Northern District of California dismissed a board diversity lawsuit against Facebook in a March 19, 2021 order. The Court found that plaintiffs in Ocegueda v. Zuckerberg, N.D. Cal., No. 3:20-cv-04444, did not plausibly plead demand futility or “a materially false statement” under Section 14(a).
That said, a legal victory may not be the goal. Faced with similar allegations from some of the same lawyers in the board diversity suits, Google’s parent recently settled its #MeToo derivative litigation by, among other things, creating a $310 million diversity, equity, and inclusion fund (operating over the next 10 years) to support global diversity and inclusion initiatives within Google, and supporting various ESG programs outside Google focused on the digital and technology industries. Ergo, the ultimate goal of the board diversity suits may be similar settlements and capitulations.
Regulatory, Industry, and Shareholder Engagement Efforts
While the lawsuits are the most recent effort to spur board diversity, they were preceded by federal and state regulatory efforts. The Securities and Exchange Commission (SEC) has issued compliance interpretations advising companies on how to disclose diversity characteristics they rely on when nominating board members. And in November 2019, the House of Representatives considered a bill requiring issuers of securities to disclose, among other things:
the racial, ethnic, and gender composition of their boards of directors and executive officers; and
any plans to promote such diversity.
California was the first state to require that public companies headquartered there have a minimum number of female directors in 2019 or face sanctions, with the minimum to be increased in 2021. In June 2020, New York began requiring companies to report how many of their directors are women. More recently, California has mandated that public companies headquartered in the state elect at least one director from an underrepresented community by December 2021, or face up to $300,000 in fines. For boards with between four and nine directors, two such directors must be in place by December 2022 and companies with more than nine directors must have three. Considering these regulations, it is no coincidence that the vast majority of board diversity suits were filed in California.
At the industry level, the NASDAQ exchange (on which many of the board diversity defendants are listed) filed a proposal with the SEC to adopt regulations that would require most listed companies to elect at least one female director and one director from an underrepresented minority or who identifies as LGBTQ+. If adopted, the tiered requirements would force noncompliant companies to disclose the reasons for any failure to meet this diversity mandate in the company’s annual meeting proxy statement or on its website. The SEC has solicited public comment on this proposal.
In the private sector, institutional investors such as BlackRock and Vanguard have encouraged companies to pursue ESG goals and disclose the racial diversity of their boards, using proxy votes to advance such efforts. Separately, Institutional Shareholder Services, many private and public companies, and some non-profit organizations have either encouraged companies to disclose their diversity efforts or have signed onto private challenges and pledges to increase the diversity on their boards.
Concrete Plans Can Decrease Director Risk
The business and social benefits of diversity are well established; and successful companies know that an organization’s diversity commitment cannot be rhetorical and may be measured by the number of their diverse board and management leaders.
As pending lawsuits and legislation use diversity statements to form the basis of liability and/or regulatory culpability, companies should ensure that their diversity proclamations are fully supported by their actions. Among other things, boards should:
Take the lead from public and private efforts and review – and (if necessary) reform – board composition to open or create seats for diverse directors.
When recruiting new board members, identify and prioritize salient diversity characteristics; if necessary, utilize a diversity-focused search consultant to ensure a diverse pool of candidates.
Develop a quantifiable plan on diversity issues by reviewing and augmenting governance guidelines, board committee efforts, and executive compensation criteria.
Create and promote diversity and inclusion goals and incorporate training at the board and management levels.
Require quarterly board reporting on diversity and inclusion programs to reveal trends and progress towards stated goals.
As companies express their commitment to board and C-Level diversity and other ESG efforts through public statements, investor engagement and shareholder proposals, recent litigation and regulatory trends should encourage companies to move beyond platitudes and, instead:
create and follow concrete plans with defined goals; and
meticulously measure their progress.
Want more? Participate in a live CLE webinar on this topic at the upcoming Business Law Virtual Spring Meeting! The program, “Diversifying Corporate Governance Institutions: Who Should Be At the Table?,” will be presented on April 23, 2021, at 12:15pm CT. Registration is completely free for Business Law Section members—sign up now!
New legislation went into effect in Brazil on January 23, 2021 that made improvements to its judicial reorganization and bankruptcy law. The amendments are known as Federal Law No. 14,112/2020 and modify Federal Law No. 11,101/2005. Federal Law No. 11,101/2005 introduced the recuperacão judicial (RJ) proceeding, which is designed to promote restructuring of insolvent businesses under court supervision. The introduction of RJ in 2005 was the last major insolvency in reform in Brazil until this year.
Chapter 11 is a source of inspiration for RJ. Yet Brazilian courts and parties in interest have still struggled with areas of uncertainty and inefficiency in RJ’s implementation over the last 16 years.
From a creditors’ perspective, RJ did not give them the ability to wipe out equity or propose a plan even if the debtors’ proposal was unworkable. The only right creditors seemed to have was attempting to force a liquidation. Also, insufficient guidance in RJ on substantive consolidation created unpredictability in credit decisions, the ability to vote on plans, and protecting entity-specific claims.
RJ posed challenges for debtors who lacked financing options to fund their reorganization efforts or the ability to sell assets free and clear in order to generate cash. Debtors also did not have the ability to file an insolvency proceeding in another jurisdiction and have it recognized in Brazil.
The COVID-19 pandemic revived dormant legislation to improve RJ, as the Brazilian government considered measures to alleviate the disease’s severe public health and economic impacts. The amendments in Federal Law No. 14,112/2020 were signed into law on Christmas Eve 2020 (with some presidential vetoes). The new law attempts to remedy the previous ambiguities and has the potential to improve outcomes for creditors and debtors. The changes to the RJ statute include, among other things:
(1) empowering creditors to file a plan of reorganization,
(2) regulating procedural and substantive consolidation,
(3) enabling debtors to obtain debtor-in-possession financing,
(4) permitting the sale of assets free and clear, and
Under the 2005 RJ law, only debtors had the ability to propose a plan of reorganization, and they were not bound by any firm deadline for submitting such a plan. Debtors also had the ability to indefinitely suspend the formal meeting of creditors, where votes are taken to approve plans. The 2021 RJ law requires debtors to file a plan within 180 days, subject to only one 180-day extension; debtors cannot suspend the creditors’ meeting for a period longer than 90 days.
The new law allows creditors to propose plans if certain conditions are met. If the debtor’s plan is rejected at the creditors’ meeting, and a majority of the creditors in attendance support the concept of submission of a creditors’ plan, creditors will have 30 days to file one. If such a plan has sufficient creditor support, it will go to a vote at a new creditors’ meeting. The law also gives creditors the ability to attend the meetings remotely by electronic means. The right to file a plan, however, does not make creditors all-powerful, because shareholders cannot be forced to capitalize the company or remain if their shares are diluted, and individual guarantors must be released.
Consolidation of debtors and their assets and liabilities will now be governed by the RJ statute. As an administrative matter, debtors may obtain procedural consolidation so that members of the same corporate group can proceed in a joint case. A court may also impose substantive consolidation of assets and liabilities, but the court must find that there was interconnection and commingling according to statutory standards rather than on an ad hoc basis.
The 2021 updates may facilitate additional liquidity for business operations in the RJ process. Debtors will now have the right to seek debtor-in-possession financing in a way that may be more appealing for lenders. Such loans will be junior only to certain administrative expenses, labor claims incurred only three months before liquidation, and holders of security interests. However, priming liens are not available without consent of the senior parties. Anyone, even shareholders and prepetition creditors, may be approved by the court to make postpetition loans. If loan disbursements have been made, the lender will maintain priority even if the approval is reversed on appeal.
The new law allows assets to be sold free and clear. One way debtors can accomplish this is by selling shares in new entities known as “isolated business units” in which any kind of assets may be deposited, including the business as a going concern. In such sales, creditors who would otherwise be unaffected by the RJ proceeding must remain entitled to payment on conditions no worse than they would have in a liquidation. Yet a presidential veto created an important limitation on these sales that affects the debtor’s ability to generate proceeds quickly: unlike sales under Section 363 of the Bankruptcy Code, RJ sales may only be conducted if approved in connection with a confirmed plan, which could add months to the process.
Under the 2021 RJ law revisions, insolvency proceedings in other countries can now be recognized by Brazilian courts, so that assets in Brazil can be protected from creditors without requiring the enterprise to go through RJ. The amendments incorporate the provisions for cross-border cooperation of the UNCITRAL Model Law. Debtors may now do the equivalent of a Chapter 15 in Brazil while pursuing Chapter 11 in the United States (if venue is available) for their overall restructuring.
The timing of these amendments is opportune in light of the harsh impacts of the pandemic on Brazil. Over a quarter-million Brazilian lives have been lost, and our sympathies are with Brazil’s citizens. Enlightened and science-based governmental action can improve outcomes, in health and economics. We hope that the revised RJ will allow Brazilian enterprises and their investors to dar um jeito (find a way) in these difficult circumstances.
Whether accidental or due to a deliberate penetration of information systems, data breaches – while not solely a 21st-century phenomenon – are an increasingly sophisticated headache for global corporate entities. As personal information and corporate data have become commoditized, the legal, gray and black markets for information have seen the exponential rise of an industry whose primary function is reactive data breach management, remediation and mitigation. After a data breach, an organization’s primary objectives are complying with the regulatory obligation to notify potentially impacted individuals while limiting its financial exposure. This requires the review of many thousands – sometimes millions – of documents. For many companies, the data remediation action ends when all required notifications are sent. This complacency can have grave consequences; there are other significant post-data breach business risks that should be evaluated. It is in a company’s best interest to utilize its expert resources to help mitigate those risks in parallel with fulfilling the legal requirements of remediation and notification.
To understand the business risks of a data breach beyond the costs of conducting remediation, companies need to be aware of the current corporate cybercrime landscape. In August 2020, INTERPOL assessed the impact COVID-19 has had on cybercrime incidents, noting that they were seeing a dramatic shift away from attacks on individuals and a significant increase in attacks on larger enterprises. In a related press release, INTERPOL noted that, “With organizations and businesses rapidly deploying remote systems and networks to support staff working from home, criminals are . . . taking advantage of increased security vulnerabilities to steal data, generate profits and cause disruption.”[1] Sophisticated criminals and criminal organizations are masters at identifying changing cultural, political and market conditions to capitalize on opportunities that maximize illicit financial gains. The pandemic has led to a wave of uncertainty and anxiety that spans the hierarchies of corporate organizations. The resulting instability of global economic conditions, along with already troubling sociopolitical volatility, has left institutions less prepared than ever to contend with the sudden onslaught of online assaults by highly skilled hackers who are often one step ahead of even the most protective IT security programs.
The fact that data breach risks are always looming, regardless of threat level, is nothing new. Corporations that have faced one before are well-aware of the potentially enormous cost of remediation. Data privacy attorneys are particularly well-acquainted with what a data breach means for their clients and the existence of aggressive regulations from multiple jurisdictions that dictate the manner and time frame for notifying individuals whose personally identifiable information (PII) has been compromised. Regulatory bodies are often inflexible, and the speed at which corporations must fully implement a remediation and notification plan is often faster than one might consider reasonable. Once a breach is identified, companies are in triage mode to protect their reputation and mitigate their financial exposure while simultaneously isolating the impacted servers to mitigate the damage from an attack, boosting their cyber resiliency to help prevent further attacks and implementing a data breach remediation review to send the required notifications to individuals.
However, the lost confidence and financial harm stem from more than the theft of PII. Companies understand that it is their proprietary, confidential data that makes what they sell valuable. This information would be exceptionally valuable to competitors and, if stolen, could be made public to embarrass or sold for profit. According to a 2020 IBM study, it takes an average of 200 days before a company realizes a cyberattack has occurred, by which time it can be nearly impossible to recover from the loss of corporate secrets. Exposed competitive information like pricing or fees negotiated with other companies, marketing plans and product development documents are just a sample of the types of information that could be floating around cyberspace for months unbeknownst to a company. Furthermore, private internal or external email or chat conversations could be the source of embarrassment – or even regulatory interest – if made public.
Separate from internal information, confidential data belonging to other entities like vendors, partners, customers, etc. helps keep companies profitable and running smoothly. Protecting these relationships is critical, and they can be easily damaged if a company has put another company’s information at risk. Identifying breached sensitive business data as soon as an intrusion is spotted is a first step toward preventing an irretrievable breakdown of business relationships. With certain exceptions – like law firms – regulations do not necessarily demand that a company do anything to mitigate the risks that may come from the loss of another company’s information. However, statutory obligations are not the only considerations. Commercial relationships are almost invariably governed by contracts between parties which often contain data security requirements, call for cyber insurance and – if written appropriately – have strong indemnification language. With this heightened exposure, it is incumbent on companies to be proactive in identifying compromised business data and notifying their owners.
If a company is prepared with a comprehensive data breach review plan that accomplishes the identification of PII for remediation and notification, as well as identifying internal company-owned data and third-party business-owned data, it will be in a much better position to limit financial exposure, reputational harm and loss of critical relationships. To do this most effectively and efficiently, it is important to have a data remediation review team with members who are not only skilled at thoroughly identifying PII of all types as well as the contact information of impacted individuals for legally required notifications, but also have significant experience identifying critical business data and categorizing it in reports so that internal departments and outside companies can be notified with specificity about data that has been potentially compromised. The tight timelines for completing PII remediation and notification do not mean business data should be sidelined. Data remediation review teams are able to review documents for both PII and business information simultaneously if they have the training and experience to know what to identify. A single review with this dual purpose allows companies to accomplish what might otherwise be overlooked or delayed with minimal additional time and cost.
[1] “INTERPOL report shows alarming rate of cyberattacks during COVID-19,” August 4, 2020, available at: https://www.interpol.int/en/News-and-Events/News/2020/INTERPOL-report-shows-alarming-rate-of-cyberattacks-during-COVID-19
Zooming is to videoconferencing as Kleenex is to tissues and Google is to search. Everyone does it, but very few enjoy it. Now there is a phrase for that feeling. “Zoom fatigue” has entered colloquial language as shorthand for that sense of emotional overload, tiredness, depression, and burnout that comes over us after the fifth hour in front of a screen filled with small squares containing our colleagues’ faces.
In the beginning of the coronavirus lockdown, online connection tools seemed like the perfect antidote to people’s isolation. Send everyone home to work, give them tools to stay connected to the office and each other, and worklife will continue as always. And, on the whole, it has succeeded. We use videoconferencing for all kinds of connections: from office meetings to family get-togethers, team meetings to scavenger hunts, business networking to first dates.
In a study by Robert Half, “[T]hree-quarters of professionals surveyed say they participate in virtual meetings . . . spending nearly one-third of their workday on camera.”[1] Thirty-eight percent say they have experienced zoom fatigue.[2] That may explain why only 20 percent of poll respondents said, “They are actively listening and providing feedback” during video calls.[3] In this article I will examine zooming fatigue and offer some solutions.
Nonverbal Communication
Ninety-three percent of communication is nonverbal: 55 percent is visual, 38 percent is vocal (tone of voice), and 7 percent is the words themselves. This is how our ancestors communicated in the savannah eons ago, before language, when those in the back of the line took their cues from the body language of those ahead of them.
Humans are puny animals. We couldn’t run fast enough, bite hard enough, or fight well enough to survive alone. But we can cooperate. We are group animals. We thrive through communication, collaboration, and teamwork.
Our brains have not evolved as quickly as our phones. They still prefer the savannah. They still work to keep us safe. In meetings, they simultaneously take in everyone’s voluntary and involuntary body signals and decode them for us. These understandings help us to decipher who is in charge, who is paying attention, who is multitasking, and who has tuned out.
Remember In-Person Meetings?
We remember the spontaneity, warmth, friendship, and collegiality of in-person meetings. We remember walking from our desk to another room, encountering colleagues along the way. We remember looking for our best friend so we could sit together and compare notes during the meeting.
Subconsciously, we notice the nonverbal cues that set the tone and rhythm of a meeting. We pay attention to people’s posture, face and eye movements, gestures, and micro-expressions. These tell us what is really going on. We respond to cues as to when to pay attention, when to speak, and when to relax.
We also rarely sit still. We talk to those around us, share glances while others are talking, fidget, take notes, doodle, stand up to get coffee or stretch. Some of us multitask. Most of the time nobody else focuses on what any one participant is doing.
Nonverbal Communication in Videoconferences
“On Zoom, nonverbal behavior remains complex, but users need to work harder to send and receive signals.”[4] We need to consciously manage our own body language and at the same time decode others’ body language cues.
“During an in-person conversation, the brain focuses partly on the words being spoken, but it also derives additional meaning from dozens of non-verbal cues. . . . Since humans evolved as social animals, perceiving these cues comes naturally to most of us. . . . However, a typical video call impairs these ingrained abilities, and requires sustained and intense attention to words instead.”[5]
Online, our inability to correctly read subtle facial cues also hampers our ability to mirror others. Mirroring is a connecting gesture that happens in conversations when we unconsciously copy the positions and gestures of others. The most frequent mirroring occurs whenever you spontaneously smile in response to someone else’s smile.
If we can’t mirror, it is difficult to genuinely relate to others. “To recognize emotion, we have to actually embody it, which makes mirroring essential to empathy and connections. When we can’t do it seamlessly as happens during a video chat, we feel unsettled because it’s hard to read people’s reactions, and thus predict what they will do.”[6]
Sources of Zooming Fatigue
Online we sit in one position for long periods of time, face the camera, and center ourselves in a small onscreen square. We feel like we are onstage, and so we perform. We exaggerate our gestures such as nodding, smiling, and laughing. We speak louder when called on. We try to ignore technological glitches that make it even harder to concentrate on content. The result is psychological overload─zoom fatigue. Let’s look in more detail at some of the most common sources of negative psychological impact.
Physical Space
The multiplicity of backgrounds on the screen causes brain confusion and psychic strain. In person, our brains always survey each meeting venue first to be sure it is a safe space for us. In online meetings, the multitude of “rooms” creates overload as the brain tries to check out each one.
Backgrounds are important. They say something about you. If you have the luxury of a separate office with a door that closes, it is fairly easy to create a nice professional background. If you are zooming from the dining room table shared with two home schoolers and dinner dishes, it is harder to carve out a professional space. When your work role and home background are not in synch, it distresses our brains.
Often, people in shared space use digital backgrounds to separate their online view from their true surroundings. All is well and good until a quick head toss or wide arm gesture morphs your body into the background. Others invest in a room divider type of screen to split off their “office” space.
Regardless of how we show our space, strangers’ eyes are invading our privacy, judging our knickknacks, searching for personal photos, and appraising the price of your abode. This privacy invasion is very disconcerting for your brain.
Personal Space
In person, we adjust the space between ourselves and others according to the degree of intimacy involved. Online, colleagues and strangers are within one or two feet of your face because your viewing screen is part of your desktop computer or phone, and you want to be able to use the keyboard.
“On Zoom, behavior ordinarily reserved for close relationships—such as long stretches of direct eye gaze and faces seen close up has suddenly become the way we interact with casual acquaintances, coworkers and even strangers.”[7]
This creates an oxymoron: People are too close physically, and at the same time they are too far away in small two-dimensional spaces. Faces appear unusually large. The too close proximity fires up the brain’s “fight-or-flight” response.
Missing Boundaries
Love it or not, commuting created physical boundary lines between work and home. Remote working removed physical boundaries. Now tasks seem to slide into each other.
In addition, you eat, help with homework, stream on social media, and work all from the same room. Doing a multitude of activities while in the same physical space confuses our brain because it is accustomed to associating specific spaces with specific activities.
Attending online meetings from your regular workspace encourages you to multitask. Because you email, text, shop, and play from your work screen, there is always the temptation to do two other activities at once.
Glitches
Rarely does zooming occur without some kind of technology glitch: transmission delays, out-of-synch audio, blurring, jiggling, or muting issues.
“These disruptions, some below our conscious awareness, confound our conscious awareness, confound perception and scramble subtle social cues. Our brains strain to fill in the gaps and make sense of the disorder, which makes us feel vaguely disturbed, uneasy and tired without quite knowing why.”[8]
Out-of-synch audio makes it almost impossible to follow the speaker’s logic. The brain often reads this discrepancy as a reason to attach negative adjectives to the speaker’s presentation.
“You’re muted” is only one of the many glitches that impairs conversational flow. Unless participants are recognized by name, conversation tends to fall on one of two extremes: either total silence as everyone waits for someone to go first or cacophony as everyone speaks at once.
Online Meeting Conversations
The absence of visible body parts limits the number of cues the brain has to work with. In person, full-body language cues set the sequence and tempo of conversations. Online, such cues become less clear for a variety of reasons.
In person, eye contact sets the pace of conversation. Online eye contact is artificial. In order to appear to be looking at others on the video screen, a speaker needs to look directly at the camera, cutting off any connection to the audience.
Glances, meaningful in person, are meaningless online. For example, in person, sideway glances can reveal opinions and relationships. Online, glances may have nothing to do with the conversation. The glance may be to someone who has walked through the person’s “office” space or to answer a child’s question.
Even if someone seems to be glancing at someone else in the meeting, it is never clear to others who the recipient is because the tiles are sequenced differently on each screen.
Psychologically, not being able to see directly into peoples’ eyes can inhibit trust. When people seem to be looking elsewhere, we think they are being evasive, and so we assign negative traits to them such as shifty, disinterested, or lazy.
Our sense of dislocation increases when we allow our visual image to show on screen. We are not used to seeing ourselves when we attend meetings or when we speak, so we constantly examine ourselves for flaws. This can make us self-conscious, increasing self-doubt and self-criticism and sometimes leading to deep despair.
In person, your gaze moves around, touching on the speaker, other participants, the view outside, and so forth. Online, often the only visual is a sea of small boxes showcasing big heads. Because it is the only visual, attendees keep looking at them. To others this feels like staring. Staring means we are looking directly at other faces, directly at others’ eyes. Our brains read this as danger and go into” fight-or-flight” mode, which creates stress.
Clearly, it takes much more psychic attention and physical energy for attendees to make sense of what they see in videoconferences. The psychological burden has serious consequences for productivity, collaboration, and self-esteem. Can we ameliorate the negative aspects of online activities?
Suggested Fixes
To make the gallery screen view less fatiguing and stressful:
When using gallery view where all participants appear, shrink the image down by exiting full screen.
Use speaker view instead of gallery view so that most of the screen shows only one person.
Rest your eyes for a few seconds by minimizing the video window or just looking away.
Set a meeting rule that only the speaker needs to be visible, as is typically the norm for webinars.
To avoid looking at yourself:
Turn off your self-view camera while your video is on. This way you don’t see yourself while the other meeting participants continue to see you.
Use the “improve my appearance” option to smooth face wrinkles. Think Doris Day’s requirement that Vaseline be smeared on camera lenses to make her look younger.
Turn your camera off when you are not speaking.
Use your cursor to drag your tile to the bottom of the screen where it is less visible.
While these fixes are useful for individuals, cumulatively they may make the meeting less successful. Meeting leaders are told to ask participants to be visible because having too many invisible people dampens the vitality of a meeting. Also, most participants assume that when someone turns off their video, it is because they are going to do something else─bathroom break, coffee refill, family interruption.
To improve online meeting conversations, the leader can take a variety of actions.
Ahead of the meeting, set the expectation that participants should not multitask.
Make sure everyone knows how you plan to run the meeting, especially how you plan to encourage conversation flow.
Encourage collegiality by beginning meetings with small talk while participants sign on.
Mute everyone who is not speaking to reduce the impact of random noises.
Make sure that everyone participates because, online, silence can lead to invisibility.
If closed captioning is available, suggest participants use it to follow multiperson conversations more easily.
Also take into consideration the fragility of remote relationships, and pay attention to conversation content. A personal reference that would be ignored or laughed off in person may hurt someone’s feelings if expressed online. Train your team to listen more than they speak and to think before they respond.
Change the Focus
In the end, probably the most effective way to eliminate zoom fatigue is to hold fewer video meetings. When deciding which meeting format to use, think about the purpose of the meeting. Can you get the same result using email or working on a shared document or with a telephone call?
If you do decide it should be a video meeting, can you shorten the time frame and keep participants engaged by using polling, breakout rooms and informal chat activities? As the meeting leader, can you check out the technology before every meeting to minimize the potential for glitches?
Make sure that everyone knows how to operate the technology. Explain how you want them to use the chat feature, Q&A, or the raised-hand symbol during the meeting. Exploiting the potential of these features creates a safer environment for more natural interaction.
Can you create a structured meeting with an explicit agenda focused on participant decisions that move the meeting forward? When there is a reason for engagement and a real role for participants, there tends to be more personal involvement and collaboration.
Or, alternatively, can you schedule optional, unstructured meetings where participants move as they wish between tables in a cafeteria-style room or go in and out of breakout room conversations? By more closely re-creating “watercooler” informality and spontaneity, these meetings often lead to interesting creative conversations, encourage team bonding, and raise individuals’ spirits.
Finally, can you shorten the meeting? While a two-hour, in-person meeting may not seem tedious, its online equivalent does, due to all the zoom fatigue factors we’ve discussed.
Concluding Thoughts
It is important to acknowledge the reality that zoom fatigue exists and that it is caused in large part by your brain’s inability to function online as naturally as it does in person. Knowing this, try to create a context for meeting members that makes it less stressful for them to stay present and participate. Use your software’s bells and whistles to make meetings less visually traumatic. Reduce the number of participants. Make the content important by using clear meeting guidelines and explicit agendas. Cut down the number of visual meetings per day. Use email or telephone whenever you can.
[1] Quoted in HRE’s Number of the Day: Video Meeting Fatigue, https://hrexecutive.com/hres-number-of-the-day-video-meeting-fatigue.
[3] R. Dallon Adams, Zoom Fatigue by the Numbers: A New Poll Looks at Video Conferencing Engagement, https:// www.techrepublic.com/article/zoom-fatigue-by-the-numbers-a-new-poll-looks-at-video-conferencing-engagement.
[4] Jeremy N. Bailenson, Nonverbal Overload: A Theoretical Argument for the Causes of Zoom Fatigue, Technology, Mind and Behavior, 2, issue 1 (Feb. 23, 2021).
[5] Julia Sklar, Zoom Fatigue Is Taxing the Brain. Here’s Why It Happens, https://www.nationalgeographic.com/science/article/coronavirus-zoom-fatigue-is-taxing-the-brain-here-is-why-that-happens (Apr. 24, 2020).
[6] Kate Murphy, Why Zoom Is Terrible, The New York Times (May 4, 2020).
For states, businesses, and other stakeholders to effectively develop a framework for the relationship between business activities and human rights, it is helpful and necessary to step back and consider the impacts of common day-to-day business activities on universally recognized fundamental human rights.[1] While a great deal of attention is rightly focused on instances where business activities adversely impact human rights (e.g., contamination of drinking water supplies, displacement of communities in the wake of new development projects, and failure to pay wages sufficient to support a dignified standard of living), businesses also pay taxes to support local services and contribute to economic development by providing jobs and underwriting the development of their workers’ skills. Impacts vary depending on the specific context and factors such as the type of industry and the state of economic and social development in the areas where the business is operating. The traditional role of business and of societal and political expectations also varies from country to country and within national borders.
More and more businesses, sensitive to the criticisms of corporate social responsibility (CSR) as being little more than a self-serving marketing activity, are taking a hard look at their activities through a human rights lens. For this reason, human rights have become a top priority within the business community, based on surveys conducted by the United Nations (UN), the International Chamber of Commerce, the Economist Intelligence Unit, and the UN Global Compact. Interest has been driven by the recognition that human rights (1) touch on every aspect of a company’s operations, (2) are universal and easier for everyone to understand as opposed to CSR, and (3) are the essence of sustainability. Moreover, the evolution and maturation of the global human rights law framework provide businesses with clarity regarding the steps to be taken to fulfill their human rights duties.[2] All of this means that sensitivity to the interaction between business and human rights can be enhanced by focusing on specific rights, such as the following:[3]
Right to an adequate standard of living: Businesses contribute to providing members of society with an adequate standard of living by creating job opportunities that allow them to afford decent housing and food. However, when businesses push forward with projects that displace communities without consultation and compensation, they endanger the livelihoods of the members of those communities.
Right to just and favorable working conditions: Businesses can provide just and favorable working conditions by following strong health and safety standards, but they can also cause harm to their workers by failing to provide sufficient breaks during working hours or exposing workers to toxic substances that are dangerous to their health.
Right to water and sanitation: Businesses can work with governmental authorities to improve the water and sanitation infrastructure in a community, but they may also contribute to water scarcity for domestic and farming uses by using large amounts of water for their business operations or discharging pollutants into the local water supply.
Right to education: Businesses pay taxes and licensing and permitting fees that governments use to support education in the communities in which the businesses are operating. However, the failure of businesses to respect restrictions on child labor will prevent children from enjoying their right to education.
Right to access to information: Businesses can publish data on their environmental and social performance in languages and formats that make the information readily available to stakeholders. However, in many cases, governments and businesses do not make the results of environmental impact assessments publicly available and fail to carry out adequate engagement and consultation prior to launching a new project that will have an adverse human rights impact.
Right to nondiscrimination: Businesses fulfill their duties with respect to rights to nondiscrimination by implementing and following employment-related practices (e.g., hiring, promotion, and benefits) that do not discriminate on unlawful grounds, but they often engage in discriminatory practices that violate the rights of women (e.g., failing to provide equal pay to men and women for the same work or not allowing women to return to the same position following maternity leave) or of persons with disabilities.
Another method for connecting business activities to human rights impacts is to sort by reference to common business functions:[4]
Human Resources: The human resources function must regularly address the impact of decisions relating to workers on their rights to be free of discrimination and on the rights of protected groups such as women and disabled persons. Key questions that need to be asked include whether female and male personnel are hired, paid, and promoted based solely on their relevant competencies for the job; whether women and men are paid the same wage for the same work; and how sexual harassment in the workplace is handled.
Health and Safety: The health and safety function involves duties to protect workers’ rights to just and favorable conditions of work and health and safety. Therefore, attention needs to be paid to assessing whether the workplace is safe and to protecting the mental and physical health of workers.
Procurement: The procurement function is responsible for monitoring suppliers to ensure that they respect the rights of their workers to form and join a trade union and to bargain collectively and to assure that suppliers do not engage in actions that violate the rights of children or prohibitions against slavery. Businesses must impose appropriate labor standards on their suppliers as a condition of the business relationship and engage in due diligence to monitor compliance with those standards.
Product Safety: Businesses have an obligation to protect the rights of the customers and end users to health and privacy with respect both to the products and services that the company sells and the processes that it uses in connection with related activities such as marketing. Attention should be paid to products that raise safety issues and/or that might create health hazards, as well as to the collection and use of sensitive personal information of customers and end users.
Businesses can also orient their stakeholder relationships and engagement to the core human rights issues that are most relevant to the members of each stakeholder group. For example, relationships with workers should conform to their human rights to freedom of association, health, an adequate standard of living, and just and favorable conditions of work, and their rights not to be subjected to slavery or forced labor. Relationships with consumers and end users should be guided by respect for their human rights to health, privacy, and personal security. Members of the communities in which a business operates are entitled to respect for their rights to health, water and sanitation, life and health, and an adequate standard of living and, in addition, to not be resettled or otherwise have their access to land and natural resources adversely impacted by businesses without free, prior, and informed consent.[5] Obviously, businesses need to order their activities in ways that do not infringe on the aforementioned rights of community members, such as by knowingly polluting drinking water or emitting toxic chemicals. However, companies can also have a positive human rights impact by creating and supporting programs to provide adequate food and clothing to individuals and groups within the community and promote local cultural life. When identifying and defining stakeholder groups, businesses should take into account particular groups or populations that have been afforded special protection in human rights instruments, including women, children, migrant workers, persons with disabilities, indigenous peoples, and members of certain types of minority groups (i.e., national or ethnic, religious, and linguistic).
While the discussion above focuses primarily on the direct impact of a business’s activities on human rights through its own operations, the wave of globalization that has occurred over the last several decades has led to calls to expand the human rights duties of businesses to include adverse human rights impacts resulting from their involvement in business relationships with other parties.[6] For example, the UN Guiding Principles expect business enterprises to carry out human rights due diligence that covers not only adverse human rights impacts that the business enterprise may cause or contribute to through its own activities, but also impacts that may be directly linked to its operations, products, or services by its business relationships. Traditionally, human rights due diligence in the supply chain has focused on working conditions and labor rights, often in response to news of unhealthy and unsafe conditions in supplier facilities that resulted in tragic outcomes for workers. However, the trend is to expand the scope of the inquiries to include human rights risks and impacts in other areas such as pollution and other environmental damage caused by the actions and corrupt activities (like bribery) of suppliers and contractors in the countries in which they operate that ultimately interfere with the human rights of the people in those countries.[7]
This article is an excerpt from the author’s new book, Business and Human Rights: Advising Clients on Respecting and Fulfilling Human Rights, published by the ABA Section of Business Law. More information on the book is available here.
[1] Alan S. Gutterman is a business counselor and prolific author of practical guidance and tools for legal and financial professionals, managers, entrepreneurs, and investors on topics including sustainable entrepreneurship, leadership and management, business law and transactions, international law, and business and technology management. He is the co-editor and contributing author of several books published by the ABA Business Law Section, including The Lawyer’s Corporate Social Responsibility Deskbook (2019), Emerging Companies Guide (3rd Edition) (2020), and Business and Human Rights: A Practitioner’s Guide for Legal Professionals (2020). More information about Alan and his work is available at his personal website at www.alangutterman.com.
[3] Business and Human Rights: A Guidebook for National Human Rights Institutions (November 2013), 8. The website of the Office of the UN High Commissioner for Human Rights includes a comprehensive list of human rights issues (https://www.ohchr.org/EN/Issues/Pages/ListOfIssues.aspx) that businesses should consult for guidance in identifying and prioritizing the issues most relevant to their specific situation. Other useful resources are the annual lists of the top ten key issues that are of particular importance in the arena of business and human rights that are published by the Institute for Human Rights and Business (https://www.ihrb.org/).
[4] Doing Business with Respect for Human Rights: A Guidance Tool for Companies (2016), 21.
[6] The OECD Guidelines for Multinational Enterprises defines the term business relationships to include relationships with business partners, entities in the supply chain, and any other nonstate or state entities directly linked to its business operations, products, or services.
[7] When developing processes for addressing human rights impacts in their supply chains, businesses can tap into a wide range of resources that have been developed as part of sector-specific standards initiatives and by organizations such as the UN Global Compact. See https://www.unglobalcompact.org/what-is-gc/our-work/supply-chain. The UN Global Compact aligns sustainable supply chain management to several of the UN Sustainable Development Goals, including decent work and economic growth, responsible production, and consumption and climate action.
Disputes in court involving representations and warranties insurance (RWI) claims are rare because many claims are resolved before a formal dispute and many policies contain arbitration provisions. Thus, a New York state court’s recent denial of a motion to dismiss in a case involving coverage under an RWI policy is especially notable.
The case arose out of Novolex Holding’s $2.275 billion acquisition of The Waddington Group (TWG), a manufacturer of food packaging and disposable products, pursuant to an Equity Purchase Agreement (EPA). Following the transaction, Novolex alleged that various representations in the EPA had been breached. The breaches related to the overarching allegation that TWG knew that its third-largest customer, Costco, intended to significantly reduce its business with TWG. Novolex claimed damages of about $267 million.
Illinois Union Insurance Company insured an excess layer of Novolex’s tower of representations and warranties insurance. It denied coverage, and Novolex sued. Illinois Union then moved to dismiss portions of the lawsuit that alleged TWG had breached Section 3.18 of the EPA. The relevant part of that representation stated that:
Since December 31, 2017, there has not been any written notice or, to the Knowledge of Parent, any oral notice, from any such Material Relationship that such Material Relationship has terminated, canceled or adversely and materially modified or intends to terminate, cancel or adversely and materially modify any Contract between a Purchased Company and any such Material Relationship.
In short, Illinois Union argued in its motion to dismiss that Novolex failed to allege that any “Contract” had been or was intended to be terminated, canceled, or adversely modified, and thus there was no breach of Section 3.18. Illinois Union reasoned that none of the written agreements between TWG and Costco imposed a legally binding commitment on Costco to make purchases from TWG in the future. Thus, according to Illinois Union, Costco’s intention to reduce its purchases in the future was not a termination or modification of any existing “Contract.”
The court rejected Illinois Union’s arguments for two reasons. First, the court found that so-called promotional agreements, which Novolex had described as a type of purchase order and which involved the sale of products prior to the holidays, qualified as “Contracts” encompassed within Section 3.18. While the Court found those promotional agreements qualified as a “Contract,” it did not explain why it did not make a similar finding for another type of purchase order called replenishment contracts. Novolex had also relied on those replenishment contracts in opposing the motion to dismiss.
Second, the court found that Section 3.18 could be read to include a representation that TWG had no knowledge that any material relationship would be terminated, canceled, or adversely modified, regardless of whether any “Contract” would be affected. Focusing on the use of the word “or,” the court explained that it was “possible” that the “or is first as to relationships and secondly as to contracts.” Interestingly, Novolex had not expressly raised that argument in the motion to dismiss briefing.
These findings highlight the potential for uncertainty in asking courts to resolve disputes over claims under RWI policies. The disagreements can involve dense corporate agreements with ambiguous, wordy provisions ripe for creating disputes between contracting parties and insurers. Adding another third party (the court) to the mix to resolve those differences may even result in previously unconsidered interpretations. The court, of course, is not limited to the contentions made by the parties in their motions and responses.
In the Novolex decision, the court reached two conclusions that the contracting parties may not have anticipated. First, it might have considered promotional agreements as being encompassed within representations in the purchase agreement that did not also encompass other types of purchase orders like replenishment contracts. (The court’s statements in its oral ruling do not reveal whether it in fact reached that conclusion.) Second, it interpreted a representation in the purchase agreement in a manner not expressly advanced by either contracting party during briefing.
In any event, the uncertainties that this decision highlight may explain, at least in part, why RWI claims are subject to more negotiation than more run-of-the-mill insurance claims. And it might help explain why RWI policies frequently contain arbitration clauses, which can lead to subject-matter experts resolving disputes rather than more generalized judges resolving disputes in court. The Novolex case now continues and, as one of the rare lawsuits involving RWI, is one to keep an eye on.
A year ago, many predicted that the COVID-19 stay-at-home orders and social distancing guidelines – and their impact on the economy – would result in a deluge of bankruptcy filings that could rival the Great Recession of 2008-2009. However, as we approach the one-year anniversary of former President Trump declaring the SARS-CoV-2 novel coronavirus a national emergency, that prediction has not come to pass.
In fact, overall bankruptcy filings dropped by more than a quarter last year compared to 2019. But looking behind that figure, Chapter 11 business bankruptcies climbed 35% year over year and for corporations with more than $50 million in assets, the number rose by 194%. The majority of these new filings were from the retail industry and other businesses that suffered from the precipitous drop in consumer foot traffic and spending. The end of government-sponsored loans, rent forbearance, and similar stimulus packages may place additional stress on balance sheets and increase these numbers in 2021.
As directors and officers evaluate the ongoing financial uncertainty arising from COVID-19 and consider seeking bankruptcy protection, they might assume that they will be adequately protected by the directors’ and officers’ liability insurance put in place to protect them from situations in which the company is unable to meet its indemnification and advancement obligations.
While insurance can provide peace of mind to executives should an insolvency-related lawsuit or investigation arise, directors and officers are often surprised to learn about exclusions, conditions, or other provisions in the company’s D&O policies that insurers may rely upon to significantly limit or even outright deny coverage. In addition to disputes with insurers, executives may also face opposition from bankruptcy trustees, creditors’ committees, or third parties seeking to limit insurance payments to preserve policy proceeds to pay claims, such as for possible breach of fiduciary duties.
While the goal of protecting executives through D&O insurance is simple, the policies themselves are complex documents with multi-faceted coverages that can be heavily modified by endorsement or even manuscripted to address particular exposures within an industry or business segment.
This article highlights 10 common insolvency-related topics for a company and its directors and officers to consider before, during, and after bankruptcy to minimize risk of uncovered losses and to maximize recovery under different types of D&O policies implicated during bankruptcy.
1. Mitigate Risk with D&O Insurance Before Bankruptcy
Robust D&O insurance programs protecting both the entity and its current and former officers and directors should be part of a company’s regular risk mitigation strategy well before any potential insolvency proceedings. Prior to any bankruptcy, however, the company should ensure that the policies it purchases will afford “runoff” coverage (also referred to as “tail” coverage or “extended reporting periods”) once the policies expire or a “change in control” (discussed below) occurs during bankruptcy.
Tail or runoff coverage is an extension of the D&O policy that allows insureds to continue reporting claims to the insurer after the policy expires or terminates. If a company sells its assets, is acquired, or otherwise undergoes a change in ownership, tail coverage protects former directors and officers, usually for a period of a year or more, for future claims alleging conduct by the directors and officers that occurred prior to the time the policy expired.
Many D&O policies provide automatic runoff at policy termination, subject to payment of additional premium or satisfying other conditions; but companies also can often negotiate new or different runoff coverage terms in advance of any planned bankruptcy.
In addition to ensuring adequate runoff coverage, executives should also consider a number of other policies to protect their interests in the event that the company’s D&O policy falls short. This includes purchasing policies to indemnify the individual directors and officers in circumstances:
where the company refuses or is unable to indemnify executives due to insolvency (often referred to as “Side‑A only” coverage);
where the company’s primary or excess policies do not respond to a particular loss, leaving individual insureds personally exposed (“difference-in-conditions” insurance);
where executives are retained by a debtor to assist with the remaining operation, liquidation, or winding down of the debtor’s business (“winding down” coverage); or
where independent directors sitting on public, private, or non-profit company boards may benefit from specialty umbrella coverages tailored to protect personal assets.
While D&O insurance issues can be addressed immediately preceding, or even during, insolvency proceedings, the best time to consider all of the above coverages and how they work together to best protect the company and its directors and officers is on a “clear day.” There are better opportunities to tailor favorable coverage at policy placement or renewal when there may be fewer financial constraints in devoting resources to more fulsome insurance protections, and the company’s and executives’ interests are more likely to be aligned.
2. Accessing the Debtor’s D&O Insurance Policies
It is well established that insurance policies issued to a company become property of the estate when that company files bankruptcy. When a policy provides for payment only to a third party, such as payments to officers and directors under an executive risk insurance policy, courts have generally held that the proceeds of such policy are not property of the estate. As a result, a bankruptcy filing should not bar directors and officers from accessing the proceeds of a D&O policy.
Frequently, the insurer and covered executives will coordinate to seek an order from the bankruptcy court authorizing the payment of policy proceeds. An estate representative, such as a Chapter 7 trustee or creditors’ committee, may request that the bankruptcy court impose limitations on access to the policy proceeds if the estate representative believes that there may be claims against the executives. Such limitations might include a cap on payment of defense costs to executives or reporting requirements for the insurer so that interested parties can monitor the availability of remaining policy proceeds. Court orders governing access to D&O policy proceeds are typically negotiated and fact dependent.
Understanding and facilitating access to the debtor’s D&O insurance is useful, not only for protection of the debtor’s executives, but also for minimizing exposure of outside directors (including those appointed by private equity firms or other investors) who are sued in their director capacities on behalf of the debtor. It is critical to continually monitor and adjust D&O coverage across all potentially triggered programs, including management liability policies issued to cover outside directors, to avoid coverage gaps and maximize recovery in the event of a claim.
3. The Automatic Stay Does Not Affect Claims Against Directors and Officers
While a company’s bankruptcy filing generally stays all claims against the company, the automatic stay does not apply to a company’s directors and officers. In certain circumstances, a debtor may seek to extend the stay to third-party claims against directors and officers if it can be shown that the continuation of such claims could impair a company’s ability to effectively reorganize. Such a situation would not include the assertion of director or officer liability claims by a Chapter 7 trustee or other estate representative, such as a creditors’ committee, if the company is not pursuing a reorganization.
An effective reorganization may include the negotiation of a release of directors and officers or limitations on pursuit of director and officer liability claims, such as limiting such claims to the proceeds of a D&O policy. Experienced bankruptcy and coverage counsel can ensure that executives navigate potential claims to minimize exposure and maximize D&O insurance protections.
4. Waiver Provisions and the Automatic Stay
While the automatic stay can protect a debtor from claims during bankruptcy, it can also pose issues to insureds in the event directors or officers need to submit their own “claim” to recover under the debtor’s D&O policies – especially since the insurer, the court, or other stakeholders may oppose the claims. With respect to the rights of the parties to the insurance contract, those risks can be mitigated in part by endorsing D&O policies with provisions clarifying, among other things:
that bankruptcy or insolvency of the company does not relieve the insurer of its obligations under the policy;
that the policy is intended to protect the individual director-and-officer insureds; and
that the parties waive any automatic stay that may apply to recovery of policy proceeds.
The effectiveness of such waiver may vary from jurisdiction to jurisdiction.
5. Filing a Petition May Not Trigger Runoff in D&O Policies
Even where companies have adequate D&O insurance with runoff coverage that will continue to protect directors and officers long after the bankruptcy concludes, many executives assume that the policy’s current coverage will terminate and go into runoff automatically upon the filing of a bankruptcy petition. That is not usually the case, although there are scenarios where a bankruptcy filing and runoff trigger may occur around the same time.
Instead, policies typically contain a “change in control” provision that provides a list of enumerated events that terminate current coverage and place the policy into runoff, limiting going-forward coverage to claims noticed during the extended reporting period that allege wrongful acts by the insured occurring before the change in control. Provisions vary between policies but generally speaking, a change in control occurs if:
the named insured consolidates with or merges into another entity;
the named insured sells all or substantially all of its assets to another entity; or
any person or entity acquires management control (i.e., greater than 50% of voting power to appoint board or management committee members) of the named insured.
Those kinds of acquisitions or asset sales may not occur until after a plan of reorganization is confirmed or, at a minimum, until the debtor provides notice to interested parties of its intent to sells its assets, and the bankruptcy court approves the sale process, which can occur months after the petition date. The delay between the petition date and a change in control can raise a number of D&O insurance considerations – most notably a potential lapse in coverage if the company’s policy is set to expire before a transaction or sale can be effectuated. This can be solved preemptively by negotiating an extension of the company’s current D&O policies to continue coverage beyond the expected plan confirmation or transaction effective date, although any such extension likely requires additional premium payments.
The cost of making even a seemingly simple modification to a debtor’s D&O coverage can be substantial. While bankruptcy courts generally allow debtors to maintain D&O insurance, the need for ongoing insurance funding can be cause for alarm for former directors and officers and other individuals or entities who may need to access the debtor’s D&O coverage but are not involved in the ongoing financial decisions of the company during bankruptcy.
6. Retentions and Non-Indemnifiable Loss
Executives should be aware of all possible payments they may be called on to make in defending against claims in the event the company is unwilling or unable to indemnify them. Those “retention” payments – also called “deductibles” or “self-insured retentions” – are the amount of money the insured is required to pay before the D&O insurer will start paying. There are two primary issues in evaluating retentions in bankruptcy.
The first is understanding what retentions apply to each type of D&O coverage. Typically, retentions apply to claims made against officers and directors that are indemnified by the company (“Side‑B” coverage), while there is usually no retention for claims against individual officers and directors that are “non-indemnifiable” by the company (“Side‑A” coverage). Directors and officers should understand the difference between the two coverages and what, if any, retention applies to Side‑A claims where they may be personally liable in the absence of reimbursement from the insurer.
The distinction between Side‑A and Side‑B coverage raises a second issue: what constitutes “non-indemnifiable” loss sufficient to avoid a retention and make sure that the insurer is paying “first dollar” for any loss? Policy language varies greatly, but many D&O policies have presumptive indemnification, meaning that the insurer assumes that the company will indemnify executives to the fullest extent permissible under the law and, as a result, will only consider loss “non-indemnifiable” if the company is truly unable to pay. Policies may also expressly recognize that a company in bankruptcy is presumed to be insolvent and, therefore, unable to indemnify.
Issues may arise in bankruptcy, however, where a policy does not make clear that the inability to pay includes financial insolvency, allowing the insurer to argue that Side‑A coverage does not apply (and the executive is subject to a steep retention) because, even though the company has no resources to pay, it is still permitted to pay under controlling corporate governance documents and applicable law. Critical policy provisions addressing permissible, required, actual, and other variations on company indemnification can raise ambiguities impacting or even negating coverage for directors and officers during bankruptcy. These ambiguities can be avoided by adequately addressing financial insolvency and its impact on retentions during policy placement or renewal.
7. D&O Exclusions and “Final Adjudication”
D&O policies contain many exclusions, but the most common insolvency-related example is the “insured vs. insured” exclusion, which bars coverage for claims brought by or on behalf of one insured against another insured. The aim of these provisions is to discourage company infighting by removing it from the ambit of the company’s D&O coverage and to avoid collusion between insureds who may assert claims driven in whole or in part by a desire to recover under insurance policies.
Serious issues can arise in bankruptcy outside of these traditional examples if, for example, a bankruptcy or liquidation trustee, creditors’ committee with derivative standing, or receiver (including the FDIC) asserts a claim against directors and officers on behalf of the debtor. Absent appropriate carve-outs to the insured vs. insured exclusion, insurers may argue that coverage is negated because, as representatives of the debtor company, those bankruptcy entities are considered insureds subject to the exclusion. Executives should ensure that any D&O policy has appropriate exceptions to the otherwise broad insured-vs.-insured exclusion that protects coverage in these situations.
In addition to raising issues under the insured vs. insured exclusion, adversary proceedings brought by bankruptcy or liquidation trustees asserting claims against directors and officers can implicate D&O exclusions for deliberate criminal, fraudulent, or dishonest acts, such as allegations of reckless or intentional conduct in breaching fiduciary duties. Those allegations, even if groundless, can pose significant obstacles to advancing legal fees and expenses unless the D&O policy’s “conduct” exclusions include a “final adjudication” requirement that prevents insurers from refusing coverage under the exclusion until the criminal, fraudulent, or dishonest acts are established by a final, non-appealable adjudication.
Even if conduct exclusions contain final adjudication language, the effectiveness of those requirements can vary widely between policies. For example, is the exclusion triggered based on final adjudications in any proceeding or only the underlying proceeding, and does such adjudication need to be adverse to the insured? These and other nuances in exclusionary language can play critical roles in maximizing executive protection during bankruptcy (and other proceedings).
8. Priority of Payment Provisions
In many instances, a debtor’s insurance policies will be one of the more valuable assets of its estate. To make matters worse, as previewed throughout this article, insolvency can lead to a number of new claims against both the company and its directors and officers at a time when the company is not in a financial position to defend itself or provide indemnification. For those reasons, there often are competing claims to recover policy proceeds that involve losses far exceeding the available limits.
Claims against different insureds may proceed on different tracks. For instance, a settlement in one matter may risk exhaustion of full limits, while a separate lawsuit against only the company’s directors and officers continues to trial after incurring millions of dollars in legal fees. This risk can be mitigated in large part by purchasing the “Side‑A only” policies discussed above, which afford separate limits to executives that cannot be impaired by claims against the company (or reimbursement to the company for indemnification paid to individual insureds).
Where executives have access only to the company’s D&O policies, however, they should ensure that all policies have a “priority of payments” provision that prioritizes “Side‑A” payments to individuals before all other kinds of payments. A priority of payments provision can also clarify that the company has a right to coverage only after all claims against individual directors and officers have been satisfied or even prohibit any payments to the company absent written approval by the board.
9. Allocation Provisions
Claims during bankruptcy can involve a number of different theories of liability, different entity and individual defendants across different stages of the debtor’s corporate history, and a variety of damages, not all of which may be covered by D&O policies. In these “mixed” claim scenarios, policyholders should understand how covered and potentially uncovered losses may be treated under D&O policies or, more specifically, what grounds insurers may raise to limit coverage to something less than all claims and damages asserted in the litigation.
Policies may be silent on “allocation,” particularly with respect to defense costs incurred by a law firm representing multiple defendants, only some of whom are insureds under the D&O policy. In those instances, many courts have held that insurers must reimburse 100% of legal fees and expenses as long as they “reasonably relate” to covered claims, even if the defense benefits non-covered claims or non-insured defendants.
Other policies, however, have explicit allocation provisions that require a particular method of allocation, such as requiring the insurer and policyholder to use their “best efforts” to determine a “fair and appropriate allocation” between covered and uncovered costs based on “the relative legal and financial exposure of the parties.” Such provisions commonly provide a process for resolving allocation disputes where the insurer must advance only those defense costs it believes to be covered until a different allocation is negotiated or determined in court or arbitration.
The best approach to avoiding allocation disputes is modifying the policy to include a provision explicitly stating that the insurer will advance 100% of defense costs as long as any claim triggers the duty to pay such costs. Working with coverage counsel and insurance brokers to understand allocation and, if needed, negotiate favorable terms well in advance of any claim is key to ensuring that directors and officers receive adequate protection for covered claims during bankruptcy.
10. Avoid Cancelled Policies
In line with all of the commentary above, many directors and officers recognize the importance of placing and renewing D&O insurance protection well in advance of any insolvency, including runoff coverage to protect executives long after they have resigned. When a claim arises during bankruptcy, insureds understandably look to the debtor’s coverage as the first line of defense.
In some instances, those directors and officers may be surprised to learn that the policy they had carefully crafted was cancelled – not by the company, but by the bankruptcy trustee, who recovered the policy premium for the benefit of the estate at the expense of leaving the debtor’s officers and directors unprotected. Thus, policyholders should confirm that D&O policies have provisions stating that they cannot be cancelled for any reason except for non-payment of premium, even if the cancellation is being requested by the insured (including a bankruptcy trustee or other entity acting in the capacity of the insured).
On November 30, 2020, the Consumer Financial Protection Bureau (“CFPB”) released an advisory opinion concerning earned wage access (“EWA”) products. The Bureau addressed whether EWA providers are offering or extending “credit” as that term is defined by Regulation Z and concluded that the “Covered EWA Programs” do not involve the offering or extension of credit under Reg. Z. On December 30, the CFPB issued a compliance assistance sandbox (“CAS”) approval order to PayActiv related to certain aspects of its EWA products.
What are Earned Wage Access Programs?
EWA programs typically enable employers to advance a certain amount of accrued wages to employees before the employees receive their regular paychecks. The employer settles-up the amount advanced through payroll deductions or bank account debits from the employee’s subsequent paycheck. In many cases third-party “EWA providers” work with the employer, the employee, or both assist in streamlining this type of wage advance.
What is the Uncertainty Around EWA Programs that the CFPB Was Asked to Address in its Advisory Opinion?
EWA providers—and the CFPB itself—identified uncertainty over whether the Truth in Lending Act (“TILA”) and its implementing regulation, Regulation Z, apply to EWA programs. Regulation Z generally applies to extensions of “credit” when four conditions are met:
the credit is offered or extended to consumers;
the offering or extending of credit is done regularly;
the credit is subject to a finance charge or is payable by a written agreement in more than four installments; and
the credit is primarily for personal, family, or household purposes.
12 C.F.R. § 1026.1(c)(1).
Regulation Z defines “credit” to mean the right to defer payment of debt or to incur debt and defer its payment. 12 C.F.R. § 1026.2(14).
What Does the Advisory Opinion Do to Resolve the Uncertainty?
The CFPB concluded that a “Covered EWA Program” is not an extension of credit and thus not subject to Regulation Z. A Covered EWA Program must meet the following criteria:
The EWA program provider contracts with the employer to offer and provide EWA services.
The amount of each advance does not exceed the accrued cash value of the wages the employee has earned up to the date and time of the transaction, as determined by the employer.
The employee pays no fee – voluntary or otherwise – to access EWA funds or otherwise use the EWA program. The advance must be sent to an account of the employee’s choice. If the account receiving the advance is a prepaid account as defined under Regulation E and that account is offered by the provider, then additional fee restrictions apply.
The provider recovers the advance only through an employer-facilitated payroll deduction from the employee’s next paycheck. One additional deduction may be attempted in the event of a failed or partial payroll deduction due to administrative or technical errors.
In the event of a failed or partial payroll deduction, the provider maintains no legal or contractual remedy against the employee. This does not, however, prevent the provider from declining to offer the employee additional EWA transactions.
The provider must clearly and conspicuously make certain warranties to the employee, including:
that there will be no fees,
that the provider has no recourse against the employee, and
that the provider will not engage in any debt collection activities.
The provider may not directly or indirectly assess the credit risk of the employee.
The CFPB concluded that a Covered EWA Program does not provide consumers with “credit” for the following reasons:
EWA transactions do not provide employees with the right to defer payment of debt or to incur debt and defer its payment because Covered EWA Programs do not implicate a “debt.”
EWA transactions operate like advances on accrued cash value of an insurance policy (or a pension account), where there is no independent obligation to repay. Advances on accrued cash value of insurance policies and pension accounts are not considered credit under Regulation Z.
The aspects of a Covered EWA Program differ in kind from products the CFPB would generally consider to be credit.
This treatment of Covered EWA Programs is consistent with the CFPB’s discussion of EWA products in the 2017 Payday Lending Rule.
The CFPB’s guidance is consistent with the Regulation Z definition of “credit.” A transaction that does not create “debt” cannot constitute “credit.” Accordingly, a transaction that does not impose a “legal or contractual remedy” for non-payment, is arguably not a credit transaction under Regulation Z. The CFPB has invited feedback to evaluate whether to provide additional guidance about programs that differ from those addressed in the advisory opinion.
What is the Bureau’s CAS Policy?
The Bureau’s CAS Policy offers certain limited safe harbors to approved programs, subject to good faith compliance with the Bureau’s approval order. PayActiv’s approval order protects the company from liability under TILA. Provisions of the order include:
PayActiv contracts with employers to offer and provide EWA services.
PayActiv warrants to the employee as part of the contract between the parties that:
PayActiv will not impose fees, aside from the fee charged under one of the models;
PayActiv has no recourse against the employee, including no right to take payment from any consumer account; and
PayActiv will not engage in any debt collection activities.
PayActiv does not directly or indirectly assess the credit risk of individual employees.
The advance amount is capped at the accrued cash value of the wages the employee has earned at the time of the transaction, as verified by information from the employer.
PayActiv offers two programs to consumers, one of which does not require the employee to pay any fee, voluntary or otherwise, to use the EWA program. The other program is explained in more detail below.
PayActiv recovers the advance through an employer’s payroll deduction from the employee’s next paycheck. If a payroll deduction is unsuccessful due to administrative or technical errors, then PayActiv attempts one additional deduction.
If a payroll deduction is not successful, PayActiv has no remedy against the employee, although PayActiv may refrain from offering the employee additional advances.
Does the CAS Approval Differ at All from the CFPB’s Advisory Opinion?
Though PayActiv’s program specifications are nearly identical to the criteria for a Covered EWA Program under the CFPB’s advisory opinion, there is a key difference. The November advisory opinion forecasted that some EWA programs may be charging nominal processing fees that do not involve the extension of “credit.” While the advisory opinion does not cover such programs, it offered providers the opportunity to “request clarification from the Bureau about a specific fee structure” by applying for an approval “under the Policy on the Compliance Assistance Sandbox.” PayActiv did just that.
While PayActiv offers a no-fee program, it also offers its “PayActiv Access Choice” program that charges a $1 non-recurring fee to employees who do not have a PayActiv-facilitated account. That fee provides access to an unlimited number of transactions during a one-day access window. If the employee accesses funds on multiple days during a single pay period, then fees are capped at $3 for a one-week period and $5 for a bi-weekly period. PayActiv does not charge fees to open a PayActiv-facilitated account.
What Does the Approval Order Mean Going Forward for Fees in EWA Transactions?
While the CFPB has clarified that an EWA provider can charge fees in some circumstances without the program being considered credit, it is not clear how the CFPB (and other regulators) will distinguish credit and non-credit programs. It’s clear that to qualify as non-credit, there cannot be a debt (i.e., there cannot be a legal claim to repayment against the employee). When an employee accesses accrued cash value of earned wages, and the wages are then routed to the EWA provider by employer-facilitated payroll deductions, rather than a contractual obligation imposed on the consumer, it seems there is no consumer debt or claim. This is especially the case when the fee charged:
is comparable to expedited transfer fee for non-credit products,
does not vary based on the amount of the transaction or repayment period, and
isn’t based on the employee’s creditworthiness.
To further support characterization of EWA as non-credit, EWA providers agree to refrain from collections activity, negative credit reporting, and imposing late fees.
Despite the factors identified above, there are some aspects of some EWA programs that may give pause to some regulators or consumer advocates. While the CFPB called PayActiv’s fee “nominal,” in an EWA, in an actual credit transaction, a $5 finance charge for a two-week period on a $100 wage advance would yield a triple-digit annual percentage rate. While this rate of return is 1/3 of the rate of return on a typical payday loan, if an EWA were considered credit, then that type of rate of return would be triple the 36% APR limitation supported by consumer advocates. Of course, there are numerous types of non-credit cash advances that would have high APRs if they were deemed “credit.” For example, an ATM machine advancing $20 for a $2 fee yields an annualized rate of return that is 10 times as much as a typical payday lender’s APR.
Since EWAs involve a cash advance of earned wages to an employee and a hope of future settlement on the employee’s payday, some regulators may be taking the position that EWA is credit. In August of 2019, numerous state regulators announced an action alleging that certain organizations advancing wages were engaged in unlawful lending, in part because they charged tips, monthly membership fees, or other fees. In January of 2021, the California Department of Financial Protection and Innovation (“DFPI”) released five separate memoranda of understanding with EWA providers that outline certain “rules of the road” for providing EWA products in California while allowing the DFPI to collect additional information on how EWA products are offered and used.
Of course, the CFPB’s approval order applies only to PayActiv and the specific product it outlined in its CAS application. Other companies are not authorized to rely on the same safe harbors for protection from the CFPB, let alone other regulators who are not part of the CAS process. Even so, the CFPB’s introduction of “nominal fees” into its regulatory calculus regarding EWA creates a potential disconnect between the CFPB and other regulators, and until a company unwittingly falls in the middle, we may not know the resolution of this disconnect.
A recent decision from the United States District Court for the District of Columbia emphasized that neither attorney-client privilege nor work product protection will shield a report provided by a third party retained by counsel where the report provides non-legal advice.**
Guo Wengui v. Clark Hill, PLC,[1] arose from the cybersecurity breach of a law firm’s database on September 12, 2017. After confidential information about him was publicly disseminated, a client (Wengui) sued the law firm (Clark Hill) claiming that it failed to take sufficient precautions to protect his data. Immediately after learning about the breach, Clark Hill ordered an investigation into what had occurred. It employed its regular cyber security provider, eSentire, to investigate and remediate, as appropriate. The purported purpose of eSentire’s work was for “business continuity.”[2]
Two days later, on September 14, 2017, while the breach may still have been ongoing, Clark Hill hired a law firm, Musick, Peeler & Garrett (“MP&G”), to provide legal advice relating to the incident. MP&G hired an independent cyber security firm, Duff & Phelps, to assist MP&G in providing legal advice to Clark Hill and to prepare for anticipated litigation. Duff & Phelps went on site on September 14, 2017.[3] It ultimately produced a full investigative report which included “specific remediation advice.”[4] The General Counsel of Clark Hill, Edward Hood, reviewed the report. Hood then shared the report with “select members of the leadership and IT team” at Clark Hill.[5] Clark Hill also shared the report with the Federal Bureau of Investigation (“FBI”) in connection with the FBI’s investigation of the incident.[6]
Litigation was, in fact, filed in September 2019. During the course of discovery, the client requested “all reports of [Clark Hills’s] forensic investigation into the cyberattack.”[7] The client also served interrogatories asking Clark Hill to state the facts or reasons why the attack occurred.[8] Clark Hill responded to the document production requests by providing (among other things) documents from eSentire. Notably, the partial production did not include any formal report or any specific findings from eSentire on the cause of the breach.[9]
Clark Hill objected to producing other responsive documents and to answering the interrogatories, claiming that the information from Duff & Phelps was protected by the attorney-client privilege and work product protection. It maintained that its understanding of the cause of the attack came solely from the investigation performed by Duff & Phelps, which was ordered by MP&G to provide legal advice and in anticipation of litigation.[10]
Plaintiff disagreed and filed a motion for sanctions. On January 21, 2021, the court granted the motion for sanctions, finding that the attorney-client privilege and the work product protection doctrine did not apply to the requested information.
Attorney-client privilege
Generally, the attorney-client privilege applies to “a confidential communication between attorney and client if that communication was made for the purpose of obtaining or providing legal advice to the client.”[11] The Duff & Phelps report was not a communication between attorney and client. Courts have recognized, however, that certain documents prepared by third parties may be covered by the privilege if the document was prepared to help facilitate the provision of legal advice by, for example, explaining technical materials or acting in the capacity of a translator.[12] The courts have cautioned that this principle must be narrowly applied – if the advice sought by the client is really the advice of the third party, and not the lawyer, no privilege would exist.[13]
The Wengui court readily concluded that the advice in the Duff & Phelps report was cybersecurity advice, and not legal advice, and therefore not protected by the attorney-client privilege.[14]
Work Product Doctrine
In federal court, the work product protection doctrine shields from discovery certain materials prepared in anticipation of litigation. Under Federal Rule of Civil Procedure 26(b), “[o]rdinarily, a party may not discover documents and tangible things that are prepared in anticipation of litigation . . . by or for another party or its representative (including the other party’s attorney, consultant, . . . or agent).”[15] The Wengui court then applied the “because of” standard in order to determine whether a document was “prepared in anticipation of litigation.” The “because of” test asks “whether, in light of the nature of the document and the factual situation in the particular case, the document can fairly be said to have been prepared or obtained because of the prospect of litigation.”[16] As the court further explained, “[w]here a document would have been created ‘in substantially similar form’ regardless of the litigation,” it fails that test, meaning that “work product protection is not available.”[17]
The Wengui court found it “highly likely” that Clark Hill would have investigated the cause of the cybersecurity breach and steps to remediate it whether or not the firm was anticipating litigation. The court favorably cited other decisions which held that investigating a cyber breach is a necessary business function. After the court’s in camera review of the report, the court concluded that “substantially the same” document would have been prepared in the normal course of business.[18]
Key Case Clearly Distinguishable
Clark Hill primarily relied on the case of In re Target Corp. Customer Data Sec. Breach Litig.[19] to support both theories to shield production of the information. The court easily distinguished the facts in Wengui from the Target case in connection with both arguments.
With respect to the work product doctrine, the court rejected Clark Hill’s view that there were two tracks to the investigation which led to the protection of the Duff & Phelps report: 1) the eSentire track allegedly being the one conducted in the normal course; and 2) the Duff & Phelps report supposedly being prepared solely to assist in the legal representation. The court found that the Duff & Phelps report was prepared instead of, rather than in addition to, the work performed by eSentire.[20] Indeed, Duff & Phelps began its work within days of Clark Hill discovering the breach, while the breach was ongoing. eSentire never produced a report or any findings about the cause of the breach. The General Counsel of Clark Hill shared the report with a broad audience, including in-house leadership, IT and Clark Hill also shared it with the FBI in connection with the FBI’s investigation. The court concluded that these non-litigation uses of the report demonstrated that the report was not prepared “because of” litigation. Merely “paper[ing]” the report through attorneys did not shield it from disclosure.[21]
As for the attorney-client privilege, there were three distinguishing facts in Target. First, Target established that it took the “two track” approach. Second, the report that was shielded from disclosure by the court in that case was not shared with a wide audience. Third, the Target report, unlike the Duff & Phelps report, did not include specific suggestions for remediation.[22]
Although the court cited In re Kellogg Brown & Root, Inc.,[24] the court did not apply its holding even though it appears directly applicable to Clark Hill’s case. The In re Kellogg Brown & Root, Inc., court addressed the standard to apply in determining whether an investigative report was protected by the attorney-client privilege. There, the appellate court rejected the “but for” test in favor of “a primary purpose” test.
Kellogg Brown & Root (“KBR”) received an employee tip about potential misconduct in connection with administering government contracts – specifically, inflating costs and accepting kickbacks.[25] KBR initiated an internal investigation, led by its Law Department, as required by its Code of Business Conduct.[26] Some, but not all, of the interviews were conducted by in-house attorneys, others were conducted by investigators at the direction of counsel. No outside counsel was retained.[27] A report of the investigation was prepared. A KBR employee then filed a whistleblower complaint relating to the same conduct.
The plaintiff/employee sought the production of documents related to KBR’s internal investigation. KBR objected on the basis of the attorney-client privilege. The lower court ordered production of the documents, but the Court of Appeals reversed. The Court of Appeals ruled that often there is not one primary purpose – legal and/or business – for a communication. The test is, rather, whether “obtaining or providing legal advice” was “a primary purpose of the communication.”[28] The Appeals Court found that the privilege applies even though interviews may be conducted by non-attorneys, if they are conducted at the direction of attorneys, and therefore by non-lawyers acting as legal agents.
Had the court in Wengui held that the report at issue included some legal advice, and applied the standard from In re Kellogg Brown & Root, would the decision have been different? Probably not. The investigation by KBR clearly was controlled by the Law Department to gain facts in order to provide advice to the company. Those interviewed were told about the purpose of the investigation and that the information would be held in confidence. The information was not shared beyond those with a need to know, and certainly not with any outside agency. And, based on the facts found by the Wengui court, learning what happened in the cybersecurity breach in order to properly remediate it was the only real purpose of the Duff & Phelps report. eSentire, the normal service provider, was not the entity tasked with determining the required remediation procedures.
Lessons Learned
Wengui emphasizes the following principles:
The mere fact that communication is made to an attorney does not mean the communication is privileged; and
Materials are not automatically protected by the privilege merely because they are provided to or prepared by an attorney.[29]
Building upon those principles, here are some steps counsel can take to preserve privilege protection for investigation materials, whether prepared by counsel or a third party at the direction of counsel:
Clearly communicate that the investigation is being performed in order to secure legal advice;
Prepare an investigation plan;
Perform the interviews or create the template for questions to be asked;
Schedule regular briefings as the investigation proceeds;
Provide analyses of the information gleaned during the investigation;
Provide recommendations of legal steps to take as a result; and
Limit distribution of any report to those who actually need the information as part of their job responsibilities in connection with the investigation.
** Hope A. Comisky is a member of Griesing Law, LLC. Hope A. Comisky is a Member of Griesing Law, LLC and Chair of the Firm’s Employment and Ethics & Professional Responsibility practice groups. She is a top-ranked employment attorney and an experienced arbiter with over thirty-five years of employment and litigation experience. She counsels clients on employment and professional responsibility issues, provides training and offers strategic advice on employment litigation matters and professional responsibility initiatives. Hope is also a frequent lecturer and author on employment law and professional responsibility topics. She received her B.A. from Cornell University and J.D. from the University of Pennsylvania Law School. She can be reached at [email protected].
[1] No. 19-3195, 2021 WL 106417 (D.D.C. January 12, 2021).
[29] Although outside the scope of this article, the court also addressed a third argument with respect to the request by Wengui for production of “[a]ll documents reflecting that the ‘hacking’ . . . resulted in a third party’s obtaining . . . information, data, or material regarding any Clark Hill client other than or in addition to plaintiff.” The court granted the motion to compel stating that any confidentiality concerns could be remedied by redacting the clients’ names. 2021 WL 106417, at *1, *6-*7.
Special Purpose Acquisition Company (SPAC) transactions have experienced a meteoric rise in the capital markets. In 2019, there were 59 SPAC Initial Public Offerings (IPOs) with gross proceeds of approximately $14 billion. In 2020, there were 248 SPAC IPOs with gross proceeds of approximately $83 billion[1] – an astronomical 320% increase in the number of SPAC IPOs and 500% year-to-year increase in gross proceeds. Generally, SPACs have maintained a similar structure. However, a recent SPAC, Pershing Square Tontine Holdings, Ltd., in conjunction with fundamental M&A law, might have unleashed market forces that will fundamentally transform the prevailing structure of SPACs.
A SPAC is a publicly-traded blank check company created to take a private company public through a merger.[2] In a SPAC IPO, a SPAC generally offers units, each consisting of one share of common stock and a warrant to purchase a fraction of common stock at a set price. Subject to the terms in the prospectus, the common stock and warrants from the units become separately and freely transferable after the IPO. A SPAC typically has two years to identify a target company and complete the business combination, often referred to as a “de-SPAC” transaction, or liquidate and return the proceeds from the IPO to the shareholders. Additionally, when a SPAC proposes a merger, the shareholders have the option to participate in the merger or redeem their shares at the initial IPO price with accrued interest.
Benefits of SPAC Transactions
SPACs have several benefits from a transactional engineering standpoint. Primarily, SPACs provide private companies an avenue to go public with less liability exposure from federal securities laws, and provide flexibility in M&A transactions. In a recently published article, I surmised that “the only significant liability distinction between public and private securities is the heightened pleading standard of scienter-based causes of action” associated with private securities. Stated succinctly, IPO issuers have exposure to the strict liability causes of action in §§ 11 and 12 of the Securities Act. Conversely, plaintiffs in causes of actions stemming from private securities are relegated to § 10(b) of the Exchange Act, which requires a showing of scienter; and scienter has become increasingly difficult to establish since the Supreme Court added a plausibility standard to pleading requirements. In effect, SPACs reduce §§ 11 and 12 liability significantly for private companies looking to go public.
Additionally, M&A lawyers often herald SPACs’ advantages over conventional IPOs and M&A transactions. These advantages include a SPAC’s potential to improve the conventional IPO process by reducing information asymmetry, increasing price and deal certainty, improving efficiency, and providing the potential for flexible deal terms.[4] From a policy perspective, proponents of SPACs argue that SPACs democratize investing and allow non-accredited investors to invest alongside private equity and hedge fund managers in potentially lucrative deals.
Downside of SPAC Transactions
Critics of SPACs argue that the investment structure is extremely and unnecessarily dilutive. The dilution stems from the compensation sponsors receive in the form of a sponsor’s “promote” (typically 20% of the post-IPO equity); underwriting fees (typically 5% of the IPO proceeds); and SPAC warrants and rights. Inevitably, the non-redeeming SPAC shareholders and/or the target company shareholders absorb the dilution inherent in conventional SPAC structures.[5] Additionally, because the sponsor’s promote and associated rights partially protect sponsors from the downside of a de-SPAC transaction, traditional SPAC structures have the potential to create a moral hazard problem, and may lead to conflicts of interests between the sponsors and SPAC shareholders. On December 22, 2020, the SEC issued a CF Disclosure Guidance highlighting this issue.[6]
The Pershing Square Tontine SPAC Model
The Pershing Square Tontine Holdings, Ltd. (PSTH) SPAC features numerous provisions that set it apart from conventional SPAC structures.[7] Of particular note:
The PSTH sponsors will not receive the traditional 20% promote of the post-IPO common stock for a nominal price. Instead, the sponsors will purchase Sponsor Warrants at fair market value, with an exercise price of $24.00 per share.
PSTH Sponsor Warrants are generally not transferable or exercisable until three years after a de-SPAC transaction.
PSTH Sponsor Warrants are not exercisable until the common stock value is at least 20% higher than the IPO price.
The fractional warrants associated with the PSTH SPAC units are considerably lower than conventional SPAC warrants. The terms of the warrants are engineered to reward non-redeeming shareholders and minimize gains for short-term investors.
PSTH’s structure mitigates several of the structural concerns of SPACs, which might give the PSTH structure a competitive advantage over conventional SPACs in the capital market, and perhaps more importantly, in the market for suitable acquisition targets. The PSTH model is less dilutive than conventional SPAC models; additionally, the warrant structure of the PSTH model aligns the downside for sponsors with its common stock shareholders and target companies’ shareholders.
As it relates to the capital market, the PSTH model might be more attractive to some investors and less so to others. Investors who are inclined to divest their shares before the consummations of the de-SPAC transaction will be less attracted to the redemption and warrant rights of the PSTH model. However, the PSTH model might be able to offset the loss of capital from short-term investors with that from traditional institutional investors. To the extent the PSTH model transforms the compensation to SPAC sponsors to align sponsors’ interest with that of SPAC shareholders and create a fee structure that resembles conventional hedge funds and private equity funds, SPACs that use the PSTH model might become more attractive to institutional investors. Additionally, the PSTH model might help assuage regulators’ and policymakers’ concerns as retail investors participate in investment activities traditionally relegated to accredited investors through SPACs, while the debate over the proper balance between investor protection and democratizing finance unfolds.
Of particular note, fundamental M&A law might give the PSTH model a competitive advantage when bidding for a suitable acquisition target. Under Delaware law and many other jurisdictions, a target company’s board has a fiduciary duty to “seek the best transaction for shareholders reasonably available” if the company decides to merge.[8] The PSTH model has embedded structural advantages that will help sponsors structure deals that are deemed best transactions in bids for target companies. As stated above, conventional SPAC models are fundamentally dilutive. To the extent that a target company has to bear part of the dilution cost, or the PSTH structure helps create a superior bid for a target company, the target company’s board will have a fiduciary duty to accept the bid from the PSTH structure.
Conclusion
As SPACs continue to evolve and gain prominence as part of the toolkit for private companies to obtain liquidity, competition for capital and attractive companies to take public will intensify. Additionally, capital from SPAC IPOs allocated for deals will start to accumulate. Contemporaneously, M&A fiduciary laws and market forces will start to affect the evolution of SPAC transactions. As SPACs with a similar structure to the PSTH model start to win competitive bids for attractive target companies because their structure helps create the best transaction, market forces will pressure market participants to adapt. The composition of SPAC investors might also evolve with a change of SPACs’ structure. Specifically, as short-term investors begin to exit the market, institutional investors looking to capitalize on the transactional and regulatory benefits of SPACs over IPOs and conventional M&A transactions might increase their SPAC investment allocation.
[2]See, Investor Bulletin: What You Need to Know About SPACs, available at: https://www.sec.gov/oiea/investor-alerts-and-bulletins/what-you-need-know-about-spacs-investor-bulletin.
[3]See, Frantz Jacques, Securities Law and Digital Asset Products, Bloomberg Law (January 22, 2021).
[4]See, Skadden, Arps, Slate, Meagher & Flom LLP, The Year of the SPAC: Insights, available at: https://www.skadden.com/insights/publications/2021/01/2021-insights/corporate/the-year-of-the-spac.
