One of the biggest legal stories of 2020 barely made any headlines because, understandably, reporting on the COVID-19 pandemic and the presidential election dominated the news cycle. Mainstream attention on data privacy focused largely on the implementation and subsequent referendum expanding the California Consumer Privacy Act (“CCPA”), while the Schrems II invalidation of the GDPR Privacy Shield framework also gained widespread attention.
As a result, Facebook’s historic $650 million biometric privacy settlement under the Illinois Biometric Information Privacy Act (“BIPA”) attracted much less media fanfare. The settlement comes just a year after Facebook was hit with a record $5 billion fine by the Federal Trade Commission for deceiving users about users’ ability to control the privacy of their personal information.
Given the pace of current events, the lack of attention on this issue is not surprising, but it is unfortunate. Access to biometric data, including facial recognition technology, is one of the most important privacy issues attorneys will need to think about in the coming decades.
Facial Recognition Technology is No Longer Science Fiction
Facial recognition technology uses data to create a biometric map of the human face. Once the data is collected, algorithms analyze incoming images for unique facial features and dimensions to find a match, thereby attributing the new image to an individual.
Some estimates predict the facial recognition market will be worth nearly $9.6 billion by 2022. Facial recognition has already been tested at large public sporting events in the United States where attendees are admitted to the facility by facial authentication, rather than paper ticket or other methods.
Facial recognition requires a database of information to reference in order to make matches. For example, social media companies and smart phone applications easily obtain this information when users voluntarily upload their photos. Such companies and applications typically obtain the users’ consent to use the uploaded photos in a terms of service agreement. But studies consistently show the majority of users rarely read digital terms of service agreements.
Facebook Settles Facial Recognition Class Action for $650 Million
In late January 2020, Facebook announced it would pay $550 million to settle a BIPA class action suit over its use of facial recognition technology. In July 2020, the settlement was increased to $650 million.
Illinois was the first state to pass legislation aimed at protecting biometric data, enacting BIPA in 2008. Among other provisions, BIPA requires that consent be obtained prior to the collection of a user’s biometric data. Because BIPA contemplates $1,000 to $5,000 for each violation of the law, a verdict could have exposed Facebook to billions in damages. The $650 million settlement is likely the largest facial recognition case to date.
The litigation arose from Facebook’s “Tag Suggestion” service. This is essentially a photo-labeling service that suggests the names of individuals in photos. Facebook obtained this information from “tagging,” a practice where users identified themselves and others in photos. This information was put into a database and eventually Facebook had enough data to automatically recognize the faces of users and make suggestions of users to “tag” in new photos.
But Facebook isn’t the only application on your smartphone potentially harvesting your biometric data. Several other popular smartphone apps have been criticized for the improper use of facial recognition technology. Most recently, the Clearview AI app came under criticism by privacy advocates. Clearview AI “scrapes” publicly available photos from social media accounts. Clearview AI contracts with law enforcement agencies, and until May 2020, also sold this information to private companies. Clearview promised to voluntarily terminate all contracts with entities based in Illinois after it was also sued under BIPA. Apple also faces multiple lawsuits under BIPA. One involves facial recognition, the other focuses on voice biometrics.
Technology Companies Promise Reform
In response to these recent controversies, several of the largest technology companies have announced restrictions on their development of facial recognition technology. On June 8, 2020, IBM announced it would no longer develop facial recognition technology.
On June 11, 2020, Microsoft followed by announcing it would no longer permit law enforcement use of its facial recognition technology.
Biometric data, including facial recognition, may be the most significant new legal front for privacy advocates. Biometric systems are becoming more common across society, such as the fingerprint sensor on many smartphones, retina scanning, and voice recognition.
Conclusion
Notwithstanding the likelihood of future litigation and public policy proposals, there are several actions individuals can take now to protect their privacy. Anyone concerned about protecting biometric data should avoid apps that require uploading a photo of their face. Also, users can avoid tagging themselves and others in social media posts. Finally, users can review their privacy settings and disable most facial recognition features.
Unfortunately, reigning in the use of facial recognition technology by government agencies is not always so easy. Other governments, most notably China, paint an alarming picture of how biometric data can be abused by authorities in the absence of appropriate legal protections.
Several local jurisdictions already prohibit the use of facial recognition technology. Major cities such as San Francisco, Boston, and Oakland have adopted such laws. In June 2020 the Boston City Council voted unanimously to ban the use of facial recognition by police. Officials cited concerns including racial bias and misidentification. Other cities are going even further. Effective January 1, 2021, Portland, Oregon’s facial recognition-ban applies to both government agencies and private businesses.
BIPA may only attract a fraction of the attention garnered by other prominent privacy laws like CCPA and GDPR, but with more actions filed under BIPA each month, this often-overlooked Illinois statute will become harder to ignore in 2021. Just as importantly, other jurisdictions may follow Illinois’ lead by enacting similar laws in the near future.
Patrick McKnight is an Associate in the Litigation Department of Klehr Harrison Harvey Branzburg LLP in Philadelphia, Pennsylvania. He is a member of the firm’s Data, Privacy, and Cybersecurity practice group. The opinions expressed in this article are those of the author and not necessarily of Klehr Harrison Harvey Branzburg LLP or its clients.
On January 1, 2021, Congress overrode the presidential veto of the National Defense Authorization Act for Fiscal Year 2021 (NDAA).[1] While the new law dealt mostly with national security, it also included a provision that substantially amended the SEC’s remedial powers, expressly authorizing the SEC to obtain disgorgement in federal court and doubling the statute of limitations for some types of relief. Early reactions to the amendments have viewed them as attempting to overturn the Supreme Court’s recent decisions in Kokesh v. SEC[2] and Liu v. SEC[3] that had curtailed the SEC’s remedial powers. Kokesh overruled a long line of lower court cases that had held that disgorgement was not subject to any statute of limitations. And Liu rejected the SEC’s broad interpretation of disgorgement, instead adopting a much narrower view of disgorgement, closer to how other courts had interpreted the sanction under common law, such as by permitting deductions for certain legitimate business expenses. Against this backdrop, some have suggested the amendments “neuter” or “upend” Liu’s limitations on disgorgement.[4]
But do they? Although the statute was enacted after Liu, the relevant provision’s language was originally introduced before the Supreme Court had even granted certiorari in Liu, let alone issued its decision. The legislative history reveals that this provision was in response to Kokesh, particularly a footnote in which the Supreme Court suggested disgorgement may not actually have been authorized by the provisions of the Securities Exchange Act of 1934[5] (Exchange Act) that the SEC and courts had long relied on.[6] Simply put, the NDAA’s amendment focused on Kokesh, not Liu.
Indeed, contrary to some suggestions, the NDAA’s characterization of disgorgement in many ways tracks the Supreme Court’s discussion in Liu. Unsurprisingly, then, under ordinary principles of statutory interpretation, some of Liu’s limitations on disgorgement probably remain, even after the NDAA’s amendments. And those limitations could continue to provide an important check on the new statutory disgorgement power that Congress has given the SEC.
Background: Kokesh and Liu
For at least several decades, disgorgement was seen as a silver bullet in the SEC’s arsenal, because it was not subject to any statute of limitation and the amount of disgorgement was largely left to the discretion of the SEC or lower courts. Over time, this perceived flexibility resulted in disgorgement becoming a powerful tool to sanction misconduct where civil money penalties were time-barred or considered insufficient. But in 2017, a unanimous Supreme Court held in Kokesh that, as applied by many courts, disgorgement was effectively a penalty. And as a result, an action for disgorgement was subject to the same default five-year statute of limitations in 28 U.S.C. § 2462 that applied to SEC actions for civil money penalties.
In a significant footnote, the Supreme Court noted that whether the SEC was even authorized to seek disgorgement remained an open, antecedent question that was not then before the Court. Given that the case was limited to addressing the applicability of a statute of limitations, the Court cautioned that “[n]othing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC enforcement proceedings or on whether courts have properly applied disgorgement principles in this context. The sole question presented in this case is whether disgorgement, as applied in SEC enforcement actions, is subject to § 2462’s limitations period.”[7]
That footnote cast doubt on the SEC’s authority under the Exchange Act to obtain disgorgement in district court actions. And, when the Supreme Court later decided to hear a case that directly challenged the SEC’s authority to obtain disgorgement, many were concerned that the Court would hold that disgorgement was not authorized by the Exchange Act.
In Liu, however, the Supreme Court held that disgorgement was a permissible “equitable remedy” under Exchange Act Section 21(d)(5), so long as the disgorgement award “does not exceed a wrongdoer’s net profits and is awarded for victims.”[8] The Court reasoned that when the Exchange Act authorized “any equitable relief that may be appropriate or necessary for the benefit of investors,” Congress incorporated longstanding equitable principles that prevented an equitable remedy from being transformed into a punitive sanction. The Court identified three limitations that, when observed, made a disgorgement award an equitable remedy:
In general, disgorgement of a defendant’s gains should be returned to wronged investors for their benefit, not simply deposited with the Treasury.
Disgorgement is available only for the profits that accrued to wrongdoers themselves and not to another party.
Disgorgement is limited to a party’s “unjust enrichment,” so awards generally must deduct legitimate business expenses so that the total award does not exceed a wrongdoer’s net profits.[9]
How these three limitations should be put into practice has vexed the SEC and defense attorneys since Liu was decided in June 2020. The Liu opinion has, seemingly, left the SEC reluctant to seek disgorgement in many cases.
The NDAA’s Amendments to the Exchange Act
Section 6501 of the NDAA directly and broadly addresses disgorgement in two ways. First, it amends Section 21(d) of the Exchange Act so that the provision now explicitly provides the SEC with authority to seek (and provides courts with authority to order) disgorgement “of any unjust enrichment by the person who received such unjust enrichment as a result of such violation . . . in any action or proceeding brought by the Commission under any provision of the securities laws.” Second, Section 6501 provides that the statute of limitations for disgorgement is generally five years but is extended to 10 years for violations of the securities laws “for which scienter must be established.” And in another subsection, Congress also expanded the statute of limitations to 10 years for “any equitable remedy, including for an injunction or for a bar, suspension, or cease and desist order,” without the need to establish scienter.
History of NDAA Section 6501
Section 6501 was inserted into the Conference Report on the NDAA (H.R.6395) on December 3, 2020, without any Congressional debate or discussion. The subject matter of Section 6501 was obviously far afield from the NDAA, so the technical statutory language in that provision had to come from somewhere else. Section 6501’s sources are three prior bills introduced in Congress well before Liu was decided.
In March 2019 (after Kokesh but before the petition for certiorari in Liu was even filed), the Securities Fraud Enforcement and Investor Compensation Act of 2019 (S.799) was introduced in the Senate. That bill would have amended Exchange Act Section 21(d) to expressly authorize the SEC to obtain disgorgement for unjust enrichment. It also would have established a five-year statute of limitations for disgorgement and a 10-year statute of limitations for equitable remedies.
In September 2019 (while the petition for certiorari in Liu was pending but not yet granted), the Investor Protection and Capital Markets Fairness Act (H.R.4344) was introduced in the House. This different bill also would have amended Exchange Act Section 21(d) to authorize disgorgement in any SEC action or proceeding. And it would have made 28 U.S.C. § 2462 inapplicable to disgorgement, though it did not specify another statute of limitations.
A few days later, the Improving Laundering Laws and Increasing Comprehensive Information Tracking of Criminal Activity in Shell Holdings Act (S.2563) was introduced in the Senate. That bill had a number of provisions unrelated to the Exchange Act, but Sections 501 and 502 of S.2563 incorporated S.799 in its entirety, with only a few changes. The only material change to S.799 in S.2563 would have been an extension of the statute of limitations for equitable remedies from 10 years to 12. The bill expressly would have applied only to actions or proceedings commenced on or after the date of enactment.
These three predecessor bills (S.799, H.R.4344, and S.2563) were all plainly focused on Kokesh, and in particular, the Supreme Court’s holding that disgorgement was subject to a five-year statute of limitations and the question raised by footnote three as to whether the SEC was even authorized to seek disgorgement.
On November 18, 2019 (shortly after the petition for certiorari in Liu had been granted), the House took up an amended version of H.R.4344. That version of the bill would have amended Section 21(d) of the Exchange Act as before, only now it would have created a 14-year statute of limitations for disgorgement, and it would have expressly applied the amendments to Section 21(d) retroactively (with the same language ultimately enacted in NDAA Section 6501). In the limited floor debate on H.R.4344, members continued to focus on expanding the statute of limitations, to abrogate Kokesh’s holding. In a comment that was representative of the floor debate, one member characterized the bill as follows: “This bill is the result of the Supreme Court’s Kokesh decision, which restricted the SEC’s disgorgement authority to five years [and the] concern that a five-year statute of limitations allows bad actors to hold on to their ill-gotten gains obtained outside that five-year window.”[10] Other members also raised concerns that the footnote in Kokesh and the Court’s decision to hear Liu meant that the Supreme Court could “remove any disgorgement action from the SEC, absent further action by Congress.”[11] Members made it clear that the purpose of the provision was not to address the contours of the Commission’s disgorgement authority, but to simply “clarify[] that the SEC does indeed have disgorgement authority.”[12]
None of these three predecessor bills were ever taken up in the Senate. That might have been the end of the matter, until Section 6501 was slipped into the Conference Report on the Defense Bill.[13] The language of Section 6501 was largely derived from S.2563, though it incorporated the retroactivity provision originally approved by the House in H.R.4344.
In summary, the legislative history suggests that the only purpose of Section 6501 was to respond to the Supreme Court’s decision in Kokesh by giving the SEC express authority to seek disgorgement and by lengthening the applicable statute of limitations. The statutory language in Section 6501 had nothing to do with Court’s decision Liu—indeed, it couldn’t have, because that language was crafted and debated many months before the Supreme Court issued its opinion in Liu. The language of amended Section 21(d) was never meant to respond Liu.
Textual Analysis of Amended Section 21(d)
Of course, just because Congress apparently didn’t intend to abrogate Liu doesn’t mean that Section 6501 didn’t effect substantive changes. The legislative history may be interesting, but the interpretation of a statute begins (and often ends) with the text.[14] Applying ordinary principles of statutory interpretation to Section 6501 reveals that, contrary to some suggestions, the disgorgement remedy Congress has now authorized likely embraces some of Liu’s important limitations on the SEC’s disgorgement authority.
Section 21(d), as amended, does not simply authorize “disgorgement.” Rather, it provides a more limited grant of authority to obtain disgorgement only “of unjust enrichment.” “Unjust enrichment” is undefined, but it is a familiar principle. Indeed, the concept was the foundation of the Supreme Court’s interpretation in Liu regarding what funds could be disgorged. As the Court explained, “unjust enrichment” had long been understood to be a “profit-based measure” that was “tethered to a wrongdoer’s net unlawful profits.” Congress is presumed to be familiar with the meaning of common legal terms and Supreme Court decisions when it legislates,[15] so its decision to limit disgorgement orders to “unjust enrichment” should be seen as embracing, not rejecting, that portion of Liu. Moreover, Congress chose the term “disgorgement”—which is of relatively recent vintage—instead of “restitution,” which has a longer history in decided cases. That decision should not be considered inadvertent, and it is consistent with the provision’s focus on unjust gains instead of the victim’s losses.
Section 6501’s text also confirms Congress’s intent that the right target of a disgorgement order is “the person who received such unjust enrichment as a result of such violation.” That approach is different from the approach the SEC and some lower courts had taken before Liu. As the Supreme Court explained, courts often imposed “disgorgement liability on a wrongdoer for benefits that accrue to his affiliates, sometimes through joint-and-several liability.” When Liu was decided, that broad approach was “seemingly at odds with the common-law rule requiring individual liability for wrongful profits.” And now, that broad approach appears to likewise be at odds with Section 21(d), as amended.
This is not to say that the statutory disgorgement authorized by Congress in Section 6501 is identical to the equitable disgorgement addressed in Liu. One key difference is that, while the disgorgement discussed in Liu is a type of equitable relief, in Section 6501 Congress textually distinguished the new disgorgement remedy and “any equitable remedy.” One consequence of this distinction is that the other limitations on equitable disgorgement that are not mirrored by Section 6501—such as the requirement to generally return disgorged funds to victims instead of depositing them in the Treasury—probably do not apply. Thus, the SEC may have more freedom to deposit funds with the Treasury now instead of returning them to victims, as Liu generally requires for equitable disgorgement. That result also addresses the practical concern, voiced by the SEC, that in many instances it may be nearly impossible to return funds to an identified group of victims.
Conclusion
There can be little doubt that NDAA Section 6501 substantially changes the SEC’s ability to obtain disgorgement in enforcement actions. But, contrary to some suggestions, the Commission’s new statutory disgorgement remedy seems to be subject to many of the same limitations recognized by the Supreme Court in Liu.
[6] Congressional Record at H8930 (Nov. 18, 2019) (“The Supreme Court further hinted, in an obscure footnote, that the SEC may not be able to seek disgorgement of ill-gotten gains at all.”).
[7]Kokesh v. Sec. & Exch. Comm’n, 137 S. Ct. 1635, 1642 n.3 (2017).
[8]Liu et al. v. Sec. & Exch. Comm’n, 140 S. Ct. 1936, 1940 (2020).
[13] H. Rept. 116-617, William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021, Conference Report to Accompany H.R.6395 at 1267–68 (Dec. 3, 2020).
[14]See, e.g., Octane Fitness, LLC v. ICON Health & Fitness, Inc., 572 U. S. 545, 553 (2014).
[15]See, e.g., Hall v. Hall, 138 S. Ct. 1118, 1128 (2018).
The COVID-19 pandemic is a triple threat to state and local solvency.
State and local governments must spend increasing amounts to save their citizens’ health and welfare through emergency treatment, testing, tracking, and unemployment insurance. The COVID-19 lock down cut retail sales, road tolls, and mass transit fares dramatically and immediately, putting budgets under immediate pressure. The Center on Budget Priorities estimated that state budget shortfalls will total $615 billion for the fiscal year ending (for most states) on June 30, 2020. Finally, a decrease in interest rates will increase pension plan liabilities (and annual funding requirements) for states with already challenged pension plans.
Thus, financial pressure on state and local governments is escalating at the same time the Bankruptcy Code is malfunctioning in Puerto Rico’s insolvency proceedings.
State and local governments with low credit ratings may obtain credit by pledging tax and other revenues, including what the Bankruptcy Code calls “special revenues”:
receipts from systems providing transportation, utility, or other services;
special excise taxes on particular activities or transactions;
incremental tax receipts from an area benefiting from tax-increment financing;
other revenues or receipts from particular functions; or
taxes specifically levied to finance one or more projects or systems, excluding general property, income, or sales taxes used for general purposes.
Chapter 9 of the Bankruptcy Code contains protections for bonds secured by pledges of special revenues. Section 928(a) provides that special revenues received during and after a municipal bankruptcy remain subject to a prebankruptcy pledge, subject to the “necessary operating expenses” of “the project or system” under section 928(b). Section 922(d) provides that the automatic stay does not operate as a stay of “application” of pledged special revenues under section 927.
These sections had been widely understood to assure revenue bondholders that they would continue to be paid from pledged special revenues during a chapter 9 case except to the extent pledged revenues were required to fund “necessary operating expenses.” The U.S. Court of Appeals for the First Circuit destroyed that understanding in Assured Guaranty Corp. v. Carrion, 919 F.3d 121 (1st Cir. 2019), a case under the Puerto Rico Oversight Management and Security Act of 2016 (PROMESA).
PROMESA Section 305 (a virtual copy of Bankruptcy Code Section 904) provides that the court may not interfere with any property or revenues of a municipal debtor. The First Circuit therefore held that the statute did not require the municipality to continue to pay pledged special revenues to bondholders; it only permitted the municipality to do so. The First Circuit reaffirmed that holding in a published decision denying en banc review over Judge Lynch’s dissent. 931 F.3d 111 (1st Cir. 2019).
Assured v. Carrion turned the statute from a straightforward assurance of during-the-case-payment into an incoherent, almost unenforceable mess.
As noted, a pre-petition pledge of special revenues continues to attach to post-petition revenues. However, the First Circuit holds that the bankruptcy court cannot enforce that pledge under section 904; thus, the debtor can just spend special revenues regardless of a bondholder pledge unless:
the bankruptcy court lifts the automatic stay for lack of adequate protection under section 362(d)(1), as it must (931 F.3d at 918); and
the bondholders get an injunction from a nonbankruptcy court to enforce their pledge.
However, then the bondholders’ pledge is subject to “necessary operating expenses” under section 928(b), which must be determined by the bankruptcy court, not the court enforcing the pledge.
Even if the bankruptcy court’s decision on adequate protection determines the amount of special revenues needed for operating expenses, that decision is good for that day only—operating expenses fluctuate. In the First Circuit, then, the bankruptcy court determining how to enforce a pledge of special revenues cannot enforce the pledge, and the court enforcing the pledge of special revenues cannot determine how to enforce the pledge.
None of this makes any sense.
Congress should amend chapter 9 to ensure that no future court adopts the misinterpretation of the First Circuit, and it should do so before that misinterpretation damages governments’ ability to issue revenue bonds at a time of financial crisis.
On December 24, 2020, after four years of extensive negotiations, the European Union (EU) and the United Kingdom (UK) reached an agreement in principle on a EU-U.K. Trade and Cooperation Agreement in an eleventh hour effort to avoid a “no-deal Brexit.” The UK had departed the EU in January 2020 following conclusion of the Withdrawal Agreement.[1] The Withdrawal Agreement included an 11-month transition period, during which the UK agreed to continue to apply EU law and procedure, and, except for participation in EU institutions and governance, the EU continued to treat the UK as if were a member state (and not as a third country). The transition period, which expired on December 31, 2020, was intended to give the UK and EU time to negotiate a framework for future cooperation.
If, as seemed likely as recently as early December 2020, no acceptable[2] trade agreement were concluded by the deadline at year-end, then the U.K. and the EU would have had to fall back on default World Trade Organization (WTO) rules[3] to manage their economic ties. With respect to goods, this would have led to imposition of fresh tariffs and a variety of border controls and new customs duties entering into force on January 1, 2021. Based on prevailing terms, exports from the EU to the UK would have been subject to an average 3.1 percent tariffs and 1.4 percent “nontariff barriers.” There would also have been 3.3 percent tariffs on goods going from the UK into the EU and the European Economic Area (EEA).[4] The major impact, however, would have been felt on cars and agricultural goods, which would have been subject to 10 percent more, and dairy products, which would have been subject to an additional 36 percent.
In connection with legal services in a no-deal Brexit, from and after January 1, 2021 the EU regulatory framework allowing UK law firms and lawyers to provide services and/or establish and practice in EU member states would simply have evaporated. Instead of being subject to a single EU-wide legal framework, UK lawyers and law firms would be subject to myriad rules and regulations in each of the 27 EU member states and ultimately would only be entitled to those rights granted by the national regulators in those states to “third country” (i.e., non-EU) lawyers.
From the EU’s perspective, the free trade agreement (FTA) with the UK was the most important agreement they had to negotiate. Their hope was to use the EU-Japan and EU-Canada FTAs as models. The European Commission would also address the ability of individual EU member states to reach bilateral agreements with the UK.
Notwithstanding negative prognostications in the media, negotiation of a UK-EU Trade and Cooperation Agreement (the “Agreement”) was successfully concluded, to much fanfare and jubilation, on Christmas Eve. The representatives of the EU member states have agreed to provisional application of the Agreement beginning January 1, 2021, but, in order to have long-term binding status, the Agreement must be ratified by the Council of the EU, the European Parliament and the U.K. Parliament.
Some “Cheerful Facts”[5] About Lawyering in the UK
Three separate jurisdictions comprise the UK — England and Wales (jointly), Scotland, and Northern Ireland — each of which divides the practice of law between solicitors and barristers (the latter known in Scotland as “advocates”). Regulation of the legal profession is likewise subdivided:
Foreign lawyers (including U.S. lawyers) practicing in the UK are required to register in some capacity with only one of these authorities (known as “competent authorities”), though it is permissible to register with more than one provided they regulate the same group (either solicitors or barristers/advocates). One cannot, however, be registered simultaneously with one of the bodies regulating solicitors and one of the bodies regulating barristers. Upon registering with a competent authority, a foreign lawyer acquires rights of practice similar to that legal profession in that jurisdiction (including the right to do the work reserved to the local profession, subject to certain restrictions in specified proceedings); likewise, the foreign lawyer becomes subject to the rules, regulation, and discipline of that competent authority.
Thus a U.S., European,[6] or other non-UK lawyer wishing to practice transactional or regulatory law in London would likely want to register with the SRA. Were that lawyer to register, instead, with the Law Society of Scotland, he or she would only be able to perform the subset of legal work that Scottish solicitors are permitted to do in England and Wales.
When the UK was part of the EU, a number of community-wide directives, layered atop the Legal Services Act 2007 (LSA)[7] and the SRA’s implementing standards and regulations, applied to British regulation of EU lawyers practicing in the U.K. These edicts included:
(2) the Lawyers’ Establishment Directive,[8] prescribing the rights of lawyers who, in general, (A) are licensed in a member state of the EU, (B) are EU nationals, and (C) comply with the requirements for practicing in the UK[9] on a permanent basis under their home professional title (e.g., a Rechtsanwalt in Austria, an avocat in France, a Δικηγόρος in Greece).
Similarly, UK lawyers who practiced in EU member states enjoyed an array of privileges, including the authority to:
establish themselves under home title in any member state;
provide advice in both home and host country law;
provide advice on EU law;
provide temporary cross-border legal services, without the need to register with the host country’s bar; and
be admitted as a lawyer in another member state, either by practicing that country’s local law (including EU law) for three years or by passing prescribed examinations, without ever establishing themselves in the other state.
Note that this congeries of practice authorizations for foreign lawyers was far broader than is available to UK lawyers in any other jurisdiction, including the United States.
All of that changed with Brexit.
The U.K. – EU Trade and Cooperation Agreement
The Agreement is complex. A summary of the Agreement prepared by Her Majesty’s Government (HMG) itself runs to 34 pages. The majority of the Agreement focuses on trade in goods, even though approximately 80 percent of Britain’s economy is based on services.[10] Judging solely by the numbers of pages involved in comparison to the total length of the Agreement, it appears that only 5 percent of the provisions dealt with trade in services. Nevertheless, a few services were accorded specific attention, and trade in legal services was one of those[11] – the only profession to merit such recognition.[12]
HMG listed this in its internal scorecard — which was publicly released just prior to finalization of the Agreement — as a victory. It is, however, the only victory on that scorecard accompanied by a footnote, and if one takes the time to pore through the document and construe the footnote, one discovers that the text giveth and the footnote taketh away.
The Agreement does not create anything more than an exoskeleton, or framework, for potential mutual recognition of professional qualifications. Similarly, there is nothing in the Agreement that would provide for the mutual recognition of court judgments. This framework, which is modeled after the EU-Canada FTA, may be elaborated in more detail in the future.
Likewise the Agreement does not provide for any harmonized, EU-wide right for UK lawyers to practice law. Rather, as of January 1, 2021, UK practitioners, like lawyers from any other non-EU country, are subject to 27 different regulatory regimes, each determining how third-country lawyers may practice within the particular jurisdiction and each with its own set of rights, obligations, and restrictions. Section 7 of Title II, Chapter 5 in Part Two of the Agreement sets forth a basic right for UK solicitors to offer in an EU member state professional services relating to their home jurisdiction law (i.e., UK law) and public international law but excluding EU law, subject to the vagaries of individualized restrictions in the aforementioned 27 regulatory regimes. Thus, as a result of Brexit, UK lawyers have lost the ability in EU member states to advise on host state law and EU law. Furthermore, those lawyers will be subject to domestic restrictions (set out in the annex to the Agreement) did not apply previously.
In short, with respect to substantive law practice, the Agreement provisions themselves do not confer anything that would not likely have been the default regulatory regime in a no-deal Brexit, to wit: the General Agreement on Trade in Services (the “GATS”).
In terms of cross-border practice, the Agreement does constitute some improvement over the default rules of the GATS with respect to independent professionals, short-term business visitors, and intra-corporate transferees. Nevertheless, the annexes refer to the ability of the 27 member states to adopt “non-conforming measures,” which might encompass a number of individualized requirements such as visas, working permits, or even economic tests.
Thus, depending on the local regulations in the countries in which a U.K. lawyer or law firm operates, an array of challenges is likely to present itself, including:
Restrictions on providing services in EU member states on a temporary basis using home state qualification (“Fly in – Fly out” or “FIFO”).
Restrictions on use of the UK limited liability partnership (LLP) structure.
Loss of rights of audience[13] before the EU courts, unless a UK lawyer independently holds alternative EU/EEA (but not Swiss) qualifications.
Restrictions on practicing with, or sharing profits or equity with, non-EU lawyers.
Loss of the protection of the EU legal professional privilege[14] in front of EU courts and other EU institutions for communications between UK-qualified lawyers and their clients (other than for non-in-house[15] UK lawyers who have requalified as EEA lawyers).
One of the key challenges for UK law firms is structuring their international practices. As a result of Brexit, the UK is now considered a third country, which means that mutual recognition has gone by the wayside and the LLP form of business organization, common to many law firms, will no longer be honored in the EU. This inconvenience may necessitate restructuring (such as by relocating an LLP’s headquarters or converting EU offices into local partnerships or subsidiaries). Some London firms appear to have activated some of those contingency plans in advance by restructuring their LLP operations in Germany.
Following the Brexit vote, solicitors in England and Wales sought an end run around some of these issues by joining the roll of the Law Society of Ireland.[16] By becoming registered, and dual-qualified, in Ireland, UK-based lawyers and their firms hoped to be able to retain the protection of the legal professional privilege, rights of audience, ability to practice in EU countries, and FIFO rights.[17] This maneuver was sometimes referred to as the “Irish backdoor.” In November 2020, however, the Irish backdoor was firmly shut when the Law Society of Ireland announced that “only solicitors who are practising (or intending to practise) in Ireland from an establishment in Ireland will be provided with practicing certificates.” Eliminating that strategem may well lead to more UK law firms establishing offices in Ireland solely in order to avail themselves of EU practice benefits.
The French government has been more accommodating with respect to the LLP structure. According to the website of the Law Society of England and Wales, in December (i.e., prior to the Agreement), France enacted an Ordinance grandfathering the rights to practice of law firms operating in France as branches of UK LLPs. The Ordinance confirmed that even though a LLP would not be recognized as a valid legal structure in France, UK law firms that had previously established LLP branch structures in France under the EU Lawyers Establishment Directive would be permitted to continue operating using their existing structure after January 1, 2021[18] and this was so irrespective of the outcome of trade negotiations between the UK and the EU.
It will be interesting to see not only how the UK and the EU understandings about lawyer licensing are fleshed out in the coming months but also whether other EU member states enter into bilateral agreements with the UK that affect trade in legal services.
[1] Officially titled “Agreement on the withdrawal of the United Kingdom of Great Britain and Northern Ireland from the European Union and the European Atomic Energy Community [Euratom],” the Withdrawal Agreement is a treaty prescribing the terms of the U.K.’s withdrawal from the EU and Euratom. This treaty was a renegotiated version of an agreement that had on three occasions been rejected by the House of Commons, which led to Queen Elizabeth II’s acceptance in July 2019 of the resignation of Theresa May as Prime Minister and the accession to that post of Boris Johnson.
[2]Press accounts attributed to EU diplomats the belief that the U.K. is trying to gain an unfair advantage by asking for a zero-quota, zero-tariff deal.
[3]E.g., the General Agreement on Tariffs and Trade (GATT), which actually was the progenitor of the WTO.
[4] The EEA is a free-trade zone created in 1994 and is composed of the EU member states together with Iceland, Norway, and Liechtenstein.
[5] With apologies to “I Am the Very Model of a Modern Major General” from W.S. Gilbert & A. Sullivan, The Pirates of Penzance (1879).
[6] “European” refers to countries in what has traditionally been referred to as the “Continent,” regardless of whether they are members of the EU. Lawyers hailing from one of the 27 (at current count) EU member states will be specifically referred herein to as “EU lawyers”).
[7] Enacted by Parliament in 2007 to liberalize and regulate the market for legal services, the LSA encouraged more competition and established a new mechanism for complaints by consumers of legal services. Section 1 of the LSA identified eight regulatory objectives: (1) protecting and promoting the public interest; (2) supporting the constitutional principle of the rule of law; (3) improving access to justice; (4) protecting and promoting the interests of consumers of legal services; (5) promoting competition in the provision of legal services; (6) encouraging an independent, strong, diverse, and effective legal profession; (7) increasing public understanding of the legal rights and duties of the citizenry; and (8) promoting and maintaining adherence to a set of professional principles. The latter encompassed, inter alia, acting with independence and integrity, maintaining proper standards of work, acting in clients’ best interests, and preserving client confidentiality.
[8] Directive 98/5/EC of the European Parliament and of the Council of 16 February 1998 to facilitate practice of the profession of lawyer on a permanent basis in a Member State other than that in which the qualification was obtained.
[9] For EU purposes, the UK constituted one member state, so the Directive did not affect transfers between Scotland, Northern Ireland, and England and Wales.
[10] Topics such as fisheries were apparently major bones of contention.
[11] The others were delivery, telecommunications, international maritime transport, and financial services.
[12] Considerable lobbying of HMG was done, it must be acknowledged, by the Law Society of England and Wales, with the backing of the Ministry of Justice.
[13] In the terminology of English law, a “right of audience” is akin to what is referred to in the United States as admission to practice before a particular court.
[14] The EU incarnation of this privilege has some similarities, but is not identical, to the attorney-client privilege. The scope of the EU legal professional privilege concerns communications relating to a Commission administrative or enforcement procedure. It does not concern a company’s right to withhold privileged documents from private parties or relate to other governmental authorities.
[15] The 2010 decision of the European Court of Justice in Akzo Nobel Chemicals Ltd. and Akcros Chemicals Ltd. v. Commission held that the privilege cannot be claimed with respect to communications between company employees and in-house lawyers.
[17] As the only English speaking common law jurisdiction left in the EU, Ireland has emerged as an important location for UK and other firms post Brexit.
[18] This grandfathering only applies to existing law firm structures. From and after January 1, 2021, it is no longer possible for a firm to establish a new branch of a UK LLP in France. Moreover, existing firms grandfathered under the Ordinance are not permitted to increase or transfer the ownership interest and/or voting rights held by UK entities and/or UK individuals in the branch structure after January 1.
On December 8, 2020, the Commodity Futures Trading Commission (“CFTC”) approved a major overhaul of its Part 190 regulations governing commodity broker bankruptcy cases.[1] The ABA played a lead role in proposing and fostering these rule changes, and the ABA Part 190 Subcommittee was honored with the CFTC “Chairman’s Award for Regulatory Excellence” by CFTC Chairman Tarbert.
Background.
A special liquidation subchapter of the Bankruptcy Code (subchapter IV of chapter 7), and the Part 190 regulations promulgated by the CFTC, apply to the bankruptcy of a U.S. futures commission merchant (“FCM”) or derivatives clearing organization (“DCO”). Unlike regulated U.S. securities markets, there is no customer account insurance program covering participants in U.S. derivatives markets. As a result, segregation of customer property is the hallmark protection for commodity broker customers. The CFTC’s Part 190 regulations, which largely rely upon and complement the segregation framework, are of paramount importance both for protecting customer property and reducing the potential systemic impact of a commodity broker insolvency.
In the aftermath of three high-profile FCM bankruptcies, MF Global,[2]Peregrine Financial Group,[3] and Sentinel Management Group,[4] the CFTC implemented a number of rules in the general regulations under the Commodity Exchange Act to improve customer protection. Among others:
The CFTC formalized an FCM’s obligation to deposit funds into segregation to cover customer debit balances,[5] and required an FCM to cover undermargined amounts in customer accounts and establish “targeted residual interest” amounts of excess funds they will maintain in segregation. It also imposed restrictions on an FCM’s ability to withdraw more than 25% of its residual interest without specified approvals.[6]
The CFTC made extensive rule changes related to risk management, audit and financial reporting standards, capital charge grace periods, and depository institution acknowledgement forms.[7] These included rules requiring that any custodian holding customer property must agree to provide the CFTC and industry self-regulatory organizations with direct, daily access to view customer segregated account balance information.[8]
To address problems identified during MF Global pertaining to MF Global’s use of affiliated foreign carrying broker accounts, the CFTC limited the ability of an FCM to opt out of foreign segregation schemes, and limited the amount of customer property that can be held in foreign accounts to only the amounts necessary to meet margin requirements, plus a small buffer.[9]
In response to MF Global complications related to customer account transfers,[10] the CFTC rules now require a DCO to collect margin on a “gross” basis from clearing member FCMs.[11]
In response to bankruptcies where the scope of permitted investments was perceived to have contributed to excessive risk-taking, the CFTC imposed strict limits on the types of investments in which an FCM could invest their customer’s funds (an FCM is the derivatives equivalent of a securities broker-dealer), eliminated credit rating-based investment criteria, and prohibited the use of so-called “internal” repurchase transactions.[12]
These rule changes were critical to restoring customer and industry confidence. The Part 190 regulations are also important for customer protection and instilling confidence, as they address the other side of the coin: how customers are protected if their commodity broker fails. However, the Part 190 regulations had remained largely unchanged since they were promulgated in 1983 – when cleared derivatives markets were far less diversified and long before the advent of electronic trading, email, and nearly continuous 24-hour markets – and needed to be modernized.
ABA Part 190 Subcommittee.
In February 2015, the ABA Derivatives and Futures Law and Business Bankruptcy committees jointly formed the ABA Part 190 Subcommittee. The subcommittee included over 45 member attorneys who work extensively in the areas of derivatives law, bankruptcy law, or both. Members included in-house counsel at DCOs, as well as representatives from several regulatory organizations and U.S. government agencies, and counsel for the trustees in the MF Global, Peregrine, and Sentinel bankruptcy cases.
Following 2½ years of work, the ABA Part 190 Subcommittee submitted proposed model rules to the CFTC for consideration in September 2017. Following a multi-year effort that included follow-up consultation with the ABA subcommittee, the CFTC proposed a comprehensive set of revisions to Part 190 in April 2020. The CFTC unanimously approved the proposed rules for public comment at an April 14, 2020 open meeting during which CFTC leadership recognized the work of the ABA Part 190 Subcommittee. After receiving public comment (including a comment letter from the ABA Part 190 Subcommittee) and making additional changes, the CFTC unanimously approved final amendments to the Part 190 Regulations at its December 8, 2020 open meeting. The revisions will become effective 30 days after the adopting release for the rules is published in the Federal Register.[13] CFTC Chairman Tarbert honored the ABA Part 190 Subcommittee at the December 2020 open meeting with the CFTC’s “Chairman’s Award for Regulatory Excellence” recognizing its work and contributions to the Part 190 rulemaking effort.
The Part 190 Rule Changes.
The changes to CFTC Part 190 are comprehensive and overall received wide support from commenters. The rule changes reflect important themes such as enhancement of rule clarity and transparency, modernization, improvement of customer protections, and the establishment of a process for administering the liquidation of a DCO. The CFTC, adopting the recommendation of the ABA subcommittee, reorganized Part 190 into three subparts:
Subpart A contains general provisions applicable in all commodity broker bankruptcy cases. It explains the CFTC’s statutory authority to adopt the rules, the organization of Part 190, core concepts embodied in the Part 190 Rules, the scope of the Part 190 Rules, and rules of construction.
Subpart B contains extensive provisions specific to an FCM bankruptcy proceeding (every commodity broker bankruptcy to date has involved an FCM). The subpart B rules retain many basic concepts found in the current rules, including customer class and account class distinctions, pro rata distribution of customer property, and the priority of public customers over non-public customers. New subpart B contains additional important changes to enhance customer protection and modernize the rules. Although the specifics of the rule changes are well beyond the scope of this article, the changes include (among others):
a more customer-friendly template for the proof of claim form;
recognition that hedge positions will likely be treated the same as other commodity contract positions;
clarifications regarding the treatment of customer-posted letters of credit;
an expansion of the definition of customer property to include the residual interest that an FCM is required to maintain in segregation under CFTC rules;
detailed rules concerning delivery accounts and for completing deliveries under commodity contracts that move into a delivery position before they can be liquidated;
rules governing transfers of customer accounts and property to other FCMs;
rules governing partial transfers or liquidations of customer positions; and
updated rules detailing how customer claims are to be calculated.
Subpart C contains provisions that are specific to a bankruptcy proceeding in which the debtor is a DCO. They apply if a DCO becomes the subject of a liquidation proceeding under the Bankruptcy Code, and are also intended to provide guidance if the clearing organization were instead to become subject to an alternative orderly liquidation proceeding administered by the Federal Deposit Insurance Corporation.
Although no U.S. DCO has ever been the subject of a bankruptcy case, the new subpart C rules drew significant attention during the comment process given the importance of clearing to financial market stability and the substantial volume and diversity of cleared derivatives. Several factors have led to major increases in the volume of derivates that are centrally cleared, such as mandated clearing for certain swaps asset classes and available clearing for others, increased standardization of swaps transactions, and lower execution costs, among others.. The ability of a DCO to address and absorb an outsized swaps default has (fortunately) not been tested outside of simulations. There is continued debate around what role, if any, market participants should have in commenting on the recovery, resolution, or wind-down plans of a DCO.
Although the rule changes were comprehensive and received wide support, there are some open issues.
Issues to Address.
The rule changes do not fully address a lingering question about the CFTC’s authority to promulgate rules that provide – in the event of a customer property shortfall – that the debtor’s general assets are included within the scope of customer property, as that likely requires a legislative fix.[14] The CFTC Reauthorization Act of 2019 proposes to amend the Commodity Exchange Act to provide that all of the commodity broker’s general estate property may be included as customer property, to the extent of a customer property shortfall, and if enacted would resolve this question.[15]
The new rules also do not fully address the treatment of customer property held by an FCM outside of segregation, including property for commodity “deliveries” that is supplied by the customer more than 10 days prior to the delivery period. The CFTC has indicated it may consider rules to shore up the protection of unsegregated property associated with deliveries.
Conclusion.
The CFTC’s Part 190 revisions enjoyed wide support and represent a welcome modernization of the rules. The ABA Part 190 Subcommittee played an integral part in moving those rule changes to fruition. The continuing thoughtful attention of the CFTC, market participants, and ABA members practicing in the relevant areas of law is critical to the development of workable insolvency rules applicable to the ever-evolving derivatives marketplace.
[7] CFTC, Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78,776 (Dec. 19, 2011); CFTC, Enhancing Protections Afforded Customer Funds and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations; Final Rule, 78 Fed. Reg. 68,506 (Nov. 14, 2013) (“Enhancing Protections”).
[10] Even though the DCOs where MF Global was a member held sufficient margin calculated on an omnibus (i.e. net) basis, several DCOs did not hold sufficient customer margin to permit a transfer (or “porting”) of customer positions to other clearing members on a fully margined, customer-by-customer basis due to netting.
[12] CFTC, Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions, 76 Fed. Reg. 78,776 (Dec. 19, 2011); CFTC, Enhancing Protections Afforded Customer Funds and Customer Funds Held by Futures Commission Merchants and Derivatives Clearing Organizations; Final Rule, 78 Fed. Reg. 68,506 (Nov. 14, 2013).
[13] On January 20, 2021, the White House issued a “Regulatory Freeze Pending Review” memo ordering a freeze on all new rules until the new administration has an opportunity to review them. Although the memo is technically not applicable to the CFTC as an independent agency, the CFTC could follow it, which would negatively impact the timing of publication in the Federal Register. Even if delayed, however, the authors expect that the Part 190 revisions will ultimately be published without change, given the nature of the amendments and the CFTC Commissioner’s unanimous bipartisan approval of them.
[14]In reGriffin Trading Co., 245 B.R. 291 (Bankr. N.D. Ill. 2000), vacated as moot sub nom.Inskeep v. MeesPierson N.V. (In re Griffin Trading Co.), 270 B.R. 882 (N.D. Ill. 2001), the bankruptcy court found that the CFTC had exceeded its authority to regulate granted in the CEA and therefore that the regulation must be stricken.
[15]CFTC Reauthorization Act of 2019, H.R. 4895, 116th Cong. (2019). As of ^, 2021, Congress had not yet acted on this bill.
On December 8, 2020, the U.S. Supreme Court heard oral arguments in Facebook, Inc. v. Duguid, a case that should establish a nationwide standard for the “autodialer” definition adopted by the Telephone Consumer Protection Act (TCPA). The Court must resolve a split among federal appellate courts regarding that definition. While predicting the outcome of Supreme Court decisions based on oral argument is a risky venture, the likelihood of a decision in Facebook’s favor, with a narrower “autodialer” interpretation, seems greater than a decision supporting Duguid.
The U.S. Court of Appeals for the Ninth Circuit, the appellate court that issued the most recent opinion in Duguid, adopted an expansive view of the autodialer definition. According to this view, equipment can be regulated as an autodialer if it is capable of automatically dialing telephone numbers from a stored list, even in the absence of random or sequential telephone number generation. At least two other federal appellate courts have adopted this interpretation.
Three, and arguably four, federal appellate courts have adopted a narrow view of the autodialer definition, limiting it to equipment with the capacity to store or produce telephone numbers to be called, using a random or sequential number generator.
All federal appellate courts that have addressed this issue seem to agree that the TCPA’s autodialer definition is frustratingly imprecise. As a result, these courts, as well as the attorneys representing Facebook, Duguid, and the United States at oral argument, have had to channel their advocacy for one interpretation or another between a rock of grammatical rules and a hard place of congressional intent from 1991. The grammatical puzzle is whether the definition’s reference to random or sequential number generation applies to both the capacity to store telephone numbers and the capacity to produce them (the narrow interpretation, favoring defendants), or whether it applies only to the latter (the broad interpretation, favoring plaintiffs). At oral argument, both sides claimed to have grammar on their side.
The challenge regarding congressional intent from 30 years ago is to determine how to apply the TCPA to technology that no one in Congress at the time was contemplating, such as smartphones. Several justices signaled their sense that the TCPA had exhausted its useful life as a regulator of the everyday technology around telephone calls. At the same time, no justice offered a strong defense of the TCPA’s consumer privacy purpose.
The justices were clearly concerned about the prospect that the Ninth Circuit’s expansive autodialer interpretation could result in TCPA lawsuits arising from people’s routine smartphone use. Under the expansive approach, equipment can be regulated as an autodialer if it has the capacity to store numbers and dial them automatically. Justice Alito noted that this sounded like call-forwarding technology, while Justice Barrett made the more modern observation that iPhones come equipped with the ability to autoreply to calls when someone is driving or does not want to be disturbed.
Interestingly, Duguid was represented at oral argument by Bryan Garner, the co-author with Antonin Scalia of Reading Law: The Interpretation of Legal Texts, a popular book regarding statutory interpretation. This could be seen as an attempt to win over the Court’s bloc of justices who purport to be guided by a statute’s text above other considerations. Garner did his best to defend the expansive interpretation as the most sensible reading of the text, but he did not appear to have won over a majority of the Court. He had an even harder time convincing the Court that ordinary smartphone use would not attract TCPA lawsuits under the expansive view.
As noted at the outset of this article, we should all be cautious about guessing the outcome of Supreme Court decisions based on oral argument. Having said that, this article’s prediction is a majority opinion in Facebook’s favor, making the case that it is time to retire the TCPA and replace it with modernized standards regulating the way we communicate by phone today.
The COVID-19 pandemic has been a global shock to businesses everywhere. Uncertainty about its path, duration and magnitude has wreaked havoc on many of our commercial clients. The associated government-mandated shutdown orders have drastically impacted businesses’ ability to make timely rental payments.
The Bankruptcy Code does not generally allow debtors to unilaterally abate or modify the terms of their property leases. However, Congress may enact legislation amending the Bankruptcy Code in order to provide bankruptcy courts additional tools to offer rent relief to debtor-tenants. Congress enacted the Consolidated Appropriations Act, 2021 (“CAA”), an approximately $2.3 trillion omnibus appropriations bill, which was signed into law on December 27, 2020. The CAA not only funds the federal government, but also provides additional COVID-19 relief for businesses and individuals. Significantly, the CAA includes nine amendments to the Bankruptcy Code, three of which directly impact commercial debtor-tenants.
This article aims to educate business law practitioners on how their commercial clients can get much needed rent relief based on case law and/or these newly enacted amendments. First, we explore how courts have provided rent relief to commercial debtors based on:
a force majeure clause in a tenant’s lease,
temporary suspension of a bankruptcy case, or
equitable rent relief.
Next, we review how the CAA amends Bankruptcy Code sections 365(d)(3), 365(d)(4), and 547 to extend the deadlines to perform rental obligations, assume or reject a lease, and preclude preference claims with respect to certain payments of rental arrearages. The amendments to section 365(d)(3), allowing courts to extend the time for performance under a commercial lease, are limited to subchapter V small business debtors. The other two amendments apply to all debtors. All three amendments have a two-year sunset.
A. Courts Considering Rent Relief Based on Lease Terms and Bankruptcy Code
The Bankruptcy Code generally requires a debtor in bankruptcy to pay its rental obligations during the bankruptcy case. Notwithstanding this requirement, at least one court has relied upon a force majeure clause in a lease to offer rent abatement during bankruptcy. The Bankruptcy Court for the Northern District of Illinois in Hitz Restaurant Group found that the Illinois governor’s executive order limiting restaurant capacity triggered the lease’s force majeure clause.[1] The landlord had sought to enforce the obligation of the debtor to pay post-petition rent under section 365(d)(3) of the Bankruptcy Code. The debtor argued its obligation to pay post-petition rent was excused by the lease’s force majeure clause. The court agreed with the debtor in part, allowing a 75% rent abatement in proportion to the percentage of floor space restricted by the ban on dining at the restaurant. It is worth noting that while the specific lease at issue contained language offering potential for relief, other leases may not. The lease in Hitz Restaurant Group included “governmental action” and “orders of government” provisions in the force majeure clause. Moreover, other leases may explicitly exclude rent obligations from the scope of obligations excused by force majeure events. What do your clients’ leases say? Can you amend the lease to include favorable language?
Other courts have looked to the Bankruptcy Code to grant rent relief for debtor-tenants. Section 365(d)(3) of the bankruptcy code requires timely payment of post-petition rent, but allows courts to extend the time for performance, for cause, up to 60 days following the petition date.[2] Yet some bankruptcy courts have used Bankruptcy Code sections 105 and 305 to defer payment of post-petition rent beyond the first 60 days of the case.[3] In Modell’s Sporting Goods, the Bankruptcy Court for the District of New Jersey granted the debtors’ request to temporarily suspend the bankruptcy case, and defer rent payment, pursuant to sections 105(a) and 305(a).[4] The bankruptcy case commenced on March 11, 2020, and two days later, the COVID-19 pandemic was declared a national emergency.[5] The debtors subsequently requested an “Operational Suspension” of the bankruptcy case, including rent deferment, due to COVID-19-related disruptions to the planned liquidation sales of the debtors’ stores. The court found that it was in the best interest of the debtors and creditors to grant the requested relief. The court extended the suspension twice—it ultimately lasted until June 15, 2020—due to the continued impact of stay-at-home orders on the ability to conduct going-out-of-business sales. To what extent do the current COVID-19-related governmental orders impact the progression of your clients’ Chapter 11 cases?
Similarly, in Pier 1 Imports, the Bankruptcy Court for the Eastern District of Virginia granted the debtors’ request for a “breathing spell” to allow some debtor-tenants to defer rental payments pursuant to the court’s equitable power under section 105(a).[6] The court “recognize[d] the extraordinary nature of the relief,” but found that the court’s “broad equitable powers” allowed such relief, notwithstanding section 365(d)(3) requiring timely performance of rental obligations and the limits on bankruptcy courts’ equitable powers.[7] The court explained that “[d]eferring rental payments during an unprecedented financial crisis in order to provide a post-Petition Date ‘breathing spell’ for the Debtors is not inconsistent with similar relief the bankruptcy process otherwise provides for pre-Petition Date obligations.”
Notably, the Bankruptcy Court for the Southern District of Texas rejected similar arguments for rent relief. In CEC Entertainment, the court denied the debtors’ motion to abate or reduce their rent obligations, notwithstanding the impact of COVID-19 in curtailing the debtors’ ability to operate key aspects of its business (operating a nationwide chain of Chuck E. Cheese venues).[8] The court found nothing in the Bankruptcy Code nor in state law or the lease’s force majeure clauses permitting rent abatement. The CEC Entertainment court disagreed with Pier 1 Imports, explaining that it could not override section 365(d)(3)’s unambiguous requirement of timely performance of obligations under commercial leases. The court cited to Law v. Siegel, a United States Supreme Court opinion explaining that a bankruptcy court’s equitable powers under section 105(a) are limited by the express provisions of the bankruptcy code, and section 365(d)(3) “expressly prohibits delays beyond 60 days after the order for relief.”
B. The CAA Amends the Bankruptcy Code to Offer Rent Relief to Commercial Debtors
Some courts have found creative avenues in the Bankruptcy Code or force majeure clauses to offer rent relief to commercial debtor-tenants struggling as a result of the COVID-19 pandemic. Sometimes, however, creative lawyering will not work, as reflected by the recent CEC Entertainment decision finding that section 365(d)(3) limits bankruptcy courts’ flexibility in crafting rent relief beyond the first 60 days of a case. The recent enactment of the CAA, however, has expanded bankruptcy courts’ discretion to grant relief regarding commercial leases.
First, the CAA amends section 365(d)(3) to allow courts to extend the time for performance of lease obligations beyond the normal extension period, but only in a subchapter V case. Generally, a debtor operating in bankruptcy must timely perform all obligations under an unexpired lease of nonresidential real property.[9] Section 365(d)(3) allows a court to extend, for cause, the time for performance—but not beyond 60 days after the petition date. The CAA, however, extends the potential relief period by an additional 60 days—for a potential total of 120 days— only for certain small business debtors filing under subchapter V of Chapter 11.[10] Where a subchapter V debtor is experiencing or has experienced a material financial hardship due, directly or indirectly, to the COVID-19 pandemic, a court may extend the time for performance of commercial lease obligations for 60 days after the petition date. “What’s new” here is that the CAA allows courts to extend the relief period by an additional 60 days for subchapter V debtors if such a debtor continues to experience material financial hardship due, directly or indirectly, to the COVID-19 pandemic. Further, if an extension is granted for an obligation, the obligation is treated as an administrative expense that has priority for payment in bankruptcy.
Second, the CAA amends section 365(d)(4) to extend the initial deadline for any debtor-tenant—not just those filing under subchapter V—to assume or reject an unexpired lease of nonresidential real property by an additional 90 days to a total of 210 days after the petition date.[11] Section 365(d)(4)(B)(i) already allows the court to extend the deadline to assume or reject a lease, for cause, by an additional 90 days. Therefore, a debtor could potentially have as many as 300 days to decide whether to assume or reject an unexpired commercial lease without the consent of the landlord. Yet, the court may grant further extension upon written consent of the landlord. The CAA includes a two-year sunset after enactment, upon which the above amendments will be struck from the Bankruptcy Code on December 27, 2022. However, the amendments apply to all debtors who file under subchapter V of Chapter 11 prior to the sunset.
Additionally, the CAA aims to incentivize a distressed company’s landlords and vendors to offer flexible payment terms by amending the preference provisions of section 547 to provide that any “covered payment of rental arrearages” cannot be avoided as preferences.[12] “Covered payments” are defined as payments made pursuant to arrangements entered into between any debtor-tenant and their landlord on or after March 13, 2020 to defer or postpone payments owed under a lease; such arrangement may also include the debtor’s obligation to pay penalties or fees. This amendment also includes a two-year sunset, after which it will be struck on December 27, 2022. However, the amendment to section 547 applies in any bankruptcy case commenced prior to the sunset.
Commercial tenants that take advantage of the relief offered under the Bankruptcy Code should be aware that if they decide to assume a lease, they must cure all back rent. Section 365(b) generally requires that a debtor-tenant cure, or provide adequate assurance of prompt cure, of any default under the lease.
C. Conclusion
Recent decisions inform us how courts have been grappling with the Bankruptcy Code’s inflexibility with respect to leases of non-residential real property. The Consolidated Appropriations Act, 2021 offers a measure of relief to debtors experiencing COVID-19-related financial woes by enacting amendments to Bankruptcy Code provisions relating to the treatment of lease . Significantly, the CAA will likely give pause to bankruptcy courts who would otherwise emulate the Modell’s Sporting Goods and Pier 1 Imports courts’ use of sections 105(a) and 305(a) to defer commercial rent obligations beyond the first sixty days of bankruptcy—in contravention of 365(d)(3). By providing for specific and limited rent-deferment relief to commercial debtor-tenants affected by the COVID-19 pandemic, and by limiting the extended relief to subchapter V small business debtors, the CAA expresses Congress’s intent that 365(d)(3)’s requirements for timely fulfillment of rent obligations should otherwise be strictly complied with.
[1]In re Hitz Rest. Grp., 616 B.R. 374 (Bankr. N.D. Ill. 2020).
[3] 11 U.S.C. § 105(a) (allowing the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title”), § 305(a)(1) (allowing a court to “suspend all proceedings in a case” if “the interests of creditors and the debtor would be better served by such…suspension”).
[7]See Law v. Siegel, 571 U.S. 415, 421 (2014) (section 105(a) “does not allow the bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code”).
[10] Under the Small Business Reorganization Act (SBRA) of 2019, Pub. L. No. 11654, 133 Stat. 1079, small business debtors may elect to file under subchapter V of Chapter 11 of the bankruptcy code if their debt does not exceed $2,725,625. The debt limit was increased to $7,500,000 by the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020, Pub. L. No. 116-136, 134 Stat. 281 (effective March 27, 2020 for a period of one year).
We have been discussing the need for businesses to make public commitments to support equality, diversity, and inclusion (EDI).[1] These three related concepts are essential to a productive and happy workforce and a fair and just society for everyone. Equality comes from equal access to opportunities, free of discrimination. However, the full range of opportunities will only be available when there is respect for diversity and a willingness to include everyone in decisions regarding their lives. A related concept is social justice, which has been described as fair and just relations between an individual and society at large, as measured by the distribution of wealth opportunities for personal activity and social privileges.
Commitments are fine and necessary, but companies must do more by taking steps to embed EDI into their operations, decision making, and organizational culture and by making those values and norms part of the company’s DNA and the guiding principles for its employment policies and other business relationships. Changing the organizational culture is a difficult and challenging process that requires patience and attention to all phases of a worker’s journey through the company and the company’s relationships with customers, suppliers, and the members of the communities in which the company operates. Some of the steps that need to be taken were suggested by the International Labour Organization, which provided guidance on developing a corporate nondiscrimination and equality policy[2]:
Make a strong commitment from the top by signaling that senior management assumes responsibility for equal employment issues and is committed to diversity, thus sending a strong message to other managers, supervisors, and workers.
Conduct an assessment to determine if discrimination is taking place within the organization.
Set up an organizational policy establishing clear procedures on nondiscrimination and equal opportunities and communicating the policy both internally and externally.
Provide training at all levels of the organization, in particular for those involved in recruitment and selection, as well as supervisors and managers, to help raise awareness and encourage people to take action against discrimination.
Support ongoing sensitization campaigns to combat stereotypes.
Set measurable goals and specific time frames to achieve objectives.
Monitor and quantify progress to identify exactly what improvements have been made.
Modify work organization and distribution of tasks as necessary to avoid negative effects on the treatment and advancement of particular groups of workers, including measures to allow workers to balance work and family responsibilities.
Ensure equal opportunity for skills development, including scheduling to allow maximum participation;
Address complaints, handle appeals, and provide recourse to employees in cases where discrimination is identified;
Encourage efforts in the community to build a climate of equal access to opportunities (e.g., adult education programs and the support of health and childcare services).
Set up bipartite bodies involving workers’ freely chosen representatives in order to determine priority areas and strategies, to counter bias in the workplace, and to ensure that all workers are committed to the organizational goals regarding diversity and nondiscrimination.
Iyer and Kirschenbaum noted that the EDI efforts of companies are often carried out separately from the business units that are primarily responsible for market expansion, the quality of customer service, or human resources. They encouraged companies to implement organizational structures and expectations of accountability that embedded EDI into operations, such as forming a permanent EDI working group or team with relevant experience and expertise drawn from throughout the company (e.g., engineers, data scientists, researchers, designers). They also suggested that companies focus exclusively on advancing inclusion and rooting out bias in key activities such as product design, marketing, and customer service. Similarly, hourly employees, women, and people of color need to be given a voice in the creation, implementation, and assessment of all employment-related processes. The working group created to develop the company’s commitments to action regarding racial equality and justice should also be involved in organizational change initiatives.[3]
Ideas about the composition of the EDI working group and the manner in which it carries out its responsibilities can be gleaned from Lee’s suggestions regarding the formation of a staff-led taskforce, working, or committee on EDI.[4] Lee’s first suggestion related to the composition of the group and the need to ensure that it includes a diverse team of employees so that discussions and actions will take into account the wide range of viewpoints throughout the workplace. Certainly, passion for EDI is an important qualification for serving within the group, and anyone who can bring that kind of energy to the issues should be considered. At the same time, an effort must be made to identify underrepresented groups and not only bring them on to the team but also consider why employees might be reluctant to participate. In addition to ensuring that the composition of the group is racially and ethnically diverse, there should be representation from all levels in the organizational hierarchy and from each of the key business groups or departments.
Another suggestion Lee offered was to establish clear goals, roles, and relationships in order to define the group’s scope of work and the way it operates internally and relates to those leaders with the authority to implement the group’s recommended actions. In general, members of the working group will still be expected to fulfill their regular day-to-day responsibilities, and so they will have only limited time to invest in the group’s activities. As such, consensus should be reached on which EDI issues are most pressing for the company. This process should begin with sharing stories and experiences with the members of the group, but the group should also go outside its own boundaries and seek input from other employees. Once the issues have been identified, the group needs to consider its internal and external capacities to do the work necessary to make an impact on each issue (e.g., are there members of the group with specific experience and skills that can be leveraged to develop effective solutions for an issue?) and make decisions about which issues the group can most influence.
Lee’s suggestions were focused on what would initially be a largely volunteer effort organized and supported by the company that depended on employees willing to commit time to the working group, in addition to their other duties to the company. In contrast, Iyer and Kirschenbaum called for companies to form a permanent, full-time EDI working group or team. This would mean that members would be pulled off their previous assignments and be required to spend all of their time working on EDI issues with experienced colleagues from other divisions of the company.[5] The decision depends on a variety of factors, notably the size of the company and the ability of the company to reallocate resources to a full-time group. It might be best to start with a voluntary group, properly staffed and operating with the explicit and public support of the company’s leaders, and then determine how best to integrate the EDI working group into the company’s permanent organizational structure. While having a full-time team working on EDI issues is useful, care must be taken to ensure that the team continues to work well with the relevant departments and business units and that steps are taken to embed EDI directly into those groups.
Racial equality in the workplace cannot be achieved unless and until everyone in the organization appreciates and respects the diverse experiences of their colleagues and understands that diversity and inclusion will lead to a stronger organizational culture, a vibrant working environment. and an engine for innovative products and services that will support a sustainable enterprise. Racial discrimination in the workplace is an extremely sensitive issue that sometimes requires painful personal introspection and difficult conversations. Nonetheless, business leaders need to understand that racism can and will damage their companies in a number of ways. Certainly, racial discrimination will expose the company to potential legal liabilities, but even more corrosive is the role racism can play in dividing the workforce and undermining morale, teamwork, and productivity. In addition, in a world in which news spreads quickly over social media, incidents of racial discrimination can instantly and permanently tarnish a company’s reputation and brand, causing it to lose customers and making it more difficult for the company to recruit, engage, and retain diverse talent.
Racial equity training involves tackling sensitive issues such as internalized racial stereotypes and “unconscious bias,” which may affect decisions made within organizations as well as employees’ communication with one another in the workplace. Training sessions should be set up in ways that promote open and safe discussions about racism. Research indicates that companies that are willing and able to facilitate dialogue succeed in building stronger bonds and greater understanding. It should be expected that white employees who are challenged on their race-related beliefs during the training sessions will act defensively, often expressing emotions such as fear, anger, and guilt. They may also have concerns about how proposed diversity and inclusivity actions might undermine their historical “white privilege” and the opportunities and access to resources they have been accustomed to. Concerns from all sides need to be aired, but debating should be avoided, and all employees, regardless of race, need to clearly understand what is at stake and what their lives in the workplace will be like once changes have been implemented. It is at this point that all employees need to be educated and reassured about the benefits to everyone in the company from setting aside inequitable practices.
Racial equity training alone will not guarantee success, but it is an essential tool for establishing and continuing dialogue. Certain elements of the training need to be mandatory in order to demonstrate that the company has taken steps to ensure that all employees are aware of both their duties under the law and the company’s own internal policies and codes of conduct. Participation in training may also be required by business partners who are generally anxious to avert reputational damage from any association with companies that fail to promote a diverse and inclusive workplace free from racial discrimination. According to the Society for Human Resource Management (SHRM), companies should offer additional training and opportunities for dialogue beyond the mandatory sessions. In addition, SHRM recommends not making attendance compulsory since people who do not want to be there will often undermine the value of the meetings by displaying hostile or defensive actions. The training sessions should be led by experienced facilitators and should begin with an explanation of the ground rules for discussions so that everyone feels comfortable sharing their experiences and opinions. SHRM encourages companies to make learning interactive and experiential, avoiding long lectures from someone in the front of the room at a podium and ensuring that everyone walks out of the room armed with practical steps that they can immediately begin using to overcome unconscious bias.[6]
[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, Emerging Companies Guide (3rd Edition) and Business and Human Rights: A Practitioner’s Guide for Legal Professionals. Alan is also currently a partner of GCA Law Partners LLP in Mountain View, California (www.gcalaw.com). More information about Alan and his work is available at his personal website at www.alangutterman.com. This article is adapted from the chapter on Racial Equality and Non-Discrimination, which was recently released on his website: https://alangutterman.com/wp-content/uploads/2020/07/EDI-_C1-Racial-Equality-and-Non-Discrimination.pdf.
Robert Dickie and Peter Russo’s book, Financial Statement Analysis and Business Valuation for the Practical Lawyer, Third Edition, guides lawyers through key principles of corporate finance and accounting with direction on how to analyze the income statement, balance sheet, and cash flow statements. The guide helps lawyers gain a working knowledge of financial concepts, terminology, and documents and an understanding of basic and advanced techniques of valuing companies.
This is the first in a series of articles intended to provide a working knowledge of financial statements, terms, and concepts, especially as that knowledge is useful in the practice of law. For business lawyers, the language of business is finance, and it pays to be equipped to understand the business dimension as well as the law.
There are three main financial statements—namely, the balance sheet, the income statement, and the cash flow statement. This article will discuss the balance sheet, also known as the statement of financial position. The balance sheet is a “snapshot” of a company’s position at a particular point in time. The report takes a simple approach: at any given moment, what you own (assets) less what you owe (liabilities) is what you are “worth” (shareholders’ equity). It’s important to note that “worth” for financial reporting purposes is very different from the market value of the company. Here, we simply mean worth from a reporting perspective.
Assets are economic resources available for use in the future. Liabilities are obligations to outsiders, and equity is the claim of the owners after the obligations. Expressed as an equation,
More simply, A – L = E. This equation can also be expressed as A = L + E; this is commonly referred to as the balance sheet equation. The balance sheet presents assets on one side, equal to liabilities and equity on the other. Another way to think about the balance sheet is that assets are what the company owns—the resources they have available to use in the future to run the company; liabilities and equity are where the money comes from to buy those resources.
Here is a summary version of IBM’s most recent year-end balance sheet.
Note the time stamp, “as of December 31, 2019.” As of the close of business on December 31, 2019, IBM froze its books to count up where it was. Also note that these numbers are presented in millions of dollars; the cash balance of $8,314 means $8.3 billion of cash.
Assets
Assets are the tangible and intangible resources owned by the company. Almost all asset values are based on the cost to acquire these assets, not the current value of the assets. This is obviously an important distinction and is why we can’t use the reported asset amounts to determine the value of a company. For example, if IBM purchased land 50 years ago for $1 million, it’s still on their balance sheet for that amount, even though today it may be worth exponentially more.
In addition to cash, IBM had other current and long-term assets, amounting to just over $150 billion in resources owned by the company at that point in time. On the bottom half of the balance sheet are the sources for the capital used to acquire and use those resources. A distinction is made between short-term (current) and long-term assets and liabilities; current assets are expected to become cash within the next 12 months, whereas current liabilities are expected to be satisfied within the same 12 months.
The most common short-term assets are cash (and cash equivalents), accounts receivable, and inventory. Typically, the most significant of the long-term assets are “property, plant and equipment” (also referred to as “fixed” assets), goodwill, and intangible assets. There may also be deferred tax assets if the company has paid a tax to the IRS but not yet reflected the expense under the accounting rules.
If a company has goodwill or intangible assets, it is most likely because it has made an acquisition, and the purchase price exceeded the fair market value of the acquired company’s “net assets” (defined as assets – liabilities). With a few exceptions, internally produced intellectual property does not appear on the balance sheet as an asset. Instead, the costs to create the intellectual property are included as expenses on the income statement.
This can be important. For example, a company’s balance sheet may report more liabilities than assets; however, it likely owns economic assets that are not reflected on its balance sheet. Coca Cola’s most valuable asset, for example, is its formula, but that is not on Coke’s balance sheet because the costs to develop it were long since expensed, and GAAP makes no attempt to reflect the fair value of assets.
Sidebar 1: Deferred Taxes
There can be differences between when a company reports taxes for accounting purposes and when it pays them to the IRS. For instance, current tax rules allow a company to depreciate an asset more rapidly on their tax return than they do on their financial statements. This means depreciation expense this year will be higher on the tax return, and taxable income will be less than accounting income, lowering the taxes due this year. This is a temporary difference in taxable income and accounting income; total depreciation expense is the same over the life of the asset, but is allocated differently over the years. This creates a deferred tax liability because expenses have been taken earlier for the tax computation and eventually will have to be paid. Conversely, if the company accrues a workmen’s compensation expense but has not yet made the payment and thus cannot yet deduct the sum on its tax return, then the expense on its income statement will be higher than the deduction on its tax return, and its tax liability will be greater than the tax paid to the IRS. This results in a deferred tax asset for accounting purposes.
It is most important to understand that GAAP accounting rules rely upon significant judgment by management in valuing assets. For example, there are two different methods to value accounts receivable, four different methods to value inventory, and six different methods to value fixed assets. Management is allowed to decide which methods it uses (note that management must consistently apply the method it chooses and can’t change methods year to year). In addition, these methods require estimates of such things as the collectability of receivables, the potential obsolescence of inventory, and the useful life of fixed assets. These are just examples of the inherent judgment involved in all assets, with the exception of cash.
When a company is struggling financially, it is most important to understand what the numbers mean and the context of how the numbers are determined. First, remember that the reported amount of the assets do not purport to be the current market values. Second, management may be so biased as to use the allowable judgment to overstate the value of an asset in order to meet a loan covenant, or understate expenses to improve profit.
In an economic crisis liquidity, the ready access to the cash needed to fund operations becomes a particularly important indicator of a company’s ability to survive. Is the company’s cash position deteriorating, and if so how quickly? Does it have additional sources of cash available? Are the assets really worth as much as the amount reflected on the balance sheet? In considering whether assets are shown at the lower of cost or market value, has management considered current market conditions? (See Sidebar 2.) Might the market value of its assets, less its liabilities, actually exceed the going concern value of the company? If so, should the company consider liquidating its assets and distributing the proceeds to its creditors and shareholders?
When performing due diligence, each asset should be looked at and probed. Have any values been impaired? Are all receivables collectible in the current economic environment? Is inventory all usable, or is obsolescence a concern? Even in the case of buildings, the market values may have declined if there are vacancies or the tenants can’t pay the rent.
Sidebar 2: The Value of an Asset Can Change with Context
During the second quarter of 2020, Delta Airlines recorded an “impairment” charge of almost $2.2 billion. U.S. GAAP requires that the reported dollar amount of an asset cannot exceed its estimated future value to the company. Delta reduced the value attributable to certain aircraft. According to the notes to its financial statements, this write-down reflected the company’s current plans for these aircraft in light of the impact of the COVID-19 pandemic. It’s important to note that this write-down did not imply that these aircraft were in any way damaged or obsolete. The lower value on their balance sheet simply reflects the current situation; they have less utility to the company under current conditions, and their liquidation value is probably impaired at this time as well. What management is doing here is exactly what GAAP requires.
At the same time, management says that it has evaluated the reported value of its goodwill and intangibles and has concluded that those values have not been impaired, meaning that they are worth at least what they are being carried at on the balance sheet. Note that management summarizes the impact of the pandemic on the financial condition and operations of the company in a single note to the financials. Any user of the financial statements would be well advised to read it carefully.
In a crisis, a key first step is to consider the company’s strategy and plans to survive the crisis and then examine the assets from the standpoint of their likely value under that scenario. At the risk of overstating it, the reported value of the assets on the balance sheet, both individually and collectively, should not be mistaken for their market values or their liquidation values in a time of crisis.
Liabilities
Liabilities are obligations of the business. This includes obligations to employees, customers, vendors, and lenders. These are separated into short-term (those due within one year) and long-term liabilities. Liabilities are generally of two types: (1) noninterest-bearing liabilities, and (2) debt, which bears interest and has a due date. The usual short-term liabilities are accounts payable (monies owed to vendors) and accrued liabilities (estimated liabilities). It also includes any principal amounts on debt due in the next 12 months. If a company is in the enviable position of receiving cash from its customers before earning the revenue (like subscriptions paid in advance), the unearned or deferred revenue will be shown as a current liability. The most common long-term liabilities are long-term debt, deferred tax liabilities, lease obligations, and pension liabilities.
One issue that arises for all companies is “contingent” liabilities. These are liabilities that may inure to the company based on some underlying future event. For example, if a company is sued by a customer for a product liability claim, the company will be obligated only if they lose the lawsuit. In this case, the liability is not included on the balance sheet unless it is highly probable that the company will lose the lawsuit and the judgement can be reasonably estimated. Up to that point it may be required to disclose the potential liability in the footnotes, unless it is highly unlikely to lose the suit. The determination of the likelihood of winning or losing is made by management based on information from legal counsel.
Solvency refers to the comparison of a company’s assets with its liabilities. Insolvency means that the accounting value of the liabilities exceeds the accounting value of the assets (because A = L+ E, if liabilities exceed assets, the equity is actually negative). The term “insolvency” can also refer to a company unable to meet its obligations as they come due, though that may also be referred to as “cash flow insolvency” or a “liquidity problem.” This may have significant consequences, such as possible violation of financial or other contractual covenants. Under the corporate laws of many states, if there is balance sheet insolvency, payment of dividends or share repurchases can result in personal liability to directors.
Especially in times of stress, we are concerned about a company’s liquidity—its ability to meet its financial obligations as they come due. The most common measure of liquidity is current assets (those expected to generate cash within the next 12 months) divided by current liabilities (those that will consume cash during that same period). This is called the “current ratio.” However, recognizing that inventory is likely to be of little use in meeting short-term liabilities if revenues are down, a more rigorous measure counts current assets minus inventory in the numerator. That is called the “quick ratio.”
Hopefully, before a company faces either insolvency or liquidity problems, financial covenants provide lenders with an early warning that the situation may be deteriorating and may need attention. Legal counsel should advise their clients to be proactive in communicating concerns about performance against their covenants and to help them negotiate covenants that both take into account expected performance and allow flexibility where warranted.
Equity
Equity represents the claims of the owners on the company. Equity comes in two forms, money invested by the owners (contributed capital) and company-generated profits that are left in the company (retained earnings) and can be used to purchase additional assets, pay dividends, or reacquire shares. As of December 31, 2019, IBM had assets of $152.2 billion and owed $131.2 billion; the balance of the assets ($21.0 billion) was funded by the owners. (Note that, of course, Assets = Liabilities + Equity).
Contributed capital is typically reported in two elements: “common stock” (reported at par value—the “minimum value of the shares”) and “additional paid in capital” (the amounts received over par value). Also commonly included in equity is “treasury stock.” This amount, a negative number, represents the company’s shares that were repurchased from the equity markets. This is a common way to manage the financing of the company.
It is important to note that there are only three sources of capital available to any company for the purchase of assets. The company can: (1) borrow the money (liabilities), (2) sell equity positions to the owners (contributed capital), or (3) earn money on its own from running its business at a profit and leaving these funds in the company (retained earnings). Every company combines these three sources to fund the purchase of its assets and decides how much will come from each of the three sources.
This mix of liabilities and equity is called the “capital structure” of the company. Deciding on an appropriate capital structure is a key part of any company’s strategy. Debt is less expensive than equity and does not dilute the ownership of the shareholders. However, adding debt increases the company’s financial risk—the risk that it will not be able to meet its financial obligations when due. Over the last few decades, the availability of low-cost debt has motivated many companies to add a greater proportion of debt (leverage). The long-term success of this strategy depends upon the company’s ability to meet its debt obligations. It will be important to watch these companies carefully during this economic crisis. Is that increased level of debt affordable under the current scenario?
A company borrows money and sells equity to buy assets. These assets are employed to produce something of value for a market: products and/or services. The company sells the products and/or services produced by the assets to its customers, generating revenue and hopefully profits. The income statement reports on these activities, revenue, and expenses. Our next article looks at the reporting context for the income statement, what the numbers mean, and how to read the results.
In the beginning, law firm marketing departments had fewer employees than the mail room. Fast-forward thirty years: today, the rule of thumb is one marketing professional for every 20 to 25 attorneys, so a firm of 500 attorneys would have a marketing department with 20 to 25 professionals. Many firms also outsource specialized services such as digital marketing and database management.
If you are in a smaller firm or practicing solo, why do you care how large marketing departments are in large firms? You care, because you, too, need to be visible to your prospects and colleagues and engaged with your clients. We can look to the marketing professionals in larger firms to glean important ideas that are relevant to and appropriate for all practicing attorneys.
First, some definitions. Within the legal profession, marketing refers to activities that build brand awareness, including content management activities online and in print. These include brochures, newsletters, websites, videos, podcasts, other digital initiatives, database management, public relations, advertising, events, sponsorships, and so on.
Activities related to finding, wooing, winning and servicing clients come under the rubric of “business development.” This includes research on specific clients, their industries and markets, relationship building and tracking, and proposal and presentation preparation. It also includes training and coaching for attorneys, assistance with marketing and business development strategy, and business development plans for individuals, practice groups, and the firm itself.
Modern marketing departments are thinking strategically about ways to relate their personnel and services to defined client clusters. To this end, according to Calibrate Legal’s survey of North American law firm marketing departments, in larger firms there is an increased demand for:
Strategic business development initiatives
Digital marketing
Lead generation and pursuits
Data analysis and content marketing.
There is less demand for participation in 2021 conferences, events, sponsorships and inclusion in directories/awards. In -person events will also be de-emphasized in 2021: one-third of the responding firms plan to reduce them by 50% or more.[1]
Strategic Basics
The key word for 21st century consumers is “me,” translated in marketing-speak to “personalization.” The onslaught of available information has forced people to triage. Any material sent to prospects or clients must be germane to their interests, needs, opportunities and pitfalls or they won’t look at it.
This means you need to be very clear about the personalization of your own practice. Everything you write needs to reflect who you are—what your brand is. Your brand distills what makes you different and how that difference comes through in what you do with and for your clients. It is your promise to them that sets their expectations as to how it would be to work with you.
To relate authentically to your clients, you need to know more about them than just their contact information and current matter number. You need to really understand their work life, home life, wants, needs, dreams, problems, opportunities, and so on. You need to be able to “walk a mile in their shoes.” This translates into a niche market focus, a sub-group of possible clients who really could benefit from your advice, expertise and experience.
Rather than seeking out any kind of client who wants you, analyze what you like to do and who benefits from your practice. Analyze your current client base going back several years and outline the characteristics of your best clients–the ones you want to replicate. Then narrow your focus:
Tie all the characteristics of your ideal client together in a “client persona.” The persona combines everything you need to know about your prospects and clients. These are the people you want to meet, get to know, and, over time, incorporate into your work life as friends, colleagues, referral sources, resources, and clients.
Marketing Initiatives
Once you know what you want to sell and who you want to sell it to, you need to create opportunities to connect either directly through networking or indirectly through your marketing materials and initiatives. Some suggestions that continue to work in the COVID-19 environment:
Join organizations that your persona belongs to online or in-person. Join their professional, trade, or industry associations to learn what is important to them and how they approach the issues.
Expand your brand online. Use your website and LinkedIn of course, but also whatever other sites your clients favor. Go where they go and join their conversations.
Pick a marketing outreach tactic that is comfortable for you: newsletters, blog, videos, podcasts, white papers. Make the content timely and pertinent to your persona. Consider working with clients or colleagues on these endeavors.
If you work for a firm with a marketing department, use them. If you don’t, hire outside marketing service consultants and companies to help you, professionalize your efforts.
Maximize your online references and reviews. “An estimated 75% of people searching for a lawyer use legal review sites, and 84% of those people trust reviews as much as personal recommendations.”[2]
Regardless of your outreach tactics, when you meet someone you want to get to know, begin a series of contacts with them. Set up one-on-one meetings using zoom or the phone; send them information that refers back to your conversation, invite them to join you at an online networking event or webinar.
Remember it takes 8 to 12 personal “touches” on average to move forward from that first meeting to friendship.
Don’t forget your current clients. People are anxious, worried what will happen in 2021. Be there for them as a sounding board. Call them just to say, “How are you doing?” Listen to them and offer advice if they want it. Often clients are just happy to have a willing ear.
In the end, whether your firm is large or small or you work alone, you can adopt the mindset of those in large marketing departments. “Remember, business development is all about relationships. Relationships that are built on trust, empathy and a deep commitment to help clients succeed.”[3] People hire people they like and trust who have the experience and expertise they need to move forward. Think positively about moving forward, craft a brand that resonates with your market niche, and make yourself relevant to them. Success will follow.
[1] Calibrate Legal, Law Firm Marketing/BD Department Size Study 2020, https://calibrate-legal.com/marketing-bd-survey-2020/.
[3] Susanne Mandel, Chief Business development and Marketing Officer at Lowndes, quoted in ‘New Law Firm Strategies for Growth Amid the COVID-19 Pandemic and After,” Strategies+ blog, Legal Marketing Association, September 4, 2020.
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