The role of a public corporation’s in-house general counsel/chief legal officer has always been a difficult balancing act. The general counsel must be an expert advisor to the company’s CEO and board of directors. He or she must fulfill significant legal obligations to the company’s owners and creditors. An effective general counsel also must function as a knowledgeable business partner in senior management. The complex responsibilities of the position have been written about extensively in numerous professional publications and have been amplified by laws passed, regulations issued, and court cases over many years.[1]

Similar complexity is involved in the obligations of boards of directors to monitor, oversee, and direct the affairs of a public corporation—to carry out effective corporate governance. In companies of all sizes, the fact that board meetings occur only on a periodic basis can make it challenging to meet these obligations. To fulfill governance responsibilities, a board must be able to understand and address issues and developments that can arise in a company at any time.

Given that management is a continuous process and boards of directors processes are intermittent, the creation of an “executive committee” can improve the flow of information that assists a company’s management and board in governing effectively. Providing relevant and timely information is one of the important checks and balances in managing and directing the affairs of a company.

What Is a Board Executive Committee?

Public company boards of directors typically have three standing committees that are mandated by regulators and listing exchanges: an audit committee, a nominating and governance committee, and a compensation committee. The responsibilities of these standing committees are described and discussed in a company’s public disclosures. Financial institutions are also mandated to have a committee to address risk.

Companies may have other committees of the board to specialize in such matters as technology; risk identification and management; safety and security; environmental issues; human capital; and other subject areas. In addition, some companies have created an executive committee to address matters that may need monitoring and attention between regularly scheduled board meetings. The roles of such executive committees can vary among companies and with changing circumstances within a company. One company describes its executive committee in its annual report as follows:

Executive Committee (3 directors) is to, as more fully specified herein, (1) monitor and review the operations of the Company and its subsidiaries (collectively, the “Group”), (2) exercise specific delegated powers of the Board, (3) review and provide recommendations on matters that would require the approval of the Board and (4) exercise such other powers and responsibilities as may be delegated to the Committee by the Board from time to time consistent with the Company’s Amended and Restated Certificate of Incorporation (the “Certificate”) and Amended and Restated Bylaws (the “Bylaws”), within the parameters delegated by the Board. The Committee shall meet as and when any member of the Committee deems necessary or desirable, subject to notice (or waiver of notice) being given in accordance with the rules and procedures of the Committee.[2]

Charters for executive committees may also describe specific limitations on committee activities. Information about a company’s board committees and board committee charters can generally be obtained from annual reports, proxy statements, or upon request to a company’s investor relations organization.

Three Reasons for a Company to Consider the Use of an Executive Committee

First, an executive committee can be a flexible resource to monitor a wide range of developments on a continuous basis. Without a necessity for periodic meetings requiring scheduling or travel, and with good use of technology, such a group can be nimble in staying abreast of internal and external developments affecting the business and can act whenever such matters arise. It can be on the lookout for issues that warrant consultation and discussion among the CEO, CFO, general counsel, and other senior management.

Second, an executive committee can serve as a sounding board for the general counsel and CEO, other members of senior management, and/or independent directors to explore emerging issues or concerns that may or may not ultimately require a presentation to the full board. Having a small, knowledgeable group with whom the CEO and general counsel can consult can facilitate preliminary evaluation of a matter and provide practical and useful advice. Such an approach enables issues to be discussed and evaluated—and possibly in some cases resolved—before they progress to a point needing to be placed upon the formal board agenda. Preliminary evaluation also facilitates definition and preparation of matters that do go forward to the full board.

Third, the effectiveness of a company’s corporate governance—its system of “governing the corporation”—is heavily dependent on creating the right checks and balances and information flows. A small executive committee can institute flexible and efficient information processes that start, stop, and change easily as needed.

Executive committee access to “inside the company” sources, with an ability to inquire about matters as needed, can strengthen the checks and balances in the corporation. One cannot help but wonder if better communications and stronger information flows at early stages might have helped to avoid the widespread and highly publicized control breakdowns that occurred at Enron, Worldcom, and more recently at Wells Fargo. In these cases, massive reputational and financial damage was done to companies and individuals.

Some Caveats for Creating and Using an Executive Committee

It is important to distinguish between “monitor, discuss, and advise” versus “make decisions.” In creating an executive committee, a company must not create an undesirable “two-tier” power dynamic inside the board, whereby the executive committee takes on decision-making authority that under the bylaws properly belongs with the full board. To minimize this risk, the committee should have a well-defined charter with clearly described delegations, along with its own internal set of checks and balances.

An executive committee’s processes for information gathering should be relevant, timely, and efficient, as well as cognizant of the need to avoid placing unnecessary burdens on management. Reporting to the full board should similarly be efficient, using written summaries to advantage in order to avoid taking up time on routine matters in periodic board meetings.

An executive committee should be small, generally not more than three to five people, including the CEO. It should include two independent directors who have relevant experience and business knowledge, as well as a mix of desirable personal and professional attributes.

The authors wish to thank other members of the Grace & Co. Board of Advisors and Senior Paralegal, Allison Hawkins, for their input and assistance.

[1] See E. Norman Veasey & Christine T. Di Guglielmo, Indispensable Counsel (Oxford University Press, 2012) (a comprehensive description of the responsibilities and obligations of counsel, the relevant legal environment, and numerous experiences of job incumbents).

[2]  BOE Annual Report 2019, at www.cboe.com.

Introduction

The economic shutdowns related to the COVID-19 pandemic (COVID-19) have created both shortages and surpluses in supply chains; in other words, ripe conditions for a surge in unauthorized gray-market goods (products with genuine trademarks sold outside authorized distribution channels). In the short term, for example, shortages and price gouging have inhibited healthcare systems’ and their suppliers’ access to vetted sources of genuine supplies, including for personal protective equipment (PPE) and pharmaceuticals. Although these market conditions may invite the substitution of gray-market goods for genuine ones based on availability, the inherent material differences in gray-market goods can pose serious health risks, often unbeknownst to end users. As another example, in the longer term, retailers may elect to liquidate unsold, out-of-date seasonal inventory, such as apparel, in international markets to mitigate losses, but risk unauthorized gray-market resellers later importing those goods back into the U.S. market to compete with next year’s fashions at a discount.

Although federal and state trademark and unfair competition laws offer protection to trademark holders against the unauthorized resale of gray-market goods, COVID-19-related closures and restrictions of state and federal district courts across the country have all but suspended activity in many of those venues for civil actions. However, owing in part to its relatively quick investigation-resolution timeframe mandates and not needing to empanel juries, the International Trade Commission’s (ITC) potential to maintain its pre-COVID-19 pace of operations adds to its already powerful ability to exclude unauthorized gray-market goods from importation[1] to make the ITC a key resource for trademark holders in today’s environment.

How Has COVID-19 Created the Potential for Gray-Market Problems?

In the short term, COVID-19 has created shortages and price gouging in numerous product categories, from healthcare to daily household essentials to sports and leisure products, as distribution chains adjust to the new “normal” of life in a pandemic. From the earliest days of the pandemic, however, no impact has been as apparent or as impactful as healthcare systems’ and individuals’ inability to access vetted sources of PPE and pharmaceuticals. These shortages and price gouging may tempt healthcare providers and individuals to turn to gray-market goods to fill the gap, but inherent material differences between the goods can pose serious health risks. For example, when third parties purchase gray-market goods and later resell them, there is no way to verify that those third parties have complied with safe storage and handling or restrictions on one-time use. This is particularly important for PPE and pharmaceuticals; dire consequences can result from using poorly handled pharmaceuticals or used N95 masks.

As just one example, 3M has filed multiple suits against companies attempting to sell its N95 masks and other PPE at multiple times the list price, alleging trademark infringement and other claims.[2] Summing up the concerns, one preliminary injunction order obtained by 3M noted that “[t]he public has an interest in avoiding confusion about the source and quality of goods and services” and that “[t]his is especially true during the global COVID-19 pandemic, when consumers, including experienced governmental procurement officials, are relying on the 3M Marks and 3M Slogan to indicate that goods and services offered thereunder originate from 3M, and are of the same quality that consumers have come to expect of the 3M brand.”[3]

In the longer term, large amounts of unsold inventory that accumulated during the shutdowns portends gray-market goods problems for retailers for years to come. For example, with the public staying home and spending less, apparel retailers may find themselves faced with unsold professional, luxury, seasonal, and vacation clothing. This surplus may be liquidated in international markets at steep discounts to mitigate losses. However, even in normal times this practice invites the later unauthorized importation of those goods back into the United States, where they compete at a discount against trademark owners’ latest fashions.

To prevent serious consequences to the public health in the short term, and to protect the trademark holders’ goodwill and ward off dilution and price erosion in the long term, trademark holders must remain vigilant to police and pursue any unauthorized sellers of trademarked goods due to the COVID-19 pandemic.

How Can the ITC Protect against Gray-Market Goods?

Under what is known as the first-sale doctrine, a person who buys a trademarked good may ordinarily resell that product without infringing the mark. However, this doctrine applies only to the resale of genuine goods and does not apply to the unauthorized resale of a trademarked good that is “materially different” from the genuine goods sold by the trademark owner—such a resale is still trademark infringement. Sections 32, 42, and 43 of the Lanham Act allow trademark owners and their exclusive and nonexclusive licensees to stop unauthorized resellers from selling gray-market goods upon showing a material difference between the authorized and unauthorized goods.

The ITC is empowered by statute to protect American industries from unfair methods of competition and unfair acts in the importation of articles as well as from importation into the United States of articles that infringe a valid and enforceable U.S. trademark.[4] In contrast with federal district courts, however, the ITC exercises in rem jurisdiction over imported articles, which enables the ITC to issue general exclusion orders in certain circumstances that block the importation of all infringing articles, regardless of whether importers participate in the ITC’s investigation. In addition, service of process against accused importers is less rigorous than in district courts in that attempted service by regular mail is all that is required. Finally, unlike in district court, one investigation in the ITC can name many different unauthorized reseller respondents, consolidating resources and avoiding unnecessary multiplication of efforts.

There are also potential advantages to the ITC as an enforcement forum in the COVID-19 environment. First, the ITC has a speedy schedule and time to final determination, which is important when considering the cumulative and continuous loss of goodwill that results from the sale of gray-market goods. The average time to a final decision for 2019 was 14.1 months.[5] The ITC can also grant a form of temporary relief “to the same extent as preliminary injunctions and temporary restraining orders” when the time period until a final determination is only 90 days in most cases and 150 days in “more complicated” cases.[6]

The ITC may also be more suited to maintain its pre-COVID-19 pace of operations than other forums, particularly considering its statutory obligation to conclude section 337 proceedings “at the earliest practicable time.”[7] In fact, a review of investigations that have been instituted since mid-March (Nos. 1192–1202) shows that the target dates have remained on a fairly typical schedule of 15–19 months, showing no significant slowdowns due to COVID-19. For example, in Investigation No. 1200, the respondents proposed that the target date be set for 19 months to allow for flexibility due to COVID-19, and the judge declined, setting the target date for 16 months.[8]

Moreover, because the ITC does not offer jury trials, it has more flexibility in conducting virtual bench trials as well as virtual hearings. Even before the pandemic, the ITC regularly held telephonic hearings and conferences when other courts may have more frequently required in-person attendance. The ITC may also be uniquely prepared to handle remote and alternative formats for trial because it already often uses written witness statements. For example, in Investigation No. 1162, the judge issued a notice and order regarding alternate hearing procedures suggesting that the parties could take depositions of witnesses regarding their written witness statements, and the parties could use that deposition testimony in lieu of live cross-examination. The judge stated that “there is a possibility of conducting the evidentiary hearing without any real-time participation by me at all,” showing the creative solutions the ITC is proposing to keep cases proceeding as quickly as possible.[9] Finally, although the ITC initially suspended in-person hearings, that restriction is set to lift on July 10, 2020.

Overall, the ITC has proven itself to be a speedy and highly adaptable forum. The ITC may be uniquely positioned to help trademark holders end gray-market problems, both generally and in view of the COVID-19 pandemic.

Conclusion

COVID-19 has unfortunately provided the potential for unauthorized gray-market goods to flourish. In the short term, such goods can threaten public health and safety when they affect the supply and quality of PPE and pharmaceuticals. In the long term, trademark holders may be battling against unauthorized gray-market goods sales and damage to their goodwill for years to come. Given its powerful remedies, practical benefits, and potential to maintain pre-COVID-19 operations, the ITC has shown itself to be a strong and effective partner to protect domestic trademark owners’ rights against unauthorized gray-market importers.

[1] See Paul Tanck & Neal McLaughlin, Combating Gray Market Goods: Using the ITC to Solve the Gray Market, Bus. L. Today, July 2, 2019 (explaining that “[t]he International Trade Commission has emerged as the go-to venue in the fight against the importation of gray-market goods”).

[2] Bill Donahue, 3M Sues Amazon Seller Over Fake N95 Masks, Law360, June 8, 2020.

[3] 3M Co. v. Performance Supply, LLC, No. 1:20-cv-02949-LAP (S.D.N.Y. May 4, 2020) (Dkt. 22).

[4] 19 U.S.C. § 1337.

[5] U.S. International Trade Commission, Section 337 Statistics: Average Length of Investigations (last accessed June 9, 2020).

[6] 19 U.S.C. § 1337(e)(2)–(3).

[7] 19 U.S.C. § 1337(b)(1).

[8] In the Matter of Certain Electronic Devices, Inv. No. 337-TA-1200, Order No. 6 (June 17, 2020); id., Joint Discovery Statement, EDIS Doc. No. 712615 (June 12, 2020).

[9] In the Matter of Certain Touch-Controlled Mobile Devices, Inv. No. 337-TA-1162, Order No. 54 (June 5, 2020).

Official committees can play an important role in a bankruptcy case, and chapter 9 municipal bankruptcy is no exception. Committees can ensure efficient, adequate representation of large stakeholder groups, including retirees, equity owners, and of course creditors. They bring together similarly situated parties, allowing the group to develop ideas and take positions that are representative of multiple parties with important interests at stake. Committee ideas and positions can thus be more powerful and persuasive than the views of any one stakeholder in a case.

Some recent decisions may threaten the appointment of official committees in chapter 9, however. Two bankruptcy judges have held that section 1102(a)(1) of the U.S. Bankruptcy Code does not authorize a committee’s appointment in chapter 9 and that, therefore, the committees the U.S. Trustee had appointed in each case should be disbanded.[1]

Section 1102(a)(1) provides, in relevant part, that “as soon as practicable after the order for relief under chapter 11 of this title, the United States trustee shall appoint a committee of creditors holding unsecured claims and may appoint additional committees . . . as the United States trustee deems appropriate.”[2] It is found in chapter 11 of the Bankruptcy Code but is incorporated in chapter 9 cases through section 901(a).[3] Even though section 1102 as a whole is incorporated into chapter 9, the courts in In re Coalinga Regional Medical Center and In re Detroit each found that section 1102(a)(1)’s reference to chapter 11 relief necessarily precluded that provision from applying in chapter 9 cases because there is no “order for relief under chapter 11” in a chapter 9 case. Both courts reached this conclusion based on the idea that it is important to give effect to every word in a statute.

Although both the Coalinga and Detroit courts disbanded the committees formed under section 1102(a)(1), both left the door open to the possibility that they could order the U.S. Trustee to appoint an official committee under section 1102(a)(2).[4] Under this provision, “[o]n request of a party in interest, the court may order the appointment of additional committees . . . if necessary to assure adequate representation. . . .”[5] However, the idea that a court could use section 1102(a)(2) to order the appointment of an initial committee does not give effect to every word of the statute: the word “additional” in that provision implies that there has already been a committee appointed in the case—a committee that the courts in Coalinga and Detroit have now held cannot be appointed. Coalinga and Detroit have thus raised the possibility that a court could hold that a chapter 9 committee cannot be appointed at all—not even with the consent of all parties.

However, this possibility is not an inevitable outcome. First, courts could adopt the U.S. Trustee’s position that Congress intended to incorporate section 1102 in its entirety into chapter 9 and knew how to exclude particular subsections if it wanted to.[6] Alternatively, courts could look to section 105(a) of the Code, which allows the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”[7] Both Coalinga and Detroit contended that section 105(a) gave the court the power to disband committees[8] in that the Code does not explicitly prohibit this action.[9] Following this reasoning, a court could arguably interpret section 105(a) to accept committee appointments because the Code does not explicitly prohibit the court from ordering or allowing the appointment of committees, either.

Given the valuable role committees can play in a case, it is troubling that some courts have seemingly found a route to prohibit committee appointments in chapter 9 outright. To some extent, this is a statutory drafting issue that Congress should address, but courts may also have the statutory tools to fix the very problem they have created.

[1] In re Coalinga Regional Medical Center, 608 B.R. 746, 747–48 (Bankr. E.D. Cal. 2019); In re City of Detroit, Mich., 519 B.R. 673, 675 (Bankr. E.D. Mich. 2014).

[2] 11 U.S.C. § 1102(a)(1).

[3] 11 U.S.C. § 901(a) (“Section[] . . . 1102 . . . appl[ies] in a case under this chapter.”).

[4] Coalinga, 608 B.R. at 759 (continuing creditor’s motion to appoint a committee under section 1102(a)(2)); Detroit, 519 B.R. at 678 (“The U.S. Trustee’s authority to appoint committees in chapter 9 is therefore limited to the authority granted in subsection (a)(2) of § 1102.”).

[5] 11 U.S.C. § 1102(a)(2).

[6] Coalinga, 608 B.R. at 750. See, e.g., 11 U.S.C. § 901(a) (incorporating five out of sixteen subsections of section 1129(a)).

[7] 11 U.S.C. § 105(a).

[8] The U.S. Trustee’s arguments in Coalinga suggest that this would be an expansive reading. Coalinga, 608 B.R. at 750 (arguing that, when section 1102 was amended, it “eliminat[ed] the court’s role in committee formation and limit[ed] court review of committee composition.”).

[9] See Detroit, 519 B.R. at 680 (“[N]owhere does the bankruptcy code explicitly prohibit the bankruptcy court from disbanding an unsecured creditors’ committee.”).

The COVID-19 pandemic (COVID-19) has created unparalleled uncertainty for nearly all businesses in that companies are unable to predict when and how businesses and consumers will resume buying their goods and services. This unpredictability has made it more difficult for dealmakers to use historical earnings to predict a company’s future earnings, and accordingly their valuation, which has severely curtailed the number of M&A transactions at the present time. Somehow, however, a trickle of deals are getting done and others are being pursued, although at a much slower pace than in 2019.

Why Would Buyers and Sellers Want to Do a Deal in This Environment?

Buyers with available funds may find that the current environment provides opportunities that would not have existed before the pandemic. In particular, strategic buyers with deep industry expertise will look for transactions that will allow them to add a new product or service, acquire new technology or a set of skilled employees, or some combination thereof. Private equity buyers have a lot of available funds to invest and will need to deploy capital, especially if they perceive this to be a buyer’s market. One of the pandemic’s principle effects for M&A transactions has been to lower seller valuation expectations, motivating sellers to be more flexible than they were only a few short months ago. As a result, valuation expectations are materially lower for sellers, making it easier to structure a transaction that makes sense for both parties.

Throughout this article, reference to “private equity” generally means platform acquisitions by a private equity fund, which are acquired to be a standalone portfolio company, as opposed to a “tuck-in” acquisition by a portfolio company. “Strategic buyer” generally means an existing company already operating in an industry, which can include both public and private companies, and can include a private equity portfolio company looking for a tuck-in acquisition.

Many young start-ups and technology companies may lack sufficient cash resources to weather the COVID-19 storm and may be unable to find additional funding quickly enough. This predicament may increase the attractiveness of a larger strategic buyer capable of providing stability and added resources that the seller and its employees sorely need. Sellers may have other reasons to seek a sale, including the death or divorce of a founder, the need for liquidity to provide some diversification for the owners, or a management team that has reached its limits for moving the company forward. Such sellers may have been trying to find a buyer before COVID-19 and do not have the luxury of waiting a year or longer for a more favorable selling environment. There are also distressed situations in which a company may face insolvency and bankruptcy, but transactions involving bankruptcy have very different rules and considerations which are beyond the scope of this article.

How Has Due Diligence and the M&A Process Changed in the Post-COVID-19 Environment?

Acquisitions typically are the start of a long-term relationship between the seller’s management team and the buyer, the success of which depends heavily on the seller’s key employees. For buyers, face-to-face meetings with the seller’s management team remain a critical component of deal-making and due diligence, and few buyers will be willing to close a transaction without several opportunities to interact in person with the management team. Most deals closing today were likely underway before the pandemic, so the buyer already had spent time with the seller and the seller’s management team. Due to the challenges posed on travel by COVID-19, the nature of due diligence on the management team is likely to change. For new transactions in which the buyer has no prior relationship with the seller, video conferences will allow the sale process to get started between motivated parties. For now, however, buyers will likely insist on meeting the management team in person before they are willing to close the deal.

If travel remains constrained for an extended period, buyers may need to rethink their dependence on face-to-face meetings. Similar to hiring decisions, buyers will become more comfortable sooner or later with video conferencing, both for getting to know the management team during due diligence and for interacting with them post-closing. Buyers may also increase their use of personality tests and similar assessment tools to better understand the management teams of the seller during due diligence. You can also expect to see buyers becoming more structured in their due diligence discussions on video conferences, similar to the hiring methodology Geoff Smart and Randy Street recommend in their book, Who—The A Method for Hiring. Although right now partners at private equity funds and strategic buyers may say that they would never buy a company without extensive meetings with the management team in person, this attitude could change if the effects of the pandemic persist.

The inability to meet with the seller’s management in person is one of several reasons to extend the due diligence time period. An extended due diligence period allows the buyer more time to assess more accurately COVID-19’s impact on the seller and to find any needed financing for the deal. As a result, look for the exclusivity period in letters of intent to be extended from the typical period of 60 days pre-COVID-19 to 90 or 120 days, if not longer.

The nature of due diligence will strongly depend on whether the key assets of the seller are intellectual property, such as for a software company, or whether the key assets are physical, such as inventory or a factory or distribution facility. The more the key assets are physical, the more likely the buyer (and the buyer’s lenders) will require physical inspections that will lengthen the closing timetable.

Certain physical assets, such as a factory or distribution facility, will require more rigid due diligence on new health and safety measures put into place to protect workers at the facility. Similar to having Phase I environmental reports for real property, third-party health and safety inspections must be added to due diligence checklists for physical facilities.

The pandemic provides new lines of questions to ask the management team to better assess its capabilities and the operations of the target business.

• What decisions did you make to cope with the pandemic and why? How did they turn out? How did you treat your employees and vendors? What did you learn, and what would you do differently?
• What is the seller’s supply chain vulnerability, especially to China and other overseas sources? What plans does management have to change the supply chain in a post-COVID-19 world?
• What additional operating costs are required to operate in a post-COVID-19 world?
• What plans does management have if the pandemic re-emerges in the Fall?

Buyers will also ask if the seller received a loan under the Paycheck Protection Program (PPP), and especially if the loan was for more than $2.0 million so that it is subject to the automatic audit promised by the Small Business Administration (SBA). Buyers should ask about the seller’s eligibility for a PPP loan under the SBA’s affiliation rules. Buyers will be leery about buying a company subject to an SBA audit when the seller’s eligibility was questionable, or there are questions regarding the seller’s good-faith certification regarding the “necessity” of the loan.

Due to the shift from a seller’s market to a buyer’s market, sellers must find ways to distinguish themselves. One way to do that is to make due diligence easier and more transparent for the buyer. In this new environment, sellers should make the up-front investment in pre-sale due diligence. This will include investing in a more thorough quality of earnings (Q of E) review before starting the sale process. The Q of E will provide the buyer with better visibility into the seller’s pre-COVID-19 financial performance and how the seller will manage through the disruptions caused by the pandemic. A seller will also want to prepare a “stress test” analysis for its business under different possible scenarios in a post-COVID-19 world. Buyers will find sellers with more transparent financial data and a plan for an uncertain future to be much more attractive. These types of “stress test” analyses are critical to help develop more creative deal structures required under the current environment, as discussed below.

What Are Ways to Bridge the Valuation Gap, Given the Uncertainty in the Seller’s Future Financial Performance?

I. Setting the Stage—Valuation Methodologies and Changing Expectations

Three common ways to value target companies are:

• Multiple of prior 12 months of EBITDA, which is used for companies with earnings. This is the most common valuation methodology.
• Multiple of revenues, most commonly used for software and other technology companies that have been able to build significant sales but are not at the stage of having earnings.
• A “build versus buy” analysis, in which the buyer assesses the cost to duplicate the functionality of the seller’s product or technology from scratch, versus the cost to buy the seller and its employee team. This measure is most commonly used for early-stage software and other technology companies prior to them having significant sales revenues. Acquisitions of these types of companies are especially attractive if they have a skilled set of employees who can jump-start the buyer’s efforts to add a new product or service or technology. This valuation methodology generally leads to lower valuations, but not always, depending on the immediate needs of the buyer. When Facebook paid $1 billion for Instagram in 2012 for a one-year-old company with 13 employees, it sounded insanely high at the time, but in retrospect, it has turned out to be a bargain.

A seller’s historical earnings are no longer a predictable measure of future performance due to the uncertainty caused by COVID-19. Before the pandemic, in a seller’s market, the multiples of EBITDA and revenue used to value sellers were at all-time highs, with auctions attracting a large number of potential buyers. Using trailing 12 months (TTM) of EBITDA or TTM of revenues were reasonable ways for buyers to predict future financial performance. COVID-19, however, has upended these metrics as a way to value companies. How do you value a company after COVID-19 when you cannot predict with any certainty how a company will perform over the next 12 to 18 months? For the “build versus buy” valuation analysis, the changed environment probably will not materially change the buyer’s analysis, but it has substantially changed the seller’s expectations, making them more receptive to an acquisition.

One big difference between the current environment and prior recessions, such as the recession of 2008–09, is that sellers have quickly grasped the uncertainty caused by the pandemic. In prior recessions, it took 12 to 18 months for sellers to fully understand the new reality. Today, sellers’ expectations have reset almost immediately. Sellers that have the staying power and resources to wait may be content to do so until conditions improve. Sellers that have other pressures may be more motivated to sell, notwithstanding the current uncertainty, and more willing to share the risks with the buyer. From the buyer’s perspective, and especially for strategic buyers, if a target company is a strategic fit that provides a new product or service, or a new technology or skilled group of employees, this may be an excellent time to make an acquisition. If both the buyer and seller are motivated and are willing to be more flexible than before the pandemic, then deals can still happen.

How do you bridge the valuation gap to deal with the uncertainty caused by COVID-19? The answer is to creatively allocate the uncertainty risk between buyer and seller. The tools to do this can differ for private equity and strategic buyers.

II. Tools to Bridge the Valuation Gap

1. Reduced Total Purchase Price and Reduced Cash at Closing. Companies that are valued as a multiple of earnings or revenues are not worth as much today as they were in January 2020 in the pre-COVID-19 world. Particularly attractive companies that were in auction processes in January 2020 with multiple bidders may have received bids of 10 times 2019 EBITDA, with 90% or more of the purchase price paid in cash at closing. In the current environment, however, a more realistic multiple might be eight or nine times 2019 EBITDA, with only 50% to 60% of the purchase price paid in cash at closing. The remaining portion of the purchase price will be contingent, deferred, or subject to an equity rollover, using some of the tools laid out in more detail below.

2. Earn-outs. Earn-outs are a tool that can be used by both private equity and strategic buyers. According to the 2020 M&A Deal Terms Study by SRS Acquiom (the SRS Study), which analyzed 1,200+ private-target acquisitions from 2015 to 2019 (i.e., the pre-COVID-19 period), earn-outs for non life-science deals were used in an average of approximately 18% of transactions over the past four years, as shown in the chart below. Given that earn-outs are used more frequently in life-science transactions, the SRS Study excluded those transactions to get a better measure of how earn-outs are used outside of life-science transactions. For transactions with earn-outs, the metrics used were revenues, EBITDA, and other milestones (such as unit sales or product launches), or sometimes combinations of these metrics, depending upon the business and the stage of development of the target company. The chart below shows how the use of these metrics has changed.

Source: 2020 M&A Deal Terms Study by SRS Acquiom

According to the SRS Study, the chart below show that in non life-science transactions with earn-outs, the earn-out potential as a percentage of the closing payment generally hovered around 40%, and the length of the earn-out period ranged from less than one year to more than five years, with a median of 24 months.

Source: 2020 M&A Deal Terms Study by SRS Acquiom

Before COVID-19, both buyers and sellers were wary of using earn-outs. Earn-outs have often half-jokingly been referred to as “litigation magnets” because disputes regarding whether the earn-out has been achieved are common. Some of the reasons for the disputes have been due to ambiguous metrics for determining whether the earn-out has been met, changes in the buyer’s operations post-closing, the allocation of expenses, and the difficulty caused by changing circumstances, especially when the earn-out period is long (more than two years). As a result, before COVID-19, earn-outs were imperfect tools that were used only when absolutely necessary to bridge the valuation gap between buyer and seller.

After COVID-19, however, earn-outs will become increasingly popular to allocate more risk to the seller for the uncertainty of future performance. As a result, these are likely changes for earn-outs:

• Earn-outs will be used in a higher percentage of transactions, from the current 18% to perhaps 30% to 40% of deals, or higher.
• The time period for earn-outs will increase from the current median of 24 months to longer timeframes. Given the uncertainty with how long it will take for companies to recover from COVID-19, most companies have no visibility into what their results will be for 2020, and even into 2021. Therefore, earn-out periods may extend into 2022, 2023, and longer to give the seller more opportunity to achieve the earn-out.
• The earn-out potential as a percentage of the closing payment can be expected to increase from the current 40% to 50% or higher.

3. Equity Rollovers. Equity rollovers are a tool used almost exclusively by private equity buyers in platform acquisitions, and sometimes for tuck-in acquisitions. Equity rollover transactions typically involve rollover participants taking between 10% and 40% of the purchase price in the form of equity in the buyer. Equity rollovers are generally restricted to founders and other members of the seller’s management team who are joining the buyer post-closing. This provides founders and management with a meaningful equity stake in the buyer to align their respective interests to grow and sell the target company. Generally, existing equity holders in the seller who are not founders or part of the management team (i.e., venture capital, private equity, or angel investors) are excluded from the equity rollover because they have no ongoing role with the buyer post-closing and would rather exit the investment in the seller. Private equity buyers also like equity rollovers because they serve as a form of seller financing that reduces the buyer’s up-front cash payments at closing.

Equity rollovers were already very common before COVID-19. In the future, they will likely be used as a tool to allocate more risk to the seller to deal with the unpredictability of post-COVID-19 financial performance. Below are some of the changes we are likely to see.

• The equity rollover percentage is likely to increase. Prior to the pandemic, a private equity buyer might have been agreeable to only a 10% or 20% rollover by the founders and management team. In the post-COVID-19 world, the equity rollover percentage will likely increase to 30% or 40% as a means of shifting more of the risk to the seller and decreasing the need for outside financing.
• The seller participants in the equity rollover are likely to expand to include more of the equity holders in addition to the founders and management team. The buyer may insist on having venture capital, private equity, or angel investors included in the equity rollover. This may not be ideal for those investors who may have wanted to completely exit their investment, but they may have no choice in the current environment. For the buyer, this shifts the post-COVID-19 risk to more of the seller’s equity holders and increases the amount of seller financing.
• The private equity buyer may insist on having a liquidation preference for its equity, which will be paid out prior to the equity rollover received by the seller participants. Before COVID-19, it was typical for the seller participants to receive rollover equity with the same economic rights and preferences as the private equity buyer. In the current environment, however, private equity buyers are more likely to insist on receiving a 1X liquidation preference, or a 1X plus a return of some amount (i.e., 8%), to provide downside protection to the buyer. The buyer will argue that the seller participants have already cashed out a significant portion of their investment so it is only fair for the buyer to be protected if the post-COVID-19 performance of the seller is significantly worse than expected.

4. Targeted Incentive Bonus Plans for the Management Team. Strategic buyers generally will not use equity rollovers. The reasons include that the strategic buyer will have no timeline to sell the target company, so the rollover recipient will never be able to exit the investment, or the strategic buyer may be privately owned by a family or other small group and have no desire to have any minority equity holders.

Strategic buyers also may not want to use earn-outs if the management team that is joining the buyer has only a small equity stake in the seller. Therefore, an earn-out may increase the purchase price for the other equity holders of the seller (i.e., venture capital, private equity, or angel investors), but the management team will not receive much of the earn-out due to its small equity holding in the seller. As a result, the management team will not have the needed incentives to help the buyer achieve the desired results post-closing. This is particularly needed when the buyer is making the acquisition to acquire new software or other technology, as well as the skilled group of employees responsible for developing the technology (i.e., a so-called acqui-hire).

This situation, especially in a post-COVID-19 world, requires the strategic buyer to be more creative in designing a structured incentive bonus plan for the management team. Even in a post-COVID-19 world of higher unemployment, talented technology employees (and especially the “A” players) may still be able to find other attractive jobs or may be motivated to start a new company. As a result, the buyer must design targeted incentive bonus plans that may be outside the norm for the buyer and are specifically tailored to incentivize the management team to achieve specific buyer goals for the transaction. Below are some thoughts for what a targeted incentive bonus plan might include:

• Specific milestones that could include the development of new software or other products, or improving existing software or other products to meet market needs, in both cases using the larger resources of the buyer. These milestones may be part of a long-term project that may take two to five years to achieve; accordingly, the incentive plan must have a longer-term horizon that matches the achievement of specific milestones.
• Specific milestones that could include sales or other financial targets for the software or other technology products acquired in the acquisition to connect the management team to the sales efforts for their products. These milestones may be combined with the other milestones in the prior bullet.
• Monetary rewards that are large enough to provide sufficient incentives for the management team to stay with the buyer. If the management team is being asked to create significant value for the buyer, then they should share in a portion of the value they create.

5. Purchase Less Than 100% of the Target Company’s Equity (With Deferred Purchase Options for the Balance). In the typical rollover structure, the rollover participants cannot sell their rollover equity until the private equity fund sells the entire company. As discussed above, strategic buyers are unlikely to use rollover equity. However, a hybrid rollover structure that can be utilized by strategic buyers is to:

(i) purchase less than 100% of the target company’s equity in the initial closing (typically more than 50% of the equity, but less than 80% (to avoid consolidation for tax purposes)); and

(ii) purchase the balance of the equity at a later date, perhaps two to three years after the initial closing, based upon a pre-set formula to determine the purchase price based upon future performance.

This structure allows the seller’s equity holders to sell a portion of their equity at the initial closing and provide some partial liquidity for their investment. In the post-COVID-19 environment, the pricing multiple for the portion of the equity purchased at the initial closing may reflect some of the uncertainty for how quickly operations of the target company will get back to pre-COVID-19 levels.

The second-step purchase of the remaining equity can use a preset formula to determine the purchase price, which will be based on the financial performance of the target company during a future time period. This structure provides potential upside to the seller if the financial performance improves within a reasonable time period, while at the same time providing downside protection to the buyer if the financial performance is permanently impaired or takes an extended time period to get back to pre-COVID-19 levels. A variation of this structure is to provide for a combination of puts to allow the seller to require the purchase of the remaining equity at a preset formula, and calls to allow the buyer to require the sale of the remaining equity based on the pre-set formula, in each case at future dates.

For example, assume that the buyer purchases 60% of the seller’s equity at the initial closing at an 8X multiple of EBITDA (which might have been a 9X or 10X multiple in January 2020). The purchase agreement would provide that the remaining 40% of seller’s equity will be purchased by the buyer based on an 8X multiple of 2021 or 2022 EBITDA, perhaps with some minimum price to provide some downside protection to the seller’s equity holders. This structure allocates the downside risk to the seller of a slow or extended recovery while providing upside incentives to the seller if the target company’s financial performance improves more quickly. This structure can be especially advantageous for a smaller target company with limited sales and distribution resources for its products, or a new product with adoption risk, being acquired by a larger company with more extensive sales and distribution channels. Obviously, there can be many variations of this structure to fit the specific circumstances of the target business and to fairly allocate post-COVID-19 uncertainty between the seller and the buyer.

How Do Buyers Finance Acquisitions in the Current Environment?

In January of 2020, senior and mezzanine lenders were avidly competing to loan money to finance acquisitions. This led to an increase in the percentage of the purchase price that buyers could borrow to finance a deal and favorable loan terms with low interest rates and relaxed financial covenants. Life was good for buyers before the pandemic hit!

Today, the environment is different because lenders are much more cautious. It will take time for lenders to become more comfortable after the economy opens up and they can get real-time information on the target company’s financial performance in the new environment. As a result, many senior and mezzanine lenders are sitting on the sidelines or simply moving slowly until the smoke clears to permit some visibility on how the target company is likely to perform over the next 12–36 months.

When lenders are willing to move forward, their appetite for risk is likely to be substantially reduced, meaning that buyers can expect the following changes:

• Due diligence will take longer and be more involved, especially when there are physical assets and facilities that must be inspected. Mezzanine lenders in particular may look closer to home for financing transactions to eliminate the need to travel far to meet the management team.
• Lenders will reduce the percentage of the purchase price they are willing to finance, which will require the buyer to provide more equity.
• Interest rates and other fees and expenses will be higher than before. Interest rates may increase by 200 basis points or more than in 2019 to account for the increased risks. Closing fees and due diligence costs will also be larger than before the pandemic.

If outside financing is not obtainable at all, or not available at the desired level, then sellers and buyers must find new ways to allocate the financing risk in the post-COVID-19 environment. We expect some combination of the following structures to be used in the coming months, some of which have already been discussed above:

1. Reduce the cash portion of the purchase price payable at closing, and increase the amount of the equity rollover, and/or add an earn-out.
2. Bridge any financing gap with seller notes, which would be subordinated to any senior or mezzanine lenders. In the current environment, this may be the only way to get a transaction financed. Although the seller may request collateral or guarantees from the private equity fund or strategic buyer, buyers can be expected to react adversely to these requests and expect the seller to bear the risk with the seller notes until the entire company can be recapitalized and the seller notes can be repaid.
3. Provide for the buyer to pay an increased portion of the purchase price in cash at closing, and then recapitalize the company with an appropriate amount of debt after the lenders have better visibility on the target company’s financial performance in the post-COVID-19 environment.

Like the rest of the economy, M&A participants and their advisors are having to deal with an extraordinary amount of uncertainty as a result of COVID-19. As a result, due diligence efforts and transaction structures are expected to change from a pro-seller environment to one in which buyers and sellers must be more flexible and creative in how they allocate the valuation and financing risks between them. If a seller can wait for a more favorable environment, then they will do so, but many sellers will not be able to wait and will still desire to get a transaction closed. Similarly, private equity buyers have a lot of funds to invest and will need to deploy capital at some point, especially those with funds that have investment periods coming to a close. Cash-rich strategic buyers, especially those looking for companies with new products and technology, may find this an attractive opportunity to acquire companies that are a strategic fit. This environment may present strategic buyers already familiar with the industry and the target company with great opportunities, especially if they are willing to move quickly and are willing to be more creative with their deal structures.

Paul Pryzant, a partner at Seyfarth Shaw LLP, has represented clients in a variety of mergers and acquisitions, equity and debt financings, and other corporate transactions for over 35 years.

The author thanks Axial, which has been hosting a series of COVID-19 virtual roundtables each week with different sets of middle-market deal professionals who have been sharing their views on how COVID-19 has been changing the way they view transactions in the current environment. The virtual roundtables can be accessed at this link. These virtual roundtables inspired some of the ideas for this article.

Delaware Bankruptcy Court Holds That Minority Shareholder Blocking Rights Are Void

A little over two years ago, I reviewed a handful of decisions confirming the public policy against permitting limited liability companies from contracting away the right to seek bankruptcy protection in operating agreements.[1] In those cases, courts held that notwithstanding state law policy of freedom of contract in LLC agreements, so called blocking rights that give a creditor the ability to bar an entity from filing a bankruptcy petition may be void under federal law.[2]

Whereas “parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law,” courts have recognized “a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy.” Last month, in a ruling from the bench,[3] the Bankruptcy Court for the District of Delaware affirmed and strengthened that public policy as it relates to a debtor’s minority shareholder’s blocking rights, setting up a potential split between the Third and Fifth Circuits.[4]

On May 5, 2020, in In re Pace Industries, LLC, Case No. 20-10927 (MFW) (Bankr. D. Del.), Bankruptcy Judge Mary Walrath, in denying a motion by Macquarie Septa (US) I, LLC (Macquarie) to dismiss the debtor’s chapter 11 case, ruled that a minority shareholder’s blocking rights were “void” in the face of the debtor’s constitutional right to file bankruptcy. Judge Walrath explained:

I do recognize that there is no case directly on point, holding that a blocking right by a shareholder who is not a creditor is void as contrary to federal public policy that favors the constitutional right to file bankruptcy. But I think that, based on the facts of this case, I am prepared to be the first court to do so, and therefore conclude that the motion to dismiss must be denied.[5]

After Pace Industries and certain affiliates commenced their chapter 11 cases, Macquarie moved to dismiss the filings. Macquarie, which had made a $37 million investment in the debtor’s preferred stock, argued that the filing was unauthorized because the debtor did not obtain Macquarie’s consent, as provided for in the applicable corporate governance agreements. Macquarie argued that its right to block a bankruptcy filing was a heavily negotiated and critical component of its investment.

Macquarie acknowledged the cases holding that blocking rights in the hands of certain creditors might violate public policy, but attempted to distinguish those cases—including Intervention Energy and Lake Michigan[6]—on the basis that those cases involved shareholders who were also creditors, and that the equity stakes at issue were in the nature of “golden shares” intended only to vest the creditor with the blocking right. Here, however, Macquarie held only preferred equity—indeed, a substantial, albeit minority, stake—and was not a creditor. Accordingly, Macquarie argued that the court was constrained by U.S. Supreme Court precedent in Price v. Gurney, 324 U.S. 100, 106 (1945), to dismiss the bankruptcy petition where those who purported to act on behalf of the corporation lacked authority to do so under applicable state law. Based on the Fifth Circuit’s Franchise Services decision, which applied Delaware law, Macquarie argued that as a minority shareholder, it was not a controlling shareholder that owed any fiduciary duties and, specifically, the fact that Macquarie was not given opportunity to even exercise its consent rights prior to the chapter 11 filing shows that it did not control the board. In Franchise Services, the Fifth Circuit held that a shareholder with a blocking right did not have control over the debtor’s conduct and concluded that not being consulted as to a bankruptcy filing where it held such a consent right was indicative of a lack of control; accordingly, the Fifth Circuit did not reach the issue of whether it breached any purported fiduciary duty.[7]

Judge Walrath rejected those arguments, however, and denied Macquarie’s motion to dismiss, holding that:

under Delaware state law, contrary to the Fifth Circuit, my interpretation of the law would and does find that blocking rights, such as exercised in the circumstances of this case, would create a fiduciary duty on the part of the shareholder; a fiduciary duty that, with the debtor in the zone of insolvency, is owed not only to other shareholders, but to all creditors.[8]

In declining to follow Franchise Services, Judge Walrath began by focusing on the debtor’s clearly deteriorated financial condition, stating that “[t]here is no contest that the debtor needs a bankruptcy,” having closed its plants and furloughed workers, and having effectively no liquidity.[9] She went on to find that the bankruptcy case would “benefit most stakeholders” because the debtor’s lenders had agreed to a proposal that would pay all creditors in full if the plan were confirmed.[10] The court determined that under such circumstances, Macquarie’s blocking rights did create a fiduciary duty, and that allowing a shareholder like Macquarie to block a bankruptcy filing to advance its own interests offends federal public policy and interferes with a company’s constitutional right to seek bankruptcy relief. The court saw “no reason to conclude that a minority shareholder has any more right to block a bankruptcy—the constitutional right to file a bankruptcy by a corporation than a creditor does,” and therefore broke from the Franchise Services decision.^[11]

In conclusion, Judge Walrath stated, “whether or not the person or entity blocking access to the Bankruptcy Courts is a creditor or a shareholder, federal public policy does require that the Court consider what is in the best interest of all, and . . . whether the party seeking to block [the filing] has a fiduciary duty that it appears it is not fulfilling[.]”^[12] Importantly, Macquarie had conceded that it was “not considering the rights of others in its decision to file the motion to dismiss.”[13] Thus, Judge Walrath’s decision should put minority shareholders seeking to block a chapter 11 case—at least one filed in Delaware—on notice that such efforts will likely be met with strong resistance, and could even give rise to liability for breach of fiduciary duties if the efforts to prevent a debtor’s filing result in harm to other stakeholders. In addition, minority shareholders seeking to negotiate such blocking rights in connection with an investment should understand that going forward, such provisions in an entity’s corporate governance documents may be of little value. Thus, if the blocking rights are so essential to the deal terms, an investor might be well-advised to walk away.

[1] Brett S. Theisen is the director and vice-chair of the Financial Restructuring and Creditors’ Rights department at Gibbons P.C.

[2] See, e.g., In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017); In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

[3] See Docket No. 173. At present, the court’s docket does not indicate that a written decision will be forthcoming.

[4] See In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 206–08 (5th Cir. 2018), as revised (June 14, 2018).

[5] Tr. of Hr’g, dated May 5, 2020 (Case No. 20-10927(MFW) (Bankr. D. Del.), at 38:10-13.

[6] See infra, note 1.

[7] 891 F.3d at 213. 

[8] Tr. of Hr’g, dated May 5, 2020 at 40:22–41:3.

[9] Id. at 38:17-25.

[10] Id. at 39:1-4.

[11] Id. at 40:14-17.

[12] Id. at 41:24–42:4.

[13] Id. at 42:5-7.

In the beginning of the treatise On War, Carl Von Clausewitz explained war as follows:

I shall not begin by expounding a pedantic literary definition of war, but go straight to the heart of the matter, to the duel. War is nothing but a duel on a larger scale. Countless duels go to make up war, but a picture of it as a whole can be formed by imagining a pair of wrestlers. Each tries through physical force to compel the other to do his will; his immediate aim is to throw his opponent in order to make him incapable of further resistance.[1]

Insurance policies often contain so-called war exclusions. These provisions, which can differ significantly in how they are worded, purport to limit coverage for losses arising out of war or warlike actions.[2]

The issue came into recent prominence in 2018 as a result of litigation initiated by Mondelez International, Inc. against Zurich American Insurance Company. Mondelez suffered losses as a result of the malware known as “NotPetya.” According to a Wired article, “[NotPetya’s] goal was purely destructive. It irreversibly encrypted computers’ master boot records, the deep-seated part of a machine that tells it where to find its own operating system. Any ransom payment that victims tried to make was futile. No key even existed to reorder the scrambled noise of their computer’s contents.”[3] Per Mondelez’s complaint, Zurich denied Mondelez’s claim for insurance coverage based on a war exclusion which purported to exclude coverage for a “hostile or warlike action. . . .”

Although much has been written on the subject of the “war” exclusion, this article seeks to take a deeper dive into cyber threats.

Cyber Threats and the War of Words

States, nonstate actors, and criminal groups regularly engage in malicious cyber activities that eschew easy classification[4] in that subtle differences are often all that separates cyber crime, espionage, terrorism, and “hacktivism.”[5] Cyber crime, in its most simple distillation, is characterized as a crime that involves the use of computer-based means to commit an illegal act.[6] Cyber criminals develop and use various tools that delve deeply and covertly into public, commercial, and private networks[7] and are motivated, for the most part, by financial gain. According to Interpol:

[c]ybercrime is one of the fastest growing areas of crime. More and more criminals are exploiting the speed, convenience and anonymity that modern technologies offer in order to commit a diverse range of criminal activities. These include attacks against computer data and systems, identity theft, the distribution of child sexual abuse images, internet auction fraud, the penetration of online financial services, as well as the deployment of viruses, Botnets, and various email scams such as phishing.[8]

In contrast, the sine quo non of cyber espionage is gathering intelligence—governmental, corporate, or individual[9]—and often involves stealing trade secrets, intellectual property, and confidential government information. Despite the military nexus, and the “real and serious threat” to the state, cyber espionage typically will not trigger “application of international law on the use of force” but rather require a domestic or international criminal law response.[10]

Cyber terrorism and “hacktivism” are also commonly used in describing hostile cyber practices. Cyber terrorism has been defined as “the intimidation of civilian enterprise through the use of high technology to bring about political, religious, or ideological aims, and actions that result in disabling or deleting critical infrastructure data or information.”[11] In turn, a “hacktivist” is a “private citizen who on his or her own initiative engages in hacking for, inter alia, ideological, political, religious, or patriotic reasons.”[12] Both of these activities can obviously cause significant damage to a state.[13]

Though certain cyber activities occur “below the level of a ‘use of force’ as this term is understood in the jus ad bellum,”[14] a “lack of agreed upon definitions, criteria, and thresholds for application” coupled with “the rapidly changing realities of cyber operations” continue to raise questions concerning law enforcement versus military responses.[15] Determining the appropriate response may be possible only by discerning the goals and motives underlying the activity,[16] which is usually very difficult in that transparency and attribution are often nonexistent in cyberspace.

Cyber warfare, by contrast, generally “trigger[s] the international law governing the resort to force by States as an instrument of their national policy,” the Law of Armed Conflict,[17] and the associated risks of traditional hostilities.[18]

 Universal Cable Productions

A September 2019 decision regarding the war exclusion, albeit not in the cyber context, addressed some of these issues.[19] In that case, the U.S. Court of Appeals for the Ninth Circuit reviewed a lower court decision regarding an insurance claim by two production companies who were forced to relocate the production of a television program from Jerusalem due to Hamas rocket attacks.[20] The insurance company denied coverage on the grounds that the covered expenses were barred by virtue of exclusions for “war” and “warlike action by a military force.”[21] The Ninth Circuit rejected these arguments and held that “war” in the insurance context is limited to hostilities between sovereigns, and that although Hamas has control over Gaza, “Gaza is part of Palestine and not its own sovereign state” and that Hamas “never exercised actual control over all of Gaza.”[22]

Resolving Cyber Insurance Disputes

As cyber threats increase in the face of COVID-19 distractions,[23] it is likely that there will be related insurance claims and disputes regarding such claims. Policyholders, brokers, CFOs, and risk-management professionals should pay close attention to the wording of “war” exclusions to assess whether insurers may seek to invoke those provision in the event of a claim.

Should a dispute arise, stakeholders may want to consider utilizing alternative dispute resolution methods. As discussed in a prior article by the authors, there may be unique advantages to doing so in the context of a cyber insurance dispute, including, among other things, confidentiality and the ability to select a neutral who is versed in the key technical issues.[24] Doing so will allow the parties to go straight to the heart of the matter and perhaps, to the chagrin of Clausewitz, avoid the duel.

[1] Carl Von Clausewitz, On War 75 (Michael Howard & Peter Paret, eds., 1989 ed.).

[2] IRMI, “War Exclusion.”

[3] See Andy Greenberg, The Untold Story of NotPetya, the Most Devasting Cyberattack in History, Wired, Aug. 22, 2010.

[4] See Scott J. Shackelford, In Search of Cyber Peace: A Response to the Cybersecurity Act of 2012, 64 Stan. L. Rev. Online 106 (Mar. 8, 2012).

[5] See Tom Bradley, When Is a Cybercrime an Act of Cyberwar?, PC World, Feb. 20, 2012; see also Brad Lunn, Strengthened director duties of care for cybersecurity oversight: Evolving expectations of existing legal doctrine, 4 J. L. & Cyber Warfare 1, 109–137 (2014).

[6] Oona A. Hathaway, Rebecca Crootof, et al., The Law of Cyber-Attack, 100 Cal. L. Rev. 817, 834 (2012); Gary Solis, Cyber Warfare 1 (unpublished manuscript) (on file with authors).

[7] See Chris C. Demchak, Wars of disruption and Resilience: Cyber Conflict, Power, and National Security 8 (2011).

[8] Interpol (last visited April 23, 2015).

[9] Tallinn Manual on the International Law Applicable to Cyber Warfare 193 (Michael Schmitt ed., 2013) [hereinafter Tallinn Manual] (defining cyber espionage narrowly as “any act undertaken clandestinely or under false pretences [sic] that uses cyber capabilities to gather information.”). The Tallinn Manual was developed “to help governments deal with the international legal implications of cyber operations.” See, e.g., Manual Examines How International Law Applies to Cyberspace, IT World (Sept. 3, 2012) (noting that The Cooperative Cyber Defense Center of Excellence, which “assists NATO with technical and legal issues associated with cyber warfare related issues,” created the Tallinn Manual to address a variety of cyber legal issues). The Tallinn Manual examines the “international law governing cyber warfare” and encompasses both jus ad bellum and the jus in bello. Tallinn Manual, supra, at 4.

[10] Tallinn Manual, supra note 9, at 4.

[11] William L. Tafoya, Cyber Terror, FBI Law Enforcement Bulletin (Nov. 2011).

[12] Tallinn Manual, supra note 9, at 259.

[13] See, e.g., Nicole Perlroth, Anonymous Attacks Israeli Web Sites, N.Y. Times, Nov. 15, 2012; Michael Rundle, ‘Anonymous’ Hackers Declare Cyber War On North Korea, Claim Internal Mail System Hacked, Huff. Post UK, Apr. 4, 2013.

[14] Id.

[15] Id. at 42.

[16] See Bradley, supra note 5.

[17] Tallinn Manual, supra note 9, at 4.

[18] See Philippa Trevorrow, Steve Wright, et al., Cyberwar, Netwar and the Revolution in Military Affairs 1, 3 (2006) (discussing how modern societies are, for the most part, highly dependent on the continuous flow of information); Michael McMaul, Hardening Our Defenses Against Cyberwarfare, Wall St. J., Mar. 6, 2013, at A19 (“Digital networks could be used as a conduit to gas lines, power grids and transportation systems to silently deliver a devastating cyberattack to the U.S.”).

[19] Peter Halprin & Nicolas Pappas, Cyber Insurance for Critical Infrastructure and Debate About War, IIoT World Cybersecurity Blog (Nov. 5, 2019); see also Michael Gervais, Cyber attacks and the laws of war, J. L. & Cyber Warfare 1.1, 8-98 (2012).

[20] Universal Cable Productions, Inc., v. Atlantic Specialty Ins. Co., 929 F.3d 1143 (9th Cir. 2019).

[21] Id. at 1147.

[22] Id. at 1148.

[23] See, e.g., Peter A. Halprin & Jacquelyn Mohr, COVID-19 Cybersecurity and Insurance Coverage, N.Y.L.J. (Apr. 20, 2020).

[24] See, e.g., Peter A. Halprin & Daniel Garrie, Arbitrating Cyber Coverage Disputes, 29 Coverage Magazine 1 (Winter 2019); see also Michael Gervais, Cyber attacks and the laws of war, J. L. & Cyber Warfare 1.1, 8-98 (2012).

Market turmoil due to COVID-19 has halted many IPO plans, but IPOs by SPACs (special acquisition companies) are actually picking up in pace. Indeed, according to my sources at the Nasdaq, 40% of proceeds raised in IPOs to date this year have been from SPACs. And, as night follows day, more SPAC IPOs will lead to more SPAC litigation.

© Nasdaq 2020, Used with Permission

Compared to traditional IPOs, SPACS have not been involved in much litigation at all. But now is not the time for directors of SPACs to become complacent about litigation risk—if the past is any guide, there are several categories of SPAC suits worth guarding against.

As I discuss below, some of these suits are more problematic than others, with bankruptcy presenting particular difficulties. I’ll also discuss ways to mitigate your litigation risk, including through insurance.

Here are five types of private litigation that may be of concern to SPACs, one of which is likely only a theoretical category. Outside the scope of this article are potential SEC enforcement actions, which are of course also a concern for SPACs.

1. SPAC IPO Suits

When a SPAC first raises money in the public market, it is technically undertaking an initial public offering of its securities pursuant to an S-1 registration statement. We do not typically see Securities Act Section 11 litigation against these registration statements. As a reminder, in a Section 11 case, a plaintiff alleges liability for damages for material misrepresentations or omissions of facts in the registration statement.

This is not a surprise given that SPACs are shell companies with the sole purpose of raising capital in an IPO to acquire or merge with a private operating company and take it public. In other words, they are not operating companies that are doing things like missing guidance and other activities that tend to draw lawsuits against traditional IPO companies.

In addition, the funds raised in a SPAC are kept in a trust, and investors have the ability to opt out of the SPAC by redeeming their shares or by voting against future proposed acquisitions.

As a result, absent a great, big, effortful fraud, we would not expect to see much in the way of securities class action suits against the SPAC related to its IPO.

2. M&A Suits Challenging the SPAC Business Combination

One type of suit that pops up with SPAC transactions challenges the completeness of the proxy statement filed in connection with the SPAC’s acquisition of an operating company (also known as the “De-SPAC transaction”).

The suit filed in the United States District Court of Delaware against Greenland Acquisition Corporation is typical. In this kind of litigation, plaintiffs file suit alleging deficiencies in a proxy statement in violation of the ’34 Act, and then go away relatively quickly for a relatively low mootness fee once the defendants amend the proxy statement with some additional disclosures.

3. M&A Suits When the Target Company Does Poorly

Another type of SPAC-relevant M&A suit is brought after the merger when plaintiffs are unhappy about how things turned out. A critical element of these suits is the allegation that shareholders learned of the true shabbiness of the target company only after the merger was completed.

The China Water Case

One example is the Heckman case (aka the “China Water” case), which settled in 2014 for $27 million. Heckman was a SPAC that raised $433 million in its 2007 IPO. In 2008, Heckman and its board solicited shareholder approval of China Water and Drinks Company, a Nevada corporation.

The plaintiffs alleged that the proxy statement misstated China Water’s operations, finances, and business prospects, among other things. The plaintiffs also alleged ’34 Act Section10(b) fraud violations. Finally, the plaintiffs complained about Heckman’s diligence of China Water’s finances, internal controls and management.

The Waitr Case

For another example, consider the 2019 case of Welch v. Meaux . The plaintiffs in this case brought both Section 11 and Section 10(b) claims against officers and directors of the publicly traded company in connection with a de-SPAC transaction. The case also included a claim concerning the subsequent follow-on offering.

The SPAC in question, Landcadia, had raised $250 million in its 2016 IPO. Landcadia had 24 months to complete its business combination before being forced to return the proceeds to its investors. With two weeks to go before the deadline, Landcadia agreed to buy a mobile food ordering and delivery company.

Things did not go well with the target company after it became publicly traded. Plaintiffs ultimately brought suit, alleging material deficiencies in the proxy statement and subsequent registration statement.

Their allegations included the charge that when the target company began publicly trading, investors were not told of all the risks being foisted onto them. Moreover, the plaintiffs alleged that they were deceived as to the company’s prospects for profitability. This case is still pending.

4. Securities Class Action Suits Against the SPAC-Funded Operating Company

Once a SPAC has completed the business combination that results in a publicly traded operating company that new operating company is subject to the same scrutiny and potential for litigation as any public company.

Consider the April 2020 case of Akazoo, a music streaming company. Akazoo became a publicly traded company through a reverse merger in 2019 with Modern Media Acquisition Corp., a SPAC.

The plaintiffs in this federal securities class action case allege that Akazoo made false and misleading statements about its revenue, profits, and operations, among other things, and that consequently shareholders purchased securities at artificially inflated prices.

Specifically, Defendants made false and/or misleading statements and/or failed to disclose that: (1) Akazoo overstated its revenue, profits, and cash holdings; (2) Akazoo holds significantly lesser music distribution rights than it has stated and implied; (3) as opposed to Akazoo’s continued statements, it does not operate in 25 countries; (4) Akazoo has a significantly smaller user base than it states; (5) Akazoo has closed its headquarters and other offices around the world; and (6) as a result, Defendants’ public statements were materially false and/or misleading at all relevant times.

None of the SPAC directors were named in this Section 10(b) suit. This case is still pending.

5. Bankruptcy Suits

During bankruptcy, directors and officers are especially susceptible to being sued, and the bankruptcy of a company that becomes publicly traded through a SPAC is no exception.

SPAC board members that become directors and officers of the operating company they acquired might have some additional risk compared to other board members. This is due to the way SPACs are traditionally structured when it comes to the incentives provided to SPAC sponsors, people who are usually also the SPAC’s board members. The situation faced by the board of Paramount Acquisition Corp. in a is a cautionary tale.

This SPAC raised over $50 million in 2005, and had two years to find a suitable target. Very close to the final drop-dead date, Paramount acquired Chem Rx. Unfortunately, within 18 months, Chem Rx was in violation of the financial covenants on its credit facilities.

Chem Rx ultimately filed for bankruptcy in 2010. When the company was liquidated, a litigation trust was established to pursue claims on behalf of Chem Rx’s unsecured creditors.

The litigation trust brought suit against the six members of the board of directors of Paramount on behalf of Chem Rx. On behalf of the creditors, the plaintiffs alleged that entering into the Chem Rx transaction was itself a breach of fiduciary duties by the Paramount directors.

The plaintiffs argued that the court could not let the directors have the benefit of the business judgment rule when it came to the acquisition of Chem Rx because the directors were self-interested. The directors had an economic interest in the acquisition of Chem Rx that went beyond what all shareholders would get if the transaction went well.

As explained by the law firm McDermott:

[U]nder Paramount’s certificate of incorporation, if a shareholder-approved acquisition of a health care entity failed to close by a “drop-dead” date . . .October 27, 2007 (24 months after Paramount’s IPO) . . .Paramount would dissolve. In such an event, the IPO proceeds held in the trust account would be distributed in liquidation to Paramount’s public stockholders, and all of Paramount’s warrants (including those purchased by the directors) would expire worthless.

The directors had purchased two million warrants for $1.3 million. They also had acquired more than two million shares of Paramount founder stock for $25,000 (which compared very favorably to the IPO price in which the purchase price per unit was $6 [consisting of one common share and two warrants per unit]).

This type of arrangement is common for a SPAC, as is the proviso that the investment by the SPAC founders becomes largely worthless if the SPAC is unable to complete a de-SPAC transaction. On the other hand, the arrangement is highly profitable should things go as planned.

This financial arrangement is intended to motivate and reward the founders for spending their time, energy, and funds organizing the SPAC, taking it through the IPO process, and finding a good acquisition target.

Unfortunately, a New York court found that this structure was sufficient to keep the directors from winning their case on a motion to dismiss based on the business judgment rule. In other words, the plaintiff’s claims as to the breach of fiduciary duty due to self-interested motivations was sufficient for the case to move forward.

A SPAC’s favorable financing arrangement with its founders may not always leave the founder directors unable to rely on the business judgement rule. According to the McDermott memo, a shareholder vote based on good information would give back to directors the benefit of the business judgment rule:

[T]here are numerous Delaware court decisions holding that the legal effect of a fully informed stockholder vote of a transaction is that the business judgment rule applies and insulates the transaction from all attacks other than on the grounds of waste, even if a majority of the board approving the transaction was not disinterested or independent. See In re KKR Financial Holdings LLC Shareholder Litigation, C.A. No. 9210-CB (Del. Ch. October 14, 2014)

This obviously puts a lot of pressure on the quality of the disclosures in the proxy statement sent to shareholders to ask for their vote for a business combination.

How Can Your SPAC Avoid Litigation?

The cases above demonstrate some clear lessons:

1. Keep the timeline top of mind. If a business combination takes place close to when a SPAC is about to expire, the timing will definitely come up in the shareholder complaint should things end badly.
2. Be diligent. Ensure you have a complete, well-written proxy statement for the business combination. This seems obvious, but the facts in some of these cases makes it worth repeating.
3. Implement federal forum provisions. This is also known as the “Grundfest Solution.” While we have not yet seen a slew of SPAC-related cases brought in state court, we know that . The result is usually a much more expensive case compared to a case brought in federal court. For this reason, make it a priority to in all relevant charter documents.
4. Use a sophisticated approach for your D&O insurance program. The cases summarized above are complicated, which indicates the need for a thoughtful approach when it comes to your D&O insurance needs. You will want to work with an insurance broker who has a lot of experience with these types of transactions, and the types of claims that can arise from them.