Last fall, the Pro Bono Services Subcommittee of the ABA’s Business Law Section’s Business Bankruptcy Committee presented a program entitled “Helping Those Who Have Borne the Battle: Working with Veterans, Servicemembers, and Their Families on Financial Issues” at the virtual Insolvency 2020 Conference. The program panelists[1] identified tips and several key issues arising in the representation of veterans, servicemembers, and their families, and explained significant changes made to the Bankruptcy Code in 2019.
The Importance of Identifying Clients Who Have a History of Military Service
It is critical for attorneys undertaking pro bono representation to identify clients who have served in the military or who may have family members who have served, because military service could qualify the client for special financial resources and increased legal protections. For example, servicemembers may be eligible for VA disability compensation or VA veterans’ pension, which may be protected income in bankruptcy. In addition, clients with military service could also require special considerations before filing for bankruptcy.
Identifying those who have a history of military service can be difficult, however, because the term “veteran” has different meanings across various state and federal programs and laws, as well as among individuals, and could lead some who have served not to identify themselves as a “veteran”. Instead, the experts recommend that attorneys ask prospective clients, “Have you ever served in the military?” Framing the question in this way can help the attorney identify whether the client might be eligible for service-related benefits and protections, even though the client might not satisfy a particular definition of the term “veteran.” Because service-related benefits and protections might also be available to, for example, certain family members, loved ones, and household members, it can also be helpful to frame the question even more broadly.
Specific Legal Protections and Benefits
Attorneys should generally be aware of the specific military service-related legal protections and benefits available in their jurisdiction. Some common protections and benefits are:
Servicemembers Civil Relief Act (SCRA)
Chapter 53, Title 38: Special Provisions Relating to [Veterans’] Benefits
VA Health Care
VA Disability Compensation
VA Veterans Pension
Soldiers’ Homes
Forever GI Bill
Vocational Rehabilitation
Pre-Bankruptcy Considerations
Attorneys should also keep pre-bankruptcy considerations in mind prior to and throughout representation, including:
Benefit overpayment disputes, waivers, and payment plans
Currently not collectible (hardship) status with taxing authorities
Military discharge status (and whether it can be upgraded or corrected)
Unusual issues:
Impact of debts and bankruptcy on a servicemember’s Security Clearance
Impact of bankruptcy upon future use of VA Home Loan Guaranty benefits
Possible nondischargeability in bankruptcy of fraud-related VA benefits overpayment
Recent Legislation: HAVEN Act
Attorneys should keep apprised of new developments in the Bankruptcy Code, such as the Honoring American Veterans in Extreme Need Act (the “HAVEN Act”),[3] that can help current and former servicemembers, among others, filing for bankruptcy.
In 2018, the American Bankruptcy Institute (“ABI”) created the Task Force on Veterans and Service Members Affairs. The Task Force sought to eliminate some of the underlying financial factors that contribute to suicide rates among those who have served. The Task Force targeted specific portions of the Bankruptcy Code that put servicemember and veteran disability benefits at risk.
The Task Force’s efforts culminated the HAVEN Act, a piece of bankruptcy reform legislation that amended 11 U.S.C. § 101(10A)—the definition for “current monthly income”—to exclude disability payments received from the U.S. Department of Defense and the U.S. Department of Veterans Affairs from the current monthly income calculation.[4] As a result, it is substantially easier for current and former servicemembers (among others, including family members who receive qualifying benefits) to keep those benefits while retaining eligibility for relief under the Bankruptcy Code.
Serving Those Who Have Served
More work to support servicemembers and their families is needed. You can find volunteer opportunities and more information at these sites:
[1] Judge Elizabeth S. Stong, U.S. Bankruptcy Court for the Eastern District of New York, Co-Chair of the Pro Bono Subcommittee of the ABA Business Law Section’s Business Bankruptcy Committee; Judge Mary Grace Diehl U.S. Bankruptcy Court for the Northern District of Georgia; (Army Lieutenant Colonel) Kristina M. Stanger, partner at Nyemaster Goode, P.C. law firm (Des Moines, Iowa); and Jessica H. Youngberg, Law Clerk, U.S. Bankruptcy Court for the District of Massachusetts.
[3] Pub. L. No. 116-52 (codified at 11 U.S.C. § 101(10A)(B)(ii)(IV)).
[4] The statute reads in relevant part, “…any monthly compensation, pension, pay annuity, or allowance paid under title 10, 37, or 38 in connection with a disability, combat-related injury or disability, or death of a member of the uniformed services…” The payment source and basis are key (Title 10 – Armed Forces; Title 37 – Pay and Allowances of the Uniformed Services; Title 38 – Veterans’ Benefits).
An important part of scaling for start-ups and emerging companies requires strategic use of investment tools. Stock options and warrants, while similar, are distinct forms of equity structures that are often confused. This article is part of our series discussing these strategies in turn and exploring key considerations that start-ups and emerging companies should be considering when issuing either. For further information about stock options, see our article “Stocked up: How start-ups and emerging companies can effectively utilize options to attract and retain talent.”
There has been a significant uptick in the number of start-ups and emerging companies using warrants to close the gap on various transactions. When offered in conjunction with effective negotiation, warrants can incentivize third parties to enter transactions or to agree to more favorable deal terms.
A warrant is an agreement between a company (the “Issuer”) and the holder of the warrant (the “Warrantholder”). Warrants entitle the Warrantholder to purchase shares at a specified price within a predetermined period.
What are Warrants?
Warrants are certificates or other instruments issued by a company as evidence of conversion privileges, options, or rights to acquire shares of the company at a specific price until a fixed expiration date. Since warrants do not typically entitle the Warrantholder to dividends or voting rights, warrants are valuable solely for their profit-earning potential.
Companies commonly use warrants as an inducement to attract investors or leverage favorable deal terms. For example, warrants are frequently used as “sweeteners” to incentivize investors to invest or to incentivize a lender to loan funds at a more favorable interest rate, whether bank financing or venture debt. Companies may also use warrants when entering into strategic relationships or transactions to encourage the other party to enter into the transaction or buy into the company’s long-term success.
Although warrants are similar in structure and serve a similar function to options, the critical difference is that options are typically issued to internal stakeholders, such as employees, directors, consultants and other service providers, and not to external third parties. Further, as options are typically issued under an option plan, the issuance of these options would need to conform to the terms of that plan. On the other hand, warrants are typically offered to external third parties as described above.
The issuance of a warrant is usually evidenced by way of a document called a warrant certificate. A warrant certificate sets out the essential terms of the warrant, including:
the exercise price, the number of underlying shares into which the warrants are exercisable and the term of the warrant;
procedures and conditions for exercising the warrant; and
adjustment provisions intended to protect the value of the warrant.
Key Considerations when Issuing Warrants
Types of Shares
Before issuing warrants, start-ups and emerging companies must first determine the type of underlying security the Warrantholder will have the right to acquire. In most instances, warrants are issued for common shares. However, in some instances, the Warrantholder may be entitled to preferred shares. When issued to investors as a “sweetener,” the underlying security will typically match the shares purchased by the investor. For example, outside investors, such as venture capital funds, will commonly only invest if the company is issuing preferred shares that have specific rights, privileges and preferences compared to the common shares.
Number of Shares
The number of shares underlying the warrant may be fixed or expressed as a formula. A formulaic approach to calculating the number of shares the Warrantholder may acquire can be a valuable tool to incentivize a third party, such as where the Warrantholder is a strategic sales channel partner. Therefore, the warrant could be structured so that the sales channel partner would have the right to purchase additional shares if the sales channel partner meets specific sales targets. In addition, a formulaic approach may also incentivize a lender to loan additional funds under an existing credit facility. The number of shares the lender may acquire may increase if the start-up or emerging company borrows additional funds. However, when using a formulaic approach or fixed percentage warrants, start-ups and emerging companies must carefully consider the dilutive effects of any mechanisms that allow for an increase in the number of shares a Warrantholder may acquire.
Alternatively, a company may issue warrants to an investor that will allow the investor to purchase a fixed percentage of shares equal to a fixed percentage of the outstanding equity securities at the time of exercise. Fixed percentage warrant generally does not require price-protection anti-dilution provisions (discussed below). As the number of shares the Warrantholder can purchase is calculated at the time of exercise, fixed percentage warrants can disproportionately impact other shareholders of the company, including its founders, if the company issues additional shares prior to exercise by the Warrantholder of the fixed percentage warrant. Any start-ups and emerging companies that are considering issuing fixed percentage warrants should determine whether there will be any inadvertent consequences of doing so and should consider if fixed percentage warrants should expire prior to a specific event, such as the company’s next round of financing.
Exercise Price
The exercise price (the “Strike Price”) of a warrant is the price of each share underlying the warrant. The Strike Price of a warrant can vary dramatically depending on the context in which the warrant will be issued. In certain circumstances, companies will set the Strike Price at or above the fair market value of the underlying securities. In other circumstances, the Strike Price will be set at a nominal value, which are typically called “penny warrants.” The Strike Price could also be calculated based on a predetermined formula or based on the future valuation of the start-up or emerging company.
Anti-dilution
The warrant may be subject to anti-dilution provisions, which are intended to protect the Warrantholder’s right to receive the value that was negotiated at the time of issuance of the warrant. Certain corporate actions taken by the Issuer during the term of the warrant may have a dilutive effect on the value of the underlying securities, such as consolidation of the company’s outstanding shares or distribution to shareholders of additional shares by way of dividend. A down round may also trigger price-protective anti-dilution provisions—this occurs where the company issues shares at a lower price per share than had been sold in a prior round. For price-protective anti-dilution provisions, the formula used to determine the manner in which the warrants will be adjusted is often a negotiation point.
Start-ups and emerging companies must carefully consider how a down-round will impact the warrant terms. Anti-dilution provisions may adjust the Strike Price and/or the number of underlying shares that are exercisable. The adjustment should be proportionate and reflective of the triggering event and place the Warrantholder in substantially the same position but for the triggering event. Both the Warrantholder and the emerging company must carefully consider how any anti-dilution provisions are drafted. This includes ensuring that there are appropriate carve-outs for predetermined events—such as equity issued as compensation—that do not inadvertently trigger the anti-dilution provisions.
Term
Warrants are exercisable up until a specific time, often referred to as the expiration date or maturity date. The term will depend on many factors, including the nature of the deal. Generally, a longer term increases the value of the warrant because there is a greater likelihood of the company’s success over time and, therefore, a more significant payout as the shares appreciate.
The term may be subject to adjustment provisions if certain fundamental changes are undertaken by the Issuer during the term of the warrant. For example, triggering events for term adjustment provisions may include an amalgamation, merger or disposition of the Issuer’s assets. In the case of these events, the term of the warrant may accelerate so that each outstanding warrant will, after the completion of such an event, be exercisable for the kind and amount of shares that the Warrantholder would have otherwise been entitled to receive immediately prior to the effective date of the event.
When determining the term of the warrant, start-ups and emerging companies must do so in the context of their growth strategy. As discussed above, the type of warrant and its terms may also need to be considered when establishing the expiration date of any warrant.
Exercise of Warrants
Most warrants will be freely exercisable in whole or in part by paying the cash exercise price. Some warrants also allow for what is called a “cashless exercise.” Cashless exercise entitles the Warrantholder to apply the exercise price against the aggregate value of shares it will receive. This is achieved by decreasing the number of shares the Warrantholder will receive by an amount equal to the exercise price that the Warrantholder would have been required to pay for exercising its warrants.
Conclusion
If used correctly, warrants can be a useful tool to incentivize investors and secure critical relationships with customers, buyers, sellers, and partnerships. However, start-ups and emerging companies must carefully consider the warrant terms to ensure they effectively support their long-term growth.
In mid-June, as we all started thinking that the pandemic was winding down, I stepped into my role as president of the International Women’s Forum (IWF) of Chicago. IWF is an international network of women leaders from across sectors that includes CEOs, entrepreneurs, artists, academics, film stars, and even prime ministers and presidents. It is a group of women who work to advance women’s leadership and equality worldwide.
I was humbled to be stepping into this role and excited to lead through a year of recovery and celebration over our collective defeat of COVID-19. I looked forward to bringing lessons of leadership and agility from my law firm and the legal profession more broadly to my new position. Instead, I am monitoring changing regulations and commiserating with women across the globe as COVID numbers rise.
The last nearly 18 months have been challenging for nearly everyone, but women have been the hardest hit in terms of job loss and familial pressure. Burnout is rampant. Women are stepping back or dropping out. This is especially true in the legal profession. Our trade has historically required long hours and tremendous commitment. Throughout the pandemic, many women attorneys struggled to maintain work hours while also monitoring remote schooling for their children, caring for parents, and counseling friends, family members, clients, and employees.
Women attorneys were the primary carriers of the emotional load of the pandemic, stressing about the safety of their loved ones, the education of their children, and the uncertainties of their clients. And, just when we thought it was safe to breathe and put down that load, COVID rates are surging again. Something has to give.
The legal profession has failed to adapt to a new world
The legal profession has too often rewarded long hours over results, complexity over efficiency, and billing over service or strategy. With all the advancements in technology and systems, the profession still clings to archaic mores. The pandemic has highlighted a truth that has been ignored for too long: this profession has failed to adapt to the changing world around us. Too many women feel forced to drop out because the profession continues to say, “We have to do it this way because that’s how we’ve always done it.” That has been the death anthem of so many businesses of the past, and yet it continues to be the battle cry of so many law firms. If there was ever a time for change in the profession, it is now.
It is impossible to do your best work when you are exhausted. It is impossible to be your best self when you are unhealthy. It is impossible to be truly present, to lead with certainty, to live your best life, when you are constantly rushing against the clock. These are simple, obvious truths. Still, busyness is idolized in the legal profession. Everyone laments the system—judges, lawyers, and paralegals alike. We all complain about the hours, the gamesmanship, and the stress. And yet we are complicit.
As the founder and managing partner of a boutique, multi-million-dollar firm, I know I am guilty of perpetuating this cycle. I started my firm before I had children and spent 12-to-16-hour days split between doing the work and building the relationships necessary to keep a full pipeline. I bought into the narrative that the hours were necessary because it worked. I scheduled meetings at 7 a.m., lunch time, and after work. I finished my legal work in between meetings and late into the night. I became active in bar associations and business organizations.
Four years after launching the firm, I had my first daughter, and just over two years later I had my second. I kept up the hours. My sleep suffered. My health suffered. My personal relationships suffered. My team at work suffered. I am committed to exploring ways to correct my mistakes. And we need both men and women to make that happen.
The glorification of overtired work must end
Working ever more hours, and doing so on little sleep, seems to be highly prized in the legal profession, even though we all know it’s fundamentally bad for us. Our profession needs to reorder its priorities so that healthy lifestyles and tenacious legal work can mutually support one another. Adequate sleep, regular exercise, and extended breaks are simple but meaningful steps that can help us course-correct.
Even as I write this, I continue to spread myself thin, but certain habits have helped me to maintain a degree of balance. To give my family, my clients, and my team the best I have to offer requires boundaries. I have made a point to carve out necessary time for sleep, which I have learned is a necessity, not a luxury. As a member of the board of the National Sleep Foundation, I know the research on sleep is irrefutable. After a good night’s rest, we are all more alert, have greater cognitive reactions, and able to deliver better physical and mental performance in nearly every activity. Exercise is equally as important. I make time early in the morning every day to focus on my body before I spend the rest of the day exercising my mind.
When we see colleagues on the cusp of burnout, we should give them permission to step back and take a break. Although I have struggled to do so in past years, I recently took a vacation. A true vacation. Such an extended break from our regular work schedules is the best way to activate creativity and truly conscious thinking. I returned to my office feeling rejuvenated and ready to dive back into client matters and office management. Law firms need to build in the ability to walk away for a discrete amount of time to re-energize. Working around the clock without sufficient breaks will lead to burnout and, eventually, turnover. Incentivizing proper breaks, however, will help individuals and firms succeed.
It is not solely the responsibility of women to lead with solutions
Lawyers are problem-solvers. We can solve our profession’s problem with balance and by recognizing the fact that it most negatively affects women attorneys. But we must not place the burden of finding solutions solely on the shoulders of women, as if they alone are responsible for creating a new legal work culture. Everyone is implicated and we all have a responsibility to move our profession forward in a healthy way.
In my involvement in women’s leadership over the years, I have sometimes seen that women expect themselves to engineer all the change that is needed to equalize the playing field. And—if they are thinking of such issues at all—men almost always share this expectation. But that mustn’t be the case. It is imperative that we craft a better legal profession so that women are not shut out and don’t have to choose between career and family. In the end, a reimagined and healthier profession will be better for everyone.
I cannot claim to have all the necessary solutions, but the prognosis is clear: all actors in the legal system need to support a more balanced profession, one that supports women’s career goals and enables them to wear other hats as well. It will not be simple and it will not be easy. But women’s empowerment and leadership does not exist in a silo. It is up to men to proactively make the changes that our field needs if it is to remain vibrant and attractive to future generations.
Last year was hard, but it made very clear what we should all have known all along: we cannot keep doing things the same way we have in the past. Clients have been seeking efficiencies for years, but firms are slow adopters. We cannot expect the industry to produce necessary boundaries. We have to be the ones to create them.
Let’s stop complaining about the profession and start taking real steps to change the way we engage with the industry. The work is not just for women, but it can certainly start with us.
The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished former Business Law Section Chair Mendes Hershman (1974–1975) lends his name to this legacy. See the abstract of this year’s second-place winner, Benjamin Seymour of Yale Law School, Class of 2021, below. The full article (available on SSRN) is forthcoming in Volume 36 of the BYU Journal of Public Law.
Despite its intense focus on inter-jurisdictional competition, corporate law scholarship has thus far overlooked the influence of inter-branch competition on business organizations. This Article shows how inter-branch struggles for control over corporations catalyzed the advent of modern corporate law and helped propel Delaware to its dominant position in the market for corporate charters.
For centuries, the legislature, judiciary, and executive vied for the decisive role in dictating the means and ends of corporations. Through the nineteenth century, competition among the branches produced a dysfunctional and volatile relationship between government and private enterprise, with each branch successively assuming a leading role in corporate oversight, only to falter under the weight of its unique structural limitations. The resulting instability ultimately proved so intolerable as to prompt the creation of an entirely new paradigm of liberalized corporate codes at the dawn of the twentieth century. Delaware’s innovation of and rigorous adherence to corporate law’s newfound separation of powers gave it a crucial, yet previously unappreciated, edge in the competition for corporate charters. Moreover, modern corporate law’s system of checks and balances curbed longstanding abuses and ushered in an equilibrium among the branches that has served as a foundation for economic growth in the United States since.
Beyond illuminating a novel factor in Delaware’s ascendancy, corporate law’s separation of powers poses unappreciated problems and provides preliminary solutions for the ongoing debate over corporate purpose. A growing chorus of progressive academics and policy-makers has called on the government to impose and enforce corporations’ social obligations. This Article offers new grounds for skepticism towards these proposed reforms, because they would jeopardize corporate law’s hard-fought equilibrium among the branches by reviving the unilateralism and dysfunction that once plagued the United States’ corporate law regime. Accordingly, this Article contends that vesting the government with a proactive role in imposing and enforcing corporate purpose, whether at the state or federal level, is ill advised. Yet this Article also providers reform-minded progressives with a concrete framework for structuring an expanded power to enforce corporate purpose with minimal risk to corporate law’s separation of powers.
When you receive a loan, is the money taxable? Of course not, because you must pay back the money. That obligation prevents the loan money from being considered income. Of course, if the loan is later forgiven, that forgiveness can trigger taxation, unless you fall within one of the few exceptions to cancellation of debt income.
Can lawyers borrow just like anyone else? Of course, and for that reason, many lawyers and litigation funders are fretting about Novoselsky v. Commissioner, T.C. Memo. 2020-68 (2020). In this case, a lawyer was taxed on litigation funding loans. It’s one of those classic bad-facts bad-law situations, and for that reason, much of the hype needs explanation. In fact, this perfect storm is full of tax lessons.
David Novoselsky, a solo Chicago lawyer, raised $1.4 million with loan agreements he drafted himself. The IRS and Tax Court said they were not loans so the proceeds were taxable as income from the start. The court agreed with the IRS that he should have reported the $1.4 million in “loans” as income. Novoselsky couldn’t complain to his tax lawyer for putting this mess together because there was no tax lawyer; there was not even a business lawyer.
It was all DIY. Novoselsky was an entrepreneurial litigator, so in 2009 and 2011, he entered into “litigation support agreements” with eight doctors and lawyers around Chicago. They fell into three groups, each with a pre-existing stake in the litigation: (i) doctors who were plaintiffs in lawsuits Novoselsky was cooking up; (ii) doctors whose economic interests were aligned with the plaintiffs; and (iii) lawyers with whom Novoselsky had fee-sharing agreements.
He documented the litigation support agreements as nonrecourse loans, promising a high rate of interest or a multiple of the investment. He did not report them as income on his 2009 and 2011 tax returns, but on audit, the IRS said the $1.4 million was not a loan. When Novoselsky refused to extend the statute of limitations—standard fare in an audit—the IRS assessed taxes and penalties totaling over $600,000.
Novoselsky went to Tax Court, but proceedings were stayed when he declared bankruptcy in 2014. Novoselsky acted as his own bankruptcy lawyer too, and he emerged from bankruptcy without a discharge. Back in Tax Court—yet again pro se—he argued that nonrecourse loans were standard for litigation funders, with security on the case or cases in question.
Unfortunately, Novoselsky didn’t bother with security agreements. In their place, he put language in the litigation support agreements requiring him to pay the investor “at the successful conclusion of this litigation.” If the litigation was a bust, he would have no obligation to pay. This probably sounded like DIY common sense, but the Tax Court cited numerous cases holding that a loan is not a loan for tax purposes if it is contingent on the occurrence of a future event. That specifically includes obligations that are contingent on the outcome of litigation.
The Tax Court reasoned that the obligations under these litigation support agreements were contingent on successful lawsuits, so they were not loans. It’s not the same thing as a nonrecourse loan, even though the effect might be similar. The burden then shifted to Novoselsky to provide another justification for excluding the advances from his declared income. He claimed they were gifts or were deposits held “in trust” for investors, but the Tax Court didn’t buy either one of those explanations.
The Tax Court even went through the seven-factor test from Welch v. Commissioner, 204 F.3d 1228 (9th Cir. 2000), which the Ninth Circuit developed to help determine whether funds from a business associate were a loan or taxable income. The Tax Court said these litigation support agreements were labeled “loans,” but there was no promissory note, no payment schedule, no security, and no payments of principal were ever made. Some called for interest or a fixed-dollar premium, but no interest or other amount was ever paid. The advances were payable only out of future litigation proceeds.
The Tax Court turned to the seventh Welch factor, the most important: Had the parties conducted themselves as if the transactions were bona fide loans? Nope. Each investor agreed that Novoselsky had no obligation to pay unless the litigation was a success. In discussing the seventh Welch factor, the Tax Court referenced Frierdich v. Commissioner, T.C. Memo. 1989-393, aff’d, 925 F.2d 180 (7th Cir. 1991).
In Frierdich, a widow hired an attorney to represent her as the executor of her late husband’s estate. The widow was well acquainted with the attorney, who had been her husband’s partner in various real estate ventures. The attorney had also dealt with the widow in certain business matters, so they came to an unusual arrangement.
The widow not only hired the attorney to provide legal services, but also lent him $100,000. The attorney gave the widow a note bearing interest at 8%, but there was no fixed schedule for repayment. Instead, the principal and interest were payable when the attorney was due his fee, which was “subject to [the] closing of the estate.” The widow was authorized to deduct the loan balance from the attorney’s fee.
In Frierdich, the Tax Court re-characterized the widow’s loan as an advance payment of the attorney’s fee. The attorney’s obligation to pay under the note was not due until he was paid for closing the estate. The Tax Court found that both parties intended that repayment would be in the form of legal services. The finding in Novoselsky extended this analysis to include not only the advances received from the formal plaintiffs in Novoselsky’s cases, but also those received from the doctors and lawyers who had interests in the outcome of the various litigation.
Novoselsky’s counterparties were clients, medical professionals with interests aligned to the interests of his clients, and lawyers with fee-sharing agreements. Repayment was not required unless the litigation was successful, so the contingency determined whether any obligation arose in the first place. The Tax Court held that the investors’ advances were actually compensation for Novoselsky’s legal services.
Real Litigation Funding?
Does this case jeopardize lawyers getting real litigation funding? Not really, since in a commercial litigation funding transaction, the funder should have no pre-existing interest in the litigation. That should make it difficult for the IRS to argue that the funder’s advance is a disguised payment for the attorney’s legal services. As long as the loan documentation does not condition the borrower’s obligation on the outcome of the litigation, Novoselsky should not prevent loans from qualifying as loans, or as purchases for the deals structured that way.
Novoselsky is a reminder—if we need one—that plaintiffs and lawyers should generally not prepare funding documents themselves. They should not include any language suggesting that their obligation to repay a loan depends on the success of the litigation. They should limit the funders’ recourse to a security interest in the litigation proceeds.
Of course, “loans” are not common in commercial litigation funding in the first place. Most are purchases, often prepaid forward purchases. That fact further diminishes the impact of Novoselsky. In the few loans that come along, professional loan documentation usually includes a non-contingent payment obligation. Novoselsky also warns lawyers not to borrow from clients or anyone else with a stake in the case’s outcome.
Otherwise, there is a risk that a lender’s advance may be re-characterized as an advance payment of compensation. If the lender is a professional funder with no prior interest in the lawsuit, the risk seems low. Still, does Novoselsky warn lawyers that they may face a somewhat greater tax risk than plaintiffs who are similarly situated?
Suppose that a plaintiff sells a part of his case under a good prepaid forward contract. It may be awfully difficult for the IRS to find a way to tax the upfront money until the contract closes on the conclusion of the case. But let’s say that only the contingent fee lawyer is the seller under the contract, and the plaintiff is not even participating in the deal.
And let’s say the lawyer is entitled to 40% if the case produces money, and he “sells” his right to half of that fee. Even if the lawyer’s funding deal is documented as a legitimate prepaid forward, it may be more tempting for the IRS to seek ways to attack the arrangement. The lawyer, unlike the plaintiff, is always earning compensation income, so a successful challenge will hit the lawyer with ordinary income. And, of course, the IRS has a long history of going after lawyers to set an example.
Perhaps this is one reason many lawyer funding deals are structured with the plaintiff(s) also participating on some level. It is another reason that the tax timing issues for lawyers may be a little more sensitive than for plaintiffs. In the end, though, the strange case of Novoselsky seems like such a slam dunk for the IRS, and such an obvious loser for the DIY lawyer that it’s also a reminder to all: don’t try this at home!
When the Supreme Court handed down Taggart v. Lorenzen,[1] practitioners held their breath knowing that the decision could drastically change the landscape of sanctions law in bankruptcy courts. In the decision, the Supreme Court clarified the standard for holding a creditor in civil contempt for violating the discharge injunction afforded by 11 U.S.C. § 524(a)(2). But Taggart left unanswered questions: Has the sanctions landscape changed? Does Taggart inform the standard for stay violations? Plan violations? This article discusses the Taggart decision and addresses the case’s implications in turn.
The Case.
Mr. Taggart became embroiled in state court litigation relating to an entity in which he had an ownership interest. During this litigation, he filed chapter 7 bankruptcy and obtained his general discharge.
After this discharge, the state-court litigation continued and the other parties to the state court action sought—and obtained—an order awarding post-discharge attorneys’ fees against the debtor.[2] The debtor moved for contempt in his bankruptcy case, but the bankruptcy court—applying governing Ninth Circuit precedent—found that the debtor had “returned to the fray” in state court and, therefore, an award of post-discharge attorneys’ fees did not violate the discharge injunction.[3] On appeal, the district court found that the debtor had not “returned to the fray” and remanded the matter.[4]
The bankruptcy court, deciding the case on remand, applied a “strict liability” standard and held the creditors in civil contempt. Specifically, the bankruptcy court found that the creditors knew of the debtor’s discharge injunction and took the actions that intentionally violated the discharge injunction.[5] The state court plaintiffs appealed. The Ninth Circuit reversed the ruling and held that a “subjective good faith standard” was applicable to civil contempt proceedings.[6]
The Supreme Court rejected the reasoning of the lower courts and instead held that the proper standard for holding a creditor in civil contempt is the absence of “fair ground of doubt as to whether the order barred the creditor’s conduct. In other words, civil contempt may be appropriate if there is no objectively reasonable basis for concluding that the creditor’s conduct might be unlawful.”[7]
Has the Sanctions Landscape Changed?
Historically, the general contempt standard has been an objective one, where the subjective beliefs of the contemnor are typically unavailing to avoid a finding of contempt.[8] However, the Supreme Court has not always held subjective intent to be irrelevant. In Chambers v. NASCO, Inc.[9], the Court noted that sanctions may be warranted where a party acts in bad faith. And, in Young v. United States, the Court found that a party’s good faith may be considered in determining an appropriate sanction.[10] It is clear, however, that the “no fair ground of doubt” standard adopted in Taggart has its roots in objective reasonableness.
The Bankruptcy Code provides authority for the court to hold a party in contempt at 11 U.S.C. § 105(a) and § 524(a)(2).[11] Indeed, the contempt powers of the bankruptcy court—as provided for in the Code—find their roots in traditional principles from the “old soil” of prior law. The “no fair ground of doubt” standard has been applied to civil contempt outside of bankruptcy for more than 150 years.[12] The Supreme Court noted that civil contempt powers in bankruptcy are rooted in this same non-bankruptcy law.
Does Taggart Apply to Stay Violations?
On its face, no, Taggart does not purport to set the standard for sanctions in cases involving violations of the automatic stay. In addressing the standard championed by the petitioner, the Court scrutinized Taggart’s argument that “lower courts often have used a standard akin to strict liability to remedy violations of automatic stays.”[13] However, the Court found that the statutory framework supporting remedies for stay violations “differs from the more general language in [11 U.S.C. §] 105(a)” that provides the remedy for violation of the discharge injunction.[14] By contrast, 11 U.S.C. § 362(k)(1) provides a remedy for “an individual injured by any willful violation of [the] stay.”[15] The Court also found that the purpose of the automatic stay and the discharge injunction differ: “A stay aims to prevent damaging disruptions to administration of a bankruptcy case in the short run, whereas a discharge is entered at the end of the case and seeks to bind creditors over a much longer period.”[16]
The standard applicable to stay violations is not entirely settled. Courts have construed the “willfulness” language in Section 362(k) to mean simple intent to do the actions that constituted the violation (rather than intent to violate the stay).[17] In effect, such a standard functions similarly to strict liability. In the Eleventh Circuit, a defendant may be held in contempt where he “[1] knew that the automatic stay was invoked and (2) intended the actions which violated the stay.”[18] Other courts have applied the Taggart standard, finding a stay violation only if there was “no fair ground of doubt” about whether the conduct violated the stay.[19]
The Supreme Court in Taggart did not address the meaning of “willful” in the context of a stay violation, although Justice Breyer noted that “the automatic stay provision uses the word willful, a word that typically does not associate with strict liability but whose construction is often dependent on the context in which it appears.”[20] Despite this teaser, practitioners are left looking to their respective circuits for guidance on the sanctions standard in stay violation cases.
Does Taggart Apply to Violations of other Orders such as the Plan?
Again, on its face, Taggart applies only to violations of the discharge injunction. However, shortly after Taggart was handed down, a few bankruptcy courts looked to the objective standard defined in Taggart to inform the general sanctions landscape.
At least one bankruptcy court has held that the standard in Taggart is applicable in deciding whether to impose sanctions when a party violates a court order that is injunctive in nature.[21] In an opinion issued just weeks after Taggart, the bankruptcy court in In re Gravel applied Taggart to the violation of “Debtor Current Orders” which were entered to enjoin a certain class of creditors from seeking to collect “(i) any prepetition mortgage arrearage that the Order declared to be cured, (ii) any postpetition amounts that the Order declared to be paid, or any (iii) fees or expenses that were not properly noticed pursuant to Rule 3002.1(b) and (c).”[22] To be sure, discharge orders and the orders entered in Gravel serve the similar purpose of enjoining collection activity, which may be an important characteristic supporting the application of Taggart in this and future cases.
Other courts have applied Taggart even more broadly. In Deutsche Bank Trust Co. v. Gemstone Sols. Grp., Inc.[23], the bankruptcy court applied the no “fair ground of doubt” standard to violations of a confirmation order.[24] However, Taggart is not the universal standard for every sanctions order. Indeed, a bankruptcy court recently imposed sanctions against an attorney under the court’s inherent powers due to the attorney’s willful failure to comply with a discovery order.[25]
Conclusion.
Post-Taggart, bankruptcy courts should apply the objective “no fair ground of doubt” standard when assessing whether a party should be sanctioned for violating the discharge injunction. However, a practitioner cannot assume that the objective Taggart standard applies in cases where the violation relates to either the automatic stay or another court order. A variety of standards—objective, subjective, or even strict liability—may apply in those instances and practitioners should be aware that the Taggart standard may not apply uniformly when a bankruptcy court is considering sanctions.
[17]In re Olsen, BAP No. EP 16-058, 2017 Bankr. LEXIS 2402 (1st Cir. B.A.P. July 19, 2017).
[18]Jove Engineering, Inc. v. Internal Revenue Service, 92 F.3d 1539, 1555 (11th Cir. 1966) (reversing district court’s finding that there was no willful violation where “there was no malice and nothing approaching arrogant defiance or reckless disregard . . . [a] computer was, perhaps, not finely tuned.” ) (internal citations omitted).
[19]See, e.g., Suh v. Anderson, BAP NO. CC019-1233-STaF, 2020 Bankr. LEXIS 714, n3 (9th Cir. B.A.P. March 16, 2020) (“[W]e assume that the contempt standard applied to the discharge violation in Taggart also applies to the violation of the automatic stay.”).
[20]Taggart at *1804 (internal citations omitted).
[23] Case No. 19-30258-KLP, 2020 Bankr. LEXIS 1377, (Bankr. E.D. Va. May 26, 2020).
[24]Gemstone at *28 (“Under Taggart, if there is a ‘fair ground of doubt’ as to whether Defendants’ conduct was a violation of the Confirmation Order, then a finding of contempt is not permitted.”).
[25]In re Markus, 619 B.R. 552 (Bankr. S.D.N.Y. 2020).
During the COVID-19 pandemic, Initial Public Offerings (IPOs) and Special Purpose Acquisition Companies (SPACs) gained considerable popularity as ways to take a company public. During the multiple lockdowns, companies had lots of time to streamline their business plans and strategize to get them to the next level. As a result, many found 2020 to be the perfect time to take their company public via IPOs or SPACs to help respond to the uncertainty created by the world health crisis and raise funds for their business.
Although there was a slight SPAC slowdown in April 2021, numbers are settling out post-COVID going into the third quarter, and there are still lots of market opportunities for companies looking to show their growth and go public through IPOs and SPACs. Before opening up your business to a national exchange, it’s critical to understand how IPOs and SPACs evolved through COVID and what to expect post-pandemic.
IPOs and SPACs Post-Pandemic
The pandemic has seen its ups and downs for IPOs and SPACs, and in January 2021, issuances of SPACs, in particular, were once again on the rise. SPACs were so popular that by the end of March 2021, there were already 292 issuances, and they had raised $87.9 billion, which exceeded the $83.4 billion total raised in 2020. However, in April 2021, the Securities and Exchange Commission (SEC) announced it was considering new guidelines that would change the way SPACs report information on financial statements for investors. The rate of issuances dropped by almost 90% that month.
Thankfully, as we move into the third quarter of 2021, later in the pandemic, we see these numbers settling back to normal. For example, there was a rush at the end of the second quarter, with 13 SPACs pricing and going public in the last week of June alone. As of September 27, 2021, the total amount raised by SPAC issuances in 2021 so far was $127.1 billion according to the website SPAC Research. SPACs are transforming the entrepreneurial landscape of the world, and there are hundreds of SPACs from 2020 and 2021 still looking for targets as well as new market opportunities for companies to go public. Overall, COVID has had a stimulating effect on financial markets, since they have experienced breakneck growth over the past 15 months, with relatively few roadblocks or downturns and no signs of stopping post-pandemic.
When the SEC announced it was considering new restrictions on SPACs in early April 2021, many companies turned their attention back to the traditional IPO route. Going into the third quarter of 2021, IPOs alone in the U.S. had raised $79.9 billion in proceeds. This number is higher than every year in the past decade except for one, which means that 2021 is on track to go down as the most prolific year for IPOs on record. With the lockdowns over the past 18 or so months, bankers have been laser-focused and able to push as many deals through as possible, taking advantage of stock market highs. Furthermore, between institutional and retail investors, there is lots of money in the market right now, pushing many companies to go public earlier than they originally planned. With 761 offerings as of September 27, 2021, this year has already beaten 2020 in IPO frequency, surpassing its 480 IPOs, and had more than three times as many as 2019, which saw 232. As we look to the last two quarters of 2021, the trend of businesses taking advantage of IPOs to take their companies public is still on the rise.
Business as Usual
Although there will be some changes to the post-pandemic landscape, if you are looking to take your company public through IPOs or SPACs, now may be the perfect time, since the market of potential buyers has perhaps never been bigger. Not to mention, both SPACs and IPOs have proved their resiliency when faced with potential roadblocks such as the pandemic and the SEC statement on potential SPAC restrictions in April 2021. In fact, since April, the issuances of SPACs and IPOs continue to increase each quarter, and numbers are set to be record-breaking yet again in 2021.
This doesn’t mean there are no complications. Currently, one thing that adds a layer of complexity to due diligence efforts would be possible travel restrictions. In these cases, meetings or on-site visits would need to be done virtually, and in an international transaction, one would need to rely more heavily on local counsel. Of course, another thing to be aware of is that because of how hot the market is, the risks involved with IPOs and SPACs increase as well.
However, with so many buyers and so much money to be had within the market, the rewards outweigh the risks for most investors. Thus, the current IPO and SPAC landscape could be an ideal market for companies looking to go public. For many companies, it is no longer a question of if they should go public, but rather how and when.
Sophisticated clients’ expectations of their M&A deal attorneys have not slackened in the age of remote working and back-to-back Zoom meetings in the wake of the pandemic.
Given that reality, the recent publication of the latest edition of Using Legal Project Management in Merger and Acquisition and Joint Venture Transactions is particularly timely. This unique guidebook contains downloadable and customizable checklists and other tools providing an arsenal of resources for deal lawyers seeking to drive efficiency for and deliver value to their clients. The new edition adds to that arsenal and responds to new developments in the evolving M&A marketplace. It also breaks new ground with an entirely new battery of resources focused on joint venture transactions.
The new edition marks the third iteration of the guidebook to be published in just five years. Several factors have driven the number of editions in this short period.
First, there has been an explosion in the field of legal project management generally as law firms and corporate law departments alike have added legions of project and pricing managers to their ranks. The editors recently participated in a global summit of such managers, something that would have been unthinkable just a few years ago.
Second, corporate law departments and other sophisticated clients are issuing RFPs with increasing frequency that require bidding law firms to include meaningful explanations of how they would use legal project management (LPM) in carrying out their engagement.
Third, the COVID-19 pandemic catalyzed the need for the tools in the field. In a remote work world with lawyers working from various venues, having an organized and coordinated team can be a challenge, but at the same time remains a necessity. The LPM tools found in the guidebook can go a long way to helping distributed legal deal teams stay in sync.
Finally, the 100+ deal lawyers from around the world who comprise the American Bar Association’s M&A Legal Project Management Task Force kept coming up with new and creative ideas as to how LPM might be used in particular types of transactions to respond to new ways of handling deal risks and other matters. As editors of the guidebook, we owe them our thanks for their seasoned perspectives and invaluable input.
As a consequence, the Third Edition includes eight new M&A tools that are particularly relevant to the tumultuous and ever fast-moving world in which deal lawyers find themselves. The following are thumbnail descriptions of the eight new tools:
Cataclysmic Event Due Diligence Questionnaire: This is a list of due diligence and document requests triggered by or related to a cataclysmic or force majeure-like event, incident, occurrence or circumstance such as a pandemic, an Act of God, or anything else that is or has the potential to be, material, major and disruptive.
Limited Auction Checklist: This is a checklist of key items to consider in connection with a limited auction process. Such a process entails a higher degree of complexity than transactions with only one potential buyer, given the need to coordinate and stage the disclosure of information to various interested parties and handle parallel negotiations with multiple bidders.
Deal Cycle Capture Tool: This tool captures and communicate significant matters identified during the deal cycle, particularly during due diligence, where such matter requires later consideration or action, including in connection with the drafting of representations and warranties.
Section 363 Bankruptcy Sale Checklist: This is a checklist of important items to consider in connection with the sale of distressed company pursuant to Section 363 of the U.S. Bankruptcy Code.
M&A Escrow Agreement Checklist: This tool identifies issues to be considered in the negotiation of an escrow arrangement to satisfy a seller’s post-closing obligations, including purchase price adjustments and indemnification claims.
Representation and Warranty Insurance (“RWI”) Tool: This tool provides practical advice and guidance on securing and structuring representation and warranty insurance as a means to make a buyer whole for seller breaches. The tool helps you consider these key questions: What is covered? What is excluded from coverage? What is the process for putting RWI in place?
Post-Closing Reference Checklist: This tool consists of a client alert letter and accompanying list of important post-closing action items and deadlines, including items related to the bringing of indemnification claims.
Post-Acquisition Integration Checklist: While deal making is hard, integration is even harder. Oftentimes, the projected synergies and value to be realized from M&A are lost on integration. One leading contributing factor can be buyer’s failure to consider and plan how the acquired business is to be integrated into its own business after closing. This tool provides a list of questions and action items for a buyer to consider in developing and implementing a post-closing integration plan.
The Third Edition moves beyond M&A by adding four new tools developed by lawyers from around the globe who are members of the International Subcommittee of the M&A Committee of the Business Law Section. Joint ventures are complicated transactions involving sophisticated parties, and raise a number of issues in thorny areas including government, intellectual property, tax, employment law, and regulatory law. As such they are perfect candidates for LPM. The new joint venture tools leverage tools that were developed for M&A transactions, including a task checklist, a scoping tool, a drafting guide and a negotiating tool.
Now more than ever, the Guidebook serves as an indispensable tool not just for driving efficiency and client value, but also for training young lawyers and managing risk.
In a June 14, 2021, Settlement Order[1] (the “Order”), the Securities and Exchange Commission (“SEC”) alleged certain cybersecurity disclosure controls failures at First American Financial Corporation (“FAFC”).
Without admitting or denying the SEC’s findings, FAFC agreed to (1) cease and desist from further violations of SEC Exchange Act Rule 13a-15(a); and (2) pay a $487,616 penalty. Rule 13a-15(a) mandates that every issuer of a security registered pursuant to Section 12 of the Exchange Act must maintain disclosure controls and procedures to ensure that information the issuer must disclose in reports it files or submits pursuant to the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. FAFC provides products and services in connection with residential and commercial real estate transactions, including title insurance and escrow services. In connection with that business, FAFC issues common stock registered with the SEC pursuant to 12(b) of the Exchange Act. Many months before this SEC action arose, FAFC’s IT security personnel had identified a computer system vulnerability that they failed to remedy in accordance with the company’s policies, and about which they failed to inform the company’s senior management.
On May 24, 2019, a cybersecurity journalist notified FAFC that its “EaglePro” application for sharing document images related to title and escrow transactions had a cybersecurity vulnerability. The vulnerability exposed over 800 million title and escrow document images dating back to 2003. These images included Personal Identifiable Information (“PII”) such as social security numbers and financial information. In response to this notification, FAFC issued the following statement to the journalist: “First American has learned of a design defect in an application that made possible unauthorized access to customer data. At First American, security, privacy and confidentiality are of the highest priority and we are committed to protecting our customers’ information. The company took immediate action to address the situation and shut down external access to the application.” The journalist quoted this statement verbatim in his cybersecurity blog report published on the evening of May 24, 2019.[2]
FAFC then furnished a Form 8-K to the SEC on May 28, 2019, attaching an additional press release stating, in part, that there was “[n]o preliminary indication of large-scale unauthorized access to customer information.” The press release also stated: “First American Financial Corporation advises that it shut down external access to a production environment with a reported design defect that created the potential for unauthorized access to customer data.”
The June 2021 SEC Order arose in part because FAFC’s senior executives responsible for the press statement and Form 8-K were not apprised of certain information concerning the company’s information security personnel’s prior knowledge of a vulnerability associated with FAFC’s EaglePro system before making those statements – information that would have been relevant to management’s assessment of the company’s disclosure response to the vulnerability and the magnitude of the resulting risk. In particular, FAFC’s senior executives were not informed that the company’s information security personnel had identified a vulnerability several months earlier in a January 2019 manual penetration test of the EaglePro application (“January 2019 Report”), or that the company had failed to remediate the vulnerability in accordance with its policies. As discussed in the Order, FAFC did not maintain disclosure controls and procedures designed to ensure that senior management had this relevant information about the January 2019 Report prior to issuing the company’s disclosures about the vulnerability.
As evidenced by the FAFC Order, and several additional recent enforcement actions, the SEC is viewing cybersecurity threats to businesses subject to SEC rules as a growing business risk. One such enforcement action concerned Pearson plc, a London-based public company listed on the New York Stock Exchange (with Pearson’s ordinary shares registered under Section 12(b) of the Exchange Act). In August 2021, Pearson agreed to pay $1 million to settle charges that it misled investors about a 2018 data breach involving the theft of millions of student records, including dates of births and email addresses, and lacked adequate disclosure controls and procedures.[3]
Other recent SEC enforcement actions include sanctions against eight firms in three actions filed August 30, 2021, “for failures in their cybersecurity policies and procedures that resulted in email account takeovers exposing the personal information of thousands of customers and clients at each firm.” The eight firms, which have agreed to settle the charges, are: Cetera Advisor Networks LLC, Cetera Investment Services LLC, Cetera Financial Specialists LLC, Cetera Advisors LLC, and Cetera Investment Advisers LLC (collectively, the Cetera Entities) – $300,000 penalty; Cambridge Investment Research Inc. and Cambridge Investment Research Advisors Inc. (collectively, Cambridge) – $250,000 penalty; and KMS Financial Services Inc. – $200,000 penalty. All were Commission-registered as broker dealers, investment advisory firms, or both. Kristina Littman, Chief of the SEC Enforcement Division’s Cyber Unit, is quoted[4] as saying, “Investment advisers and broker dealers must fulfill their obligations concerning the protection of customer information…. It is not enough to write a policy requiring enhanced security measures if those requirements are not implemented or are only partially implemented, especially in the face of known attacks.”
Collectively, these SEC enforcement actions underscore the importance of a business:
Having appropriate privacy and cybersecurity policies;
Educating/training employees about these policies;
Ensuring the business’s contracting practices contain appropriate provisions consistent with these policies; and
Conducting periodic legal audits for compliance to these policies.
The FAFC Order also highlights the importance of executives maintaining an awareness of all material internal and external communications of the privacy and cybersecurity threats facing the business, and providing leadership from the top as to the importance of privacy and cybersecurity issues to the business’s risk management.
Special Purpose Acquisition Companies (SPACs) have become a popular way to raise funds for public mergers and acquisitions in recent years. However, the directors and officers of a SPAC can face unique exposures. These liabilities can include direct risks to personal assets because the funds the SPAC raises through a public offering must be held in a trust. A SPAC’s trust funds cannot be used to cover its defense and settlement costs and its at-risk capital may not be sufficient to cover these kinds of costs.
The right insurance can offer valuable peace of mind, but there is often some confusion about how it all works. This article will review two recent SPAC lawsuits and examine how an insurance policy—a Representations and Warranties (RWI) Policy or a Directors and Officers (D&O) Policy—would respond in each situation.
RWI Insurance and the Immunovant Case
Although SPACs are an exciting way of fundraising and going public, a SPAC is still, at heart, an M&A deal, making RWI insurance useful.
Let’s look at a recent case involving the biopharmaceutical company Immunovant. In Pitman v. Immunovant, Inc.,[1] a company developing a new drug to help with a common and debilitating disease connected with a SPAC looking for such a company. The two merged and went public.
However, when Immunovant announced it had “become aware of a potential problem” and “out of an abundance of caution” was placing a voluntary hold on its ongoing clinical trials, its stock price plunged 42%.
Shareholder Plaintiffs’ attorneys multiplied the 42% stock drop by the number of shares in open circulation and felt that the resulting amount was a large enough “pot of gold” to be worth the trouble of bringing a lawsuit. They united enough shareholders for a securities class action lawsuit with multiple allegations, including:
The SPAC failed to perform adequate due diligence.
The SPAC failed to disclose safety issues associated with the drug.
Because of either of these two factors, the prospects for approval, viability and profitability were diminished.
As a result, the company’s public statements were materially false and misleading.
Let’s first focus on the allegations of inadequate due diligence. These kinds of allegations typically assert that the SPAC team was incentivized to close a deal by a specific deadline and did not take the time or the effort to perform sufficient due diligence. The first implication here is that if the SPAC had made a proper effort to diligence the business and operations of the target company, it would have uncovered the problems being called out by the plaintiffs and would have been able to disclose them. The second implication is that if the SPAC’s diligence had been thorough, but had not uncovered problems, those problems were so well and intentionally hidden by the target company that they amounted to fraud on the part of the target company.
Putting aside the fraud implication for a moment, how does a SPAC refute the first implication of inadequate due diligence? The SPAC is responsible for establishing that it did, in fact, perform adequate diligence. To do so, an RWI policy, similar to the one used in the Immunovant deal, could be of great use. The process the buyer of the RWI policy (in this case, the SPAC) undertakes to secure the policy includes an intensive review by the insurer of the diligence the buyer conducted. The insurer usually engages specialized counsel from big law firms to review the diligence and probe areas that the insurer and its counsel (who see dozens of similar kinds of deals in the same industry on a weekly basis) believe to be particularly risky. In a way, this process serves as a safety net for anything the SPAC’s diligence team could have missed while reviewing the target’s business and operations. The insurer is incentivized to be extremely thorough because it will be the one paying the bills if diligence is patchy.
So in the Immunovant case, if—hypothetically—there were representations given as to the accuracy of Immunovant’s records of previous clinical drug trials, the RWI policy defenses would include:
The assertion that since the company has gone through the process of acquiring an RWI policy, which requires third parties to review the diligence and probe the adequacy of the work done. Thus the Plaintiffs have a much more difficult argument that that diligence was inadequate.
The argument that RWI speaks very clearly to what was known and not known by the SPAC. In essence, RWI provides the Immunovant parties with a third-party paper trail showing how much Defendants knew, how hard they worked to get to the information, and how innocent they were.
Coming back to the second implication of fraud, a RWI policy covers seller’s fraud. So if the diligence efforts fail in the face of fraud by the target company, the RWI policy would step in to cover losses resulting from such fraud. This means that the SPAC could potentially recoup some lost money and return it to the SPAC investors (Plaintiffs), which would diminish their losses and consequently the amount claimed by Plaintiffs’ attorneys in their lawsuit against the SPAC.
The Importance of RWI to SPACs
Representations and warranties insurance can hedge the risk for both the buyer and the seller in SPACs. There’s a common misperception that RWI is not useful in a public company style deal because in a public company deal the seller typical provides very limited or no representations and warranties in the purchase agreement and no indemnification. This reasoning is flawed. When there is lack of indemnification from the seller, the buyer is saddled with all of the risk with no avenue for a recourse. That is exactly the situation where RWI coverage is even more critical. In these kinds of cases, synthetic representations and warranties can be put in place through the use of a RWI policy and at least some of the risk can be transferred to the insurer. The definition of loss in these situations essentially comes from the insurance policy and not from the indemnification section of the agreement, and the buyer is insured against that loss.
D&O Insurance and the Lucid Motors Case
D&O insurance is on everyone’s minds these days because of its rising cost. Naturally, many companies are asking about ways they can save on their D&O premiums by reducing coverage.
Clients often ask if they need D&O coverage at the time of the SPAC’s IPO and whether they can get away with buying the least possible amount. There’s a myth out in the SPAC market that SPACs are not really subject to risk between the time of their IPO and their de-SPAC. Unfortunately, the common belief that all litigation comes after the de-SPAC is just not true and can cause some serious problems for the SPAC and its team of directors and officers. In fact, it is crucial to have coverage between the IPO and the de-SPAC.
Now, let us examine a case study that illustrates the importance of D&O insurance: Churchill Capital Corporation IV SecuritiesLitigation.[2] The Complaint alleges that Rumors spread that Churchill Capital Acquisition Corporation IV was going to acquire Lucid Motors, an electric vehicle company, which caused the price of the SPAC’s shares to jump from $10 to $22 per share. Then, the Lucid Motors CEO spoke to the media and mentioned a plan to deliver 6,000 vehicles in 2021. After several other statements to the media, the SPAC shares climbed to over $57 a share. The merger was finally announced on February 22, 2021, and on the same day the Lucid Motors CEO told the media that, in fact, the production of the vehicles would be delayed.
Documentation filed with merger announcement revealed that only 557 vehicles were planned versus the 6,000 that were previously mentioned and, not surprisingly, the price of the SPAC’s shares tanked. By the time the lawsuit was filed on April 18, 2021, the SPAC’s shares were trading at $18 per share.
What is interesting to note here is that this lawsuit is not your garden variety merger objection suit in which the plaintiffs allege insufficient disclosure and argue for the merger to be halted. These kinds of allegations and demands are typically addressed through additional SEC filings to close any gaps in the disclosure, and the plaintiff usually goes away for a few thousand dollars in mootness fees. These merger objections suits are not looked upon kindly by Delaware courts, which is why they are often filed in New York and have been commonly referred to as an M&A (and now a SPAC) “transaction tax.”
The Lucid Motors case, however, is a full-blown securities class-action lawsuit brought in federal court in Alabama against the SPAC, its CEO and CFO, and the target and its CEO. It alleges that these parties made or were involved in making false statements and omissions that drove the wild price fluctuations, which then resulted in losses for the SPAC’s shareholders. What’s even more interesting is that this lawsuit is being brought in advance of the merger for statements made prior to even the merger announcement.
When lawsuits of this type are brought, defendants’ thoughts automatically turn to insurance. The questions typically are:
Is there an insurance policy in place to protect my SPAC and my directors and officers?
Will the limits of that policy be sufficient to cover litigation defense and settlement costs?
Here we should take a short detour and understand the kinds of policies that a SPAC team will encounter as it proceeds through the life cycle of the SPAC. There are three main types of D&O policies and it is essential to understand which D&O policies are in play before, during, and after the SPAC merger.
The first policy is the one that covers the SPAC and its directors and officers between the SPAC’s IPO and its business combination. This policy binds at the IPO and is funded by the SPAC’s at-risk capital. It typically has a tail component, which is essentially an extended reporting period for claims that come after the merger. Because a SPAC’s at-risk capital is usually very limited and the current SPAC D&O insurance pricing is quite high, these policies, if not planned and budgeted for properly, can cause a lot of aggravation to SPAC teams.
The second policy is the private company policy that covers the target company and its directors and officers until the company mergers with the SPAC. This policy can also have a tail component but is quite different from the public company D&O policy. It is a lot less complex and a lot less expensive than the public company D&O policy placed for a SPAC and for the combined company after the merger. This policy is typically in place ahead of the de-SPAC and is funded out of the target company’s operating capital.
The third policy covers the combined company and its directors and officers after the merger. It binds at the time of the merger and looks and feels very much like any traditional public company D&O policy. It is also considerably more expensive than the SPAC D&O policy and usually renews on an annual basis.
The Importance of Choosing the Right D&O Coverage
The first lesson we can learn from the Lucid Motors case is that serious, expensive lawsuits can and do occur before the de-SPAC and that the period between the SPAC IPO and its business combination is not risk-free. Consequently, the terms and limits of that first policy that covers the SPAC and its directors and officers between the IPO and the de-SPAC should be considered very carefully.
The second lesson is that lower limit of coverage may not be sufficient to cover defense and settlement costs and can put you at risk. Last year, SPAC teams usually considered $20 million in coverage limits for their SPACs because premium pricing was low and affordable. In recent months, however, increases in D&O premium pricing have forced SPAC teams to gravitate towards much lower limits. The majority now purchase between $5 million and $10 million in coverage, and some have even considered limits as low as $2.5 million. While D&O insurance costs are high and at-risk capital is restricted, going for the least expensive policy may not be the right decision for your SPAC and your team.
The importance of risk mitigation is another great lesson to take away from the Lucid Motors case. It is incredibly critical for all SPAC executives and the executives of the target company to pay very close attention to public messaging around deal time. They must be especially careful when making any statements on social or other media because getting sued for even inadvertent misrepresentations can be extremely painful, time consuming, and distracting in the midst of a deal and, without proper insurance coverage, can lead to serious financial losses.
Conclusion
The SPAC market is extremely dynamic and has grown dramatically in size and sophistication over the last few months. SPAC teams and teams aiming to merge with a SPAC must keep on top of the latest developments in the financial, regulatory, and legal aspects of this market.
Allegations and complaints in the lawsuits like the ones discussed above, while novel now, may become standard in the future. Having advisers who can steer you away from traps and anticipate risks and pitfalls, including guiding you through the most efficient and effective use of RWI and D&O policies is a must have for any SPAC team.
[1] Case No. 1:21-cv-00918, U.S. District Court for the Eastern District of New York.
[2] Case No. 21-cv-00539, U.S. District Court for the Northern District of Alabama, Eastern Division. See also, Arico v. Churchill Capital Corporation IV, Case No. 21-cv-12355, U.S. District Court for the District of New Jersey.
Connect with a global network of over 30,000 business law professionals
