Amidst all of the tributes on 9/11, there are two more public servants who deserve America’s thanks. They are not among the first responders, such as firefighters or police officers, who ran towards the burning buildings. They protected America’s financial system on that terrible day and during the days thereafter. They served the public with courage and distinction.
The first is Roger W. Ferguson, Jr., who was Vice Chairman of the Board of Governors of the Federal Reserve System. As the Federal Reserve website notes, “When the terrorist attacks occurred on September 11, 2001, Ferguson was the only member of the Board of Governors in Washington (others were traveling). He quickly moved to assure bankers and investors that the Fed would provide the lending necessary to keep the economy going in the aftermath of the crisis.”
As Mr. Ferguson later explained, the attack “could prompt a chain reaction drying up liquidity, which, unchecked, could lead to real economic activity seizing-up. The shocks to the financial system and the economy that were possible could have been disastrous to the confidence of businesses and households in our country and, to a significant degree, the rest of the world.”[1] It was critical for the Fed to demonstrate leadership in the face of this vicious attack.
First, Mr. Ferguson made sure that the financial system maintained liquidity, the lifeblood of our economy.
Why were we so concerned about maintaining liquidity in the financial system? Liquidity, as you know, serves as the oil lubricating the engine of capitalism to keep it from burning itself out. The efficiency of our financial system at maintaining adequate liquidity is often taken for granted. But on September 11, it could not be taken for granted. The bottlenecks in the pipeline became so severe that the Federal Reserve stepped in to ensure that the financial system remained adequately liquid. In other words, our massive provision of reserves made sure that the engine of finance did not run out of oil and seize up.[2]
Vice Chairman Ferguson and his Fed colleagues made sure that the Fed discount window was open and lending to banks.
On September 12, lending to banks through the discount window totaled about $46 billion, more than two hundred times the daily average for the previous month. The flood of funds released into the banking system reduced the immediate need for banks to rely on payments from other banks to make the payments they themselves owed others.[3]
These and other actions that Mr. Ferguson spearheaded prevented the American economy from going into a tailspin. I don’t know what went on behind the scenes at the Fed. But as the senior Fed governor, Roger acted with focus and determination. He didn’t dither. He demonstrated leadership and patriotism under extraordinary circumstances. If I had an opportunity to whisper in President Biden’s ear, I would urge him to award the Medal of Freedom to Roger Ferguson for his extraordinary service on that day.
A second person who deserves our thanks is Annette L. Nazareth. Ms. Nazareth was the Director of the SEC’s Division of Market Regulation (now known as the Division of Trading & Markets). (President George W. Bush later appointed her to be an SEC Commissioner.) After the attacks, there was enormous political pressure for Wall Street to reopen immediately. Notwithstanding the terrible loss of life and physical damage in lower Manhattan, many in Washington felt it was important to show the nation and the world that Wall Street could keep functioning.
The exchanges and broker-dealers appreciated the need to reopen, but they knew that they were not ready. For those firms whose personnel survived the attack, it was not easy to resume trading. Many firms’ offices were destroyed or were inaccessible. The attack knocked out communications lines and other systems. No one had considered disaster planning for a terrorist attack. Working from home wasn’t a possibility in those days. A premature opening would have resulted in failures and would have done more damage to the public’s confidence, rather than enhancing it.
On 9/11, I was general counsel of the Securities Industry Association (now called SIFMA), the trade group for broker-dealers. My members asked me to deliver one message to Ms. Nazareth at the SEC: don’t force the markets to open before they are ready. Of course, many others offered the same advice to others at the SEC, including Chairman Harvey Pitt.
Fortunately, the SEC took the advice that so many offered. As TheWall Street Journal recently described it, “The stock market stayed closed for four trading days—its longest shutdown since 1933—as crews worked to fix the damage.”[4] The subsequent reopening went reasonably well.
* * * * *
The financial markets are very different today than they were in 2001. Physical trading floors are much less important today than they were twenty years ago. Financial markets face different challenges, such as cyberattacks.[5] Those changes don’t diminish the leadership and heroism of the numerous individuals who worked so hard to restore America’s financial system after the 9/11 attacks.
Both Annette Nazareth and Roger Ferguson deserve our thanks for keeping their heads cool and acting sensibly in the face of a crisis. They prevented a terrible attack from cascading into a financial calamity. And for those of you who don’t know, Roger and Annette are husband and wife.
[1]Remarks by Vice Chairman Roger W. Ferguson, Jr. At Vanderbilt University, Nashville, Tennessee, February 5, 2003.
The folk rock group The Mamas and the Papas’ first hit and Grammy Hall of Fame song, “California Dreamin’,” expressed the hopes and dreams of leaving behind the cold of a winter’s day for the warmth of Los Angeles.[1] Under a recent decision of the California Court of Appeal that reversed the judgment of an L.A. trial court, whether a hit song means that the songwriter realizes the hopes and dreams of the warmth of financially sharing in the song’s success, or bears the cold of a winter’s day in not so sharing,[2] turns on the grant of discretion in the songwriter’s contract with the music publisher.
THE GRANT OF DISCRETION UNDER CALIFORNIA LAW
In Gilkyson v. Disney Enterprises, Inc.,[3] the children of the late songwriter Terry Gilkyson sued Disney Enterprises, Inc. and its music publishing subsidiary, Wonderland Music Company, Inc. (collectively, “Disney”), over royalties for the use of Gilkyson’s songs in the home entertainment releases of the 1967 animated film, The Jungle Book. One of the songs was “The Bare Necessities,” a song that has warmed the hearts of children around the world, whose laughter then warmed the hearts of their parents.
In 1963, Gilkyson entered into a contract with Disney that provided for a royalty equal to 50% of the net amount received by the Disney music publisher on account of licensing or other disposition of the mechanical reproduction right in and to material written by Gilkyson.
In another section of the contract, Disney reserved all revenue and receipts received by and paid to Disney by virtue of the exercise of grand, dramatic, television, and other performance rights, including the use of the material in motion pictures, photoplays, books, merchandising, television, radio, and endeavors of the same or similar nature.
Finally, another section of the contract provided that Gilkyson had no interest in any of the material other than his right to receive the royalties specifically set forth in the contract. In addition, nothing contained in the contract was to be construed as obligating Disney “to publish, release, exploit or otherwise distribute any of the material, and the same shall be always subject to [Disney’s] sole discretion.”
The jury returned a verdict of $350,000 in favor of the Gilkyson children for Disney’s breach of the contract. The trial judge then awarded an additional $699,316.40 as damages for the period after the date of the verdict through the duration of the songs’ copyrights.
Disney appealed the trial court’s judgment. The California Court of Appeal reversed and held that, under the language of the contract, Disney did not have any obligation to pay royalties to the Gilkyson children during the contract’s limitations period. Since the Disney music publisher was not paid for digital downloads of the motion picture or other audiovisual reproductions, it did not receive any amounts for which royalties were due.
Furthermore, nothing in the contract required Disney to exploit the mechanical reproduction rights at all or, if it elected to do so, exploit them in any particular manner. Rather, exploitation of these rights was in Disney’s sole discretion. Accordingly, the Disney music publisher had the right to permit its home entertainment affiliate to use the songs without charging an intercompany license fee and without incurring any liability to Gilkyson. The court keenly observed, “Had the parties intended that Disney would use its best efforts to exploit the mechanical reproduction rights in a manner that generated royalties for Gilkyson, the contracts would not have expressly granted Disney such unfettered discretion.”[4]
Since the trial court had denied the Gilkyson children’s motion for leave to file a second amended complaint that would have added a cause of action for breach of the implied covenant of good faith and fair dealing, and their appeal did not raise this issue, the covenant was not before the Court of Appeal. However, the Court of Appeal rejected the Gilkyson children’s argument that several general provisions of California law required the payment of royalties. Their argument would effectively require the court to rewrite the express language of the contract, which granted Disney the sole discretion on how to exploit the rights it obtained from Gilkyson and limited his right to royalties to Disney’s net receipts. The court was not authorized to engage in such an endeavor.
THE GRANT OF DISCRETION UNDER DELAWARE LAW
The reasoning of the court in Gilkyson is not unique to the jurisprudence of California. Delaware, the venerable bastion of corporate law, has used similar reasoning in its jurisprudence. In Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC,[5] the Delaware Supreme Court’s most recent guidance on the implied covenant of good faith and fair dealing, the court rejected the use of the covenant in the face of a grant of discretion.
In Oxbow Carbon, two minority investors, Crestview Partners, L.P. and Load Line Capital LLC, became members (the “Minority Members”) of Oxbow Carbon LLC (“Oxbow”) in 2007. Oxbow was the leading third-party provider of marketing and logistics services to the global petroleum coke market. Crestview made a $190 million capital contribution in exchange for a 23.48% membership interest, and Load Line made a $75 million capital contribution in exchange for a 9.27% membership interest.
The majority investor, Oxbow Carbon & Minerals Holdings, Inc. (“Oxbow Holdings”), made a $483,038,499.86 capital contribution in exchange for an almost 60% membership interest. Oxbow and Oxbow Holdings were controlled by William I. Koch. Several of Koch’s family members and affiliates also invested in Oxbow, which meant that the Koch group owned a combined 67% of Oxbow’s equity.
The Minority Members bargained for the following exit rights. First, they received a put right that could be exercised after seven years. Second, if Oxbow rejected the put, the party exercising the put could force an exit sale of all of Oxbow’s equity interests. However, a member could not be forced to sell its equity interest unless it received total distributions from operations and the exit sale was equal to or greater than 1.5 times the member’s aggregate capital contribution (the “1.5x requirement”). The LLC agreement provided that all distributions were to be made pro rata in accordance with each member’s percentage interest and that any exit sale must be on equal terms and conditions for all members.
In 2011 and 2012, Oxbow admitted additional minority members, Ingraham Investments LLC and Oxbow Carbon Investment Company LLC (collectively, the “Small Holders”). The Small Holders received a combined 1.4% membership interest. The members of Ingraham were members of Koch’s family, and the members of Oxbow Carbon Investment Company were executives of a large sulfur trading company acquired by Oxbow. Ingraham made a $20 million capital contribution, and Oxbow Carbon Investment Company made a $15 million capital contribution. Oxbow distributed approximately $8.2 million to Crestview and $3.2 million to Load Line from these capital contributions.
The board of directors of Oxbow unanimously approved the admission of the Small Holders, including the directors appointed by Crestview and Load Line, who otherwise had the right to block their admission. Although their admission did not comply with the LLC operating agreement’s preemptive rights provisions and the special approval requirements for related party transactions,[6] and the Small Holders did not deliver signed counterpart signature pages, the Court of Chancery found that in their course of dealing, the parties treated the Small Holders as members.
On September 28, 2015, Crestview exercised its put. When Oxbow rejected the put, on January 20, 2016, Crestview exercised its right to an exit sale. However, at the price offered by the bidder, the sale proceeds were insufficient to distribute to the Small Holders an amount equal to or greater than the 1.5x requirement.
Litigation then ensued. The Court of Chancery held that although the 1.5x requirement prevented an exit sale, under the implied covenant of good faith and fair dealing, the exit sale should go forward. Since the board of directors did not expressly determine the rights, powers, and duties of Small Holders at the time of their admission, in particular whether the Small Holders would have the benefit of the 1.5x requirement, there was a gap in the contractual rights of the Minority Members and Small Holders. According to the Court of Chancery’s summary judgment opinion, had the Minority Members realized that the Small Holders would have the ability to block an exit sale due to the 1.5x requirement, the Minority Members would not have consented to their admission. In addition, had the parties recognized this gap, they most likely would have agreed that the Minority Members could satisfy the 1.5x requirement by making additional payments to the Small Holders from the proceeds the Minority Members received from the sale.
The Delaware Supreme Court reversed and held that there was no gap and the implied covenant of good faith and fair dealing did not apply. Therefore, under the plain language of the LLC operating agreement, the Small Holders had the benefit of the 1.5x requirement and could block the exit sale.
Under the LLC agreement, the terms of admission of new members were left to the discretion of the board of directors.[7] Since the board chose not to specify different rights for the Small Holders, the terms of the LLC agreement applied with equal force to them. The court would not imply new contract terms merely because the contract granted discretion to a board of directors.[8] Conferring discretion on the board was a contractual choice to grant authority to the board and not a gap. Although the grant of discretion did not relieve the board of its obligation to use that discretion consistent with the implied covenant of good faith and fair dealing, the Minority Members did not argue that the board exercised its discretion in bad faith in admitting the Small Holders.
The court found that in light of the absence of a gap, and since the admission of new members and its effect on the exit sale process could have been anticipated, the court would not apply the covenant. The court observed that the parties could have limited the 1.5x requirement to certain members, excluded subsequently admitted members, amended the exit sale right to permit distributions by Oxbow to the Small Holders to satisfy the 1.5x requirement before distributions were made pro rata to the members, or amended the exit sale right to permit the Minority Members to make payments to the Small Holders to satisfy the 1.5x requirement.
The court then described the limited use of the implied covenant of good faith and fair dealing. The covenant was a cautious enterprise best understood as a way of implying terms in a contract, whether employed to analyze unanticipated developments or to fill gaps in the contract. It was not an equitable remedy for rebalancing economic interests after events occurred that could have been anticipated but were not, which later adversely affected a party to the contract. Rather, the covenant was a limited and extraordinary legal remedy.
The covenant did not apply when the contract addressed the conduct at issue, but only when the contract was truly silent concerning the matter at hand. Even when the contract was silent, an interpreting court could not use an implied covenant to rewrite the parties’ agreement and should be most chary about applying a contractual protection when the contract could easily have been drafted to expressly provide for that protection.
Finally, the court pointed out the two situations in which the covenant generally would apply. First, a situation has arisen that was unforeseen by the parties, and the agreement’s express terms do not cover what should happen. Second, a party to the contract is given discretion to act as to a certain subject, and the discretion has been used in a way that is impliedly proscribed by the contract’s express terms.
THE TAKEAWAY
The takeaway from Gilkyson and OxbowCarbon is that in drafting contracts, the grant of discretion usually wins the day. If a party wants to avoid or lessen the risk of another party’s exercise of discretion to deprive it of a benefit, then to the extent that the party has the leverage, it should bargain for the contract to clearly set forth nondiscretionary obligations of the other party or well-defined parameters on the other party’s exercise of discretion. To rely on the implied covenant of good faith and fair dealing is likely no more than a vain hope and dream.
[1] The Mamas and the Papas, “California Dreamin’,” Music and lyrics by John E.A. Phillips and Michelle Gilliam Phillips, on If You Can Believe Your Eyes and Ears (Dunhill 1966).
[2]Cf. Gladys Knight & the Pips, “Midnight Train to Georgia,” Music and lyrics by Jim Weatherly, on Imagination (Buddah 1973) (“L.A. proved too much for the man (too much for the man, he couldn’t make it). So he’s leaving a life he’s come to know, ooh (he said he’s going). He said he’s going back to find (going back to find), ooh, what’s left of his world, the world he left behind not so long ago. . . . He kept dreaming (dreaming), ooh, that someday he’d be a star (a superstar, but he didn’t get far). But he sure found out the hard way that dreams don’t always come true, oh no, uh uh (dreams don’t always come true, uh uh, no, uh uh). So he pawned down his hopes (woo, woo, woo-woo), and even sold his old car (woo, woo, woo-woo). Bought a one way ticket back to the life he once knew, oh yes he did, he said he would.”).
[3] 2021 WL 3075699 (Cal. Ct. App. July 21, 2021).
[5] 202 A.3d 482 (Del. 2019) (en banc) (Valihura, J.).
[6] The LLC operating agreement provided for the admission of new members “on such terms and conditions as the Directors may determine at the time of admission. The terms of admission may provide for the creation of different classes or series of Units having different rights, powers and duties.”
[7]Seealso Kenneth A. Adams, A Manual of Style for Contract Drafting 3.188 (ABA 4th ed. 2017) (“Discretion is primarily conveyed by means of may, which expresses permission or sanction.”).
[8]See also Mohsen Manesh, “Express Contract Terms and the Implied Contractual Covenant of Delaware Law,” 38 Delaware Journal of Corporate Law 1, 35 (2013) (“[W]hen the express terms of a contract unambiguously grant one party unfettered, sole, and absolute discretion, the court will readily construe the express terms to permit the discretion-exercising party to act under any circumstances and for any reason, free of judicial intervention. It is because the Implied Covenant notwithstanding, such language in the contract permits only that reasonable expectation.”) (footnote omitted).
In decisions that may signal things to come for employee plaintiffs in the wake of the Supreme Court’s decision in Alston,[1] two federal courts applying the rule of reason have denied class certification in two pending no-poach antitrust franchise claims for a failure to show the predominance of common questions. On July 28, a Chicago federal judge declined to certify a class action against McDonald’s for violating Section 1 of the Sherman Act.[2] Two days later, a Southern District of Illinois judge also declined to certify a class against Jimmy John’s due to several Rule 23(a) and (b) failures of proof, including the predominance of individual questions.[3]
Both class actions challenged no-poach clauses in the fast food giants’ franchise agreements, which prevented their franchisees from hiring employees of other franchises or company-operated restaurants. Although the courts denied class certification on varied bases, both found that the alleged unlawful restraint — the no-poach provisions — should be evaluated under the rule of reason and not the quick-look analysis sought by the plaintiffs, and the plaintiffs who sought to certify nationwide classes did not present evidence that the relevant geographic market where they offered their labor services was national in scope. The courts suggested instead that the relevant geographic markets for fast-food employees like the plaintiffs could be the hundreds or thousands of markets near where the employees lived and worked, and that they would include all quick-service restaurants in the markets, not just the defendants’ branded restaurants.
Background
Until July 2018, both McDonald’s and Jimmy John’s had provisions in their franchise agreements generally prohibiting their franchisees from employing or seeking to employ individuals who work for other franchisees or restaurants operated by the company. While most of the fast-food giants’ branded restaurants are franchised, they both operate a small portion of the restaurants themselves. The plaintiffs in Deslandes v. McDonald’s and Conrad v. Jimmy John’s Franchise LLC are current or former employees of McDonald’s and Jimmy John’s restaurants, who allege that the no-poach provisions violate Section 1 of the Sherman Act by limiting competition and suppressing their wages.
While the proposed classes — nationwide classes of all persons employed at the defendants’ branded restaurants from roughly 2013 through July 12, 2018 — were sufficiently numerous under Fed. R. Civ. P. 23(a), both courts found, among other things, that common questions did not predominate under Rule 23(b)(3), thus barring certification. Although not discussed in this article, both courts denied class certification on other grounds factually specific to the claims raised in their respective cases.[4]
Rule of Reason v. Quick-Look Analysis
Before assessing whether common questions predominated, both courts decided whether the alleged anticompetitive effects should be analyzed using the rule of reason or a quick-look analysis. Relying on the Supreme Court’s recent decision in Alston, which involved a similar Section 1 Sherman Act claim against the NCAA and 11 Division 1 conferences for allegedly wielding monopsonist power in the market for student athletes, the courts held that a quick-look analysis applies only in rare situations, where the court has “considerable experience with the type of restraint at issue.”[5]
The McDonald’s court did not have enough experience with no-poach provisions in franchise agreements to say with confidence that the practice must always be condemned. Thus, with Alston as precedent, the McDonald’s court applied the rule of reason, as opposed to the quick-look analysis.
The Jimmy John’s court relied on Alston to answer the question it had punted at the motion to dismiss stage and found that the rule of reason applies “in this monopsony case challenging a nationwide franchise’s use of intrabrand restraints that were arguably ‘designed to help [the company] more effectively compete with other brands by ensuring cooperation and collegiality among franchisees, and by encouraging investment in training.’”[6] In addition to following the Supreme Court’s precedent in Alston, the Jimmy John’s court also found that the plaintiffs had failed to present common proof that will show that each franchisee conspired with Jimmy John’s to suppress labor mobility and wages.[7]
The rule of reason applied for several other important reasons. First, Defendant McDonald’s put forth sufficient evidence of the pro-competitive effects of the alleged restraint — preventing free riding and encouraging training — warranting the application of the rule of reason.[8] Second, because Defendant McDonald’s operates far fewer restaurants than its franchisees, franchises do not compete with restaurants McDonald’s operated for employees in many areas of the country, establishing that in many geographic markets, the restraints are vertical not horizontal.[9] Vertical restraints are judged under the rule of reason.[10] Third, Jimmy John’s presented expert opinion that the no-poach provision actually benefited the members of the putative class by encouraging their employers to invest in training, and the relevant labor market was not nationwide in scope and not limited to employment with the Jimmy John’s branded restaurants.[11] Rather, it encompassed employment at all quick-service restaurants within a local relevant market.[12]
Rule of Reason Application Creates Individual Questions Preventing Class Certification
The first question under the rule of reason analysis is whether the challenged restraint of trade has a substantial anticompetitive effect in the relevant market.[13] Both courts rejected the plaintiffs’ characterization of the relevant market as a national service market for McDonald’s or Jimmy John’s restaurant workers. The McDonald’s court said “it defies logic to suppose” that McDonald’s employees sell their labor in a national market.[14] According to the court, employees that compete in national markets are “highly skilled or highly paid” like CEOs — not fast-food employees.[15] This conclusion is buttressed by Defendant McDonald’s evidence: the deposition testimony from lay and expert witnesses demonstrated that McDonald’s restaurants experience local, not national, competition.[16] As such, the court found that proposed class members competed in different relevant geographic markets, making the rule of reason antitrust questions predominantly individual for purposes of Rule 23(b)(3).
Similarly, the Jimmy John’s court found, based on expert testimony, that competition from other quick-service restaurant employers and others would “push the worker’s wages … up to the competitive level associated with the worker’s skills.”[17] As such, individual questions as to whether individual plaintiffs suffered injury because of the alleged restraints existed, given the “varied and dynamic labor markets across the country.”[18]
Because the predominate question of whether the restraint causes an anticompetitive effect in the relevant market is not common to class members, the McDonald’s court did not decide whether the question of antitrust injury or impact is common.[19] But the court did say that it would be “difficult … to imagine that it could be a common question … ” since the question is based on wages, and “[t]he amount each person’s wages are suppressed,” which “will almost certainly vary depending on the amount of labor market power McDonald’s possessed in each relevant market.”[20]
Takeaways
While other courts could disagree,[21] these decisions represent big wins for employers and franchisors after the Alston decision, representing persuasive authority for limiting the use of quick-look analysis in franchise no-poach antitrust claims. Further, to the extent the rule of reason applies, the decisions illustrate the difficulty class plaintiffs and their counsel will face in trying to establish the predominance of common questions under the rule of reason when alleging both horizontal and vertical restraints.
[1]National Collegiate Athletic Association v. Alston, 594 U.S. ___.
[2]Deslandes v. McDonald’s USA LLC, No. 17 C 4857, 2021 WL 3187668 (N.D. Ill. July 28, 2021).
[4] The McDonald’s court found the class was not fairly and adequately represented by counsel due to its litigation tactics, including waiving the right to pursue a rule of reason antitrust claim. The Jimmy John’s court denied class certification for a number of reasons beside predominance, including a failure of typicality and adequacy, and a class was not a superior method of adjudicating the claims.
[5] McDonald’s, 2021 WL 3187668 at *11 (quoting Nat’l Collegiate Athletic Ass’n v. Alston, 141 S. Ct. 2141, 2156 (2021)): Jimmy John’s, 2021 U.S. Dist. 142272, at 25-6 (quoting Nat’l Collegiate Athletic Ass’n v. Alston, 141 S. Ct. 2141, 2156 (2021)).
[8]McDonald’s, 2021 WL 3187668 at *12-16. Even the plaintiffs’ experts echo this point, saying “for the restaurant employees in particular, the crew employees, there may be labor markets of different geographic size and that the key issue there might not even be size, it might be commuting distance.” Id. at 13.
[21]See e.g., Jarvis Arrington, et al v. BKW, et al., No. 20-13561 (11th Cir.). Oral arguments in the appeal of this franchise no-poach agreement case against Burger King have been scheduled for September 22, 2021.
On July 9, 2021, President Biden signed a broad Executive Order on Promoting Competition in the American Economy. This Executive Order—along with the related Fact Sheet and the President’s remarks at its signing—suggest that the administration is committed to an aggressive and coordinated approach to competition issues, especially in the areas of labor markets, agriculture, healthcare, and the tech sector. While many are skeptical that the Executive Order will change anything, the ability of the antitrust enforcement agencies to tie up mergers, challenge business decisions, and influence the courts—and the ripple effect on private actions—should not be ignored or underestimated. After summarizing the Executive Order, we recommend certain steps aimed at mitigating antitrust risks in the current political environment.
The White House was critical of past corporate consolidation across 75% of U.S. industries and argued that consolidation had increased prices for consumers, decreased wages for workers, and even hindered growth and innovation by making it more difficult for small and independent businesses. The Executive Order establishes what the White House refers to as a “whole-of-government effort to promote competition in the American economy,” encouraging 72 initiatives by more than a dozen agencies.
The Executive Order creates the White House Competition Council (the “Council”) within the Executive Office of the President as part of the plan to institute the coordinated and aggressive approach to competition-related matters across federal agencies.[1] The Council will work to implement the policies and the specific initiatives described in the Executive Order.
1. Labor and Noncompetes
The executive order places particular focus on labor issues and encourages the Federal Trade Commission (“FTC”) to ban or limit employee noncompete arrangements to increase economic mobility by making it easier for employees to change jobs. This effort builds on the Department of Justice’s (“DOJ”) recent efforts to challenge employee no-poach agreements as criminal antitrust violations. Companies considering business noncompetes should continue to ensure that such agreements are narrowly tailored for a legitimate business purpose. Similarly, the executive order encourages the FTC to ban unnecessary occupational licensing requirements.
2. Merger Enforcement
The executive order introduces uncertainty for businesses planning mergers or other actions that may raise competition issues. In fact, the order appears to invite such uncertainty by, among other things, supporting the “challenge [of] prior bad mergers that past administrations did not previously challenge.”
The executive order also urges the FTC and DOJ to review and revise their Merger Guidelines, which the FTC and DOJ immediately took up by announcing their plan to review the guidelines “to determine whether they are overly permissive.” The executive order also specifically asks the agencies to scrutinize and reconsider their approach to mergers in the hospital, banking and consumer finance, and Big Tech spaces. Some anticipated changes include lowering the concentration thresholds for presumptively anticompetitive mergers, refining potential competition prohibitions, and eliminating or greatly limiting the efficiencies defense.
The Executive Order also directed a number of actions aimed at specific sectors of the economy and even set short deadlines for some:
Labor Markets
Use FTC rulemaking authority to limit the use of non-compete clauses.
Use FTC rulemaking authority to limit unfair occupational licensing restrictions.
Food and Drug Administration (“FDA”) to work with states and tribes to import drugs from Canada.
Within 120 days, Department of Health and Human Services (“HHS”) to propose rules to make hearing aids available over the counter.
Within 45 days, HHS to increase support for generic drugs and issue a plan to combat high prescription drug prices and price gouging.
HHS to implement federal legislation to address surprise hospital billing.
HHS to standardize plan options in the National Health Insurance Marketplace to make it easier for people to comparison shop.
FTC to implement a rule that bans “pay for delay” agreements.
DOJ and FTC to revise merger guidelines so that patients are not harmed by hospital mergers.
Transportation
Within 45 days, Department of Transportation (“DOT”) to propose rules that require airlines to refund fees for services that are not provided, such as baggage fees when luggage is substantially delayed.
Within 90 days, DOT to consider rules that require airlines to clearly disclose to customers any ancillary fees, such as for baggage, ticket changes, or cancellations.
Agriculture
Department of Agriculture (“USDA”) to consider new rules under the Packers and Stockyards Act to address the unfair treatment of famers and improve competition in markets for their products.
USDA to consider new rules regarding when meat products can have “Product of USA” labels.
Within 300 days, USDA to develop a plan to increase farmers’ and small food processors’ access to retail market and submit a report to the Chair of the Council.
FTC to propose rules that limit equipment manufacturers from restricting farmers from repairing their own equipment.
Internet Service
Federal Communications Commission (“FCC”) to conduct future spectrum auction under rules that avoid excessive concentration of spectrum licenses.
FCC to prohibit internet service providers from charging excessive early termination fees.
FCC to establish rules that prevents landlords from making deals with ISPs to limit tenants’ choices.
FCC to restore Net Neutrality rules.
FCC to establish rules that requires broadband providers to provide a consumer label with clear information about prices and fees, performance, and network practices and to require those providers to report broadband price and subscription rates to the FCC for dissemination to the public.
Technology
Make it Administration policy to enforce antitrust laws in the area of new industries and technologies, and to scrutinize mergers by dominant internet platforms when they “stem from serial mergers, the acquisition of nascent competitors, the aggregation of data, unfair competition in attention markets, the surveillance of users, and the presence of network effects.”
FTC to establish rules pertaining to data collection and surveillance that may damage competition, consumer autonomy, and consumer privacy.
FTC to establish rules against unfair competition in major internet marketplaces.
Banking and Consumer Finance
Within 180 days, DOJ and federal banking agencies to review current practices and adopt for greater scrutiny of mergers under the Bank Merger Act and the Bank Holding Company Act of 1956.
Consumer Financial Protection Bureau (“CFPB”) to use rulemaking to make consumer financial data more portable and make it easier for consumers to switch banks.
The Executive Order does not immediately change the existing antitrust framework, but businesses should be prepared for a near-term change in enforcement by the relevant agencies. Companies should consider or be prepared to take steps such as those identified here:
Agreements or policies affecting employee freedom of movement should be assessed for less restrictive alternatives and focused as narrowly as possible to accomplish procompetitive objectives.
Compliance programs should be updated to shift focus from only or primarily customers/consumers to include competitors.
Given calls to abandon proof of a relevant product market, companies that have previously relied on a broad market definition when assessing the lawfulness of their actions should reexamine such actions to determine how their actions have affected their competitors.
Existing or contemplated discount, rebate, pricing, or other promotional allowance programs that cover 30% or more of the total U.S. market, particularly those that go back to dollar zero, apply retroactively, or allow for the claw back of credits already awarded, should be reassessed.
Agreements or programs that require or strongly encourage exclusive or bundled purchases should be reviewed.
Practices or programs that have generated multiple or significant complaints of foreclosure from customers or critical inputs should be examined.
[1] The Council will be led by the Assistant to the President for Economic Policy and Director of the National Economic Council as Chair, and includes the Secretaries of the Treasury, Defense, Agriculture, Commerce, Labor, Health and Human Services, Transportation, the Attorney General, and the Administrator of the Office of Information and Regulatory Affairs.
Judgment enforcement requires a combination of strategy, creativity, diligence, and patience. With a valid judgment in hand, what do you do next?
Assessing Collectability and Informing the Client
The collection of a judgment is a significant engagement for both an attorney and their judgment creditor client. Judgment collection requires the collecting attorney to assess the collectability of the judgment and to discuss the prospect of collection and the likely cost of collection with the judgment creditor client so the client can make well-informed decisions about collection strategies.
To avoid a dissatisfied client, any discussion about judgment collection must include a candid and realistic assessment by counsel of the various challenges inherent in the process and a recognition that having a judgment does not guarantee it will be collected, even with diligent enforcement efforts. Any candid assessment of the collectability of a judgment should include:
an assessment of available asset information and a plan to obtain further information about the existence of potential assets from which the judgment can be collected;
an analysis of the jurisdiction from which the original judgment arose (whether it is the local jurisdiction, from a sister state, or a foreign country) and any process required to cause the judgment to be enforceable in the jurisdiction in which any of judgment debtor’s located assets exist;
an assessment of the likelihood of further challenge to the validity and finality of the judgment;
the likely timeline for collection activities;
any applicable legal issues, such as applicable statutes of limitations; and
the likely cost of various collection activities, broken out by collection phase.
When preparing this analysis, counsel must also take into account a number of practical factors, including the amount of the subject judgment, the client’s willingness and ability to invest further resources in the collection process, and the client’s time horizon for recovery upon the judgment. With careful attention to these aspects of a judgment enforcement engagement, the attorney and client can formulate a clear, consensual, and preliminary collection plan that is practical based upon the circumstances and available information.
Gathering Information, Identifying Assets, and Conducting Discovery
Given the time and expense often involved in enforcing judgments, efficient asset recovery requires a targeted approach. There are often significant opportunities to gather information about the judgment debtor’s assets from third parties through domestic legal processes, even where the judgment debtor is based overseas. Gathering timely, specific intelligence about the debtor’s assets before initiating enforcement efforts is essential to combatting the myriad evasions typically employed by judgment debtors.
As an initial step, judgment creditors should attempt to identify assets of the judgment debtor located in the jurisdiction in which the judgment was entered. Such assets can be attached directly using the judgment jurisdiction’s available enforcement mechanisms. Where no assets can be readily located in the judgment jurisdiction, judgment creditors can pursue domestic judgment enforcement in state courts through the Uniform Enforcement of Foreign Judgments Act (“UEFJA”), as adopted, or in federal courts through Rule 69 of the Federal Rules of Civil Procedure and 28 U.S.C. § 1963.
Where no assets can be located domestically and reason exists to believe that the judgment debtor may own assets abroad, counsel for judgment creditors can expand their search overseas. The two primary means of procuring discovery abroad are: (a) to sue on the judgment in order to domesticate it in the target jurisdiction and then issue discovery from that proceeding; or (b) to utilize the processes of the Hague Convention on the Taking of Evidence Abroad in Civil or Commercial Matters (the “Hague Evidence Convention”). Both options present their own distinct challenges and often require retention of local counsel. Suing to register the judgment overseas often requires judgment creditors to initiate plenary proceedings, and foreign tribunals are typically reticent to recognize foreign judgments entered by default or otherwise lacking due process. Similarly, utilizing the Hague Evidence Convention can be notoriously cumbersome. Both avenues are constrained by the scope of discovery available in the target jurisdiction, which is generally significantly more limited than what is available in state and federal courts in the United States.
Given the difficulties of procuring discovery through foreign tribunals, targeting judgment debtor assets through United States banking channels can also be an attractive option. Issuing state or federal subpoenas to stateside financial institutions can often yield critical information about both domestic and foreign assets of the judgment debtor. Thanks to the centrality of the United States banking system to world financial markets, a significant portion of global financial transactions are routed through banks with footprints in the United States (read: subject to the jurisdiction of domestic state and federal courts). Accordingly, by serving carefully targeted subpoenas on such financial institutions, one can often identify crucial information regarding judgment debtors’ domestic and overseas assets, without the need to petition a foreign court.
In short, counsel must consider all available domestic and international discovery options with an emphasis on efficiently enforcing judgments and maximizing return on legal investment.
Enforcement Litigation in the United States
Domestic state and federal courts are busy, to say the least. Constitutional considerations frequently require courts to prioritize the management of criminal dockets and trials. Moreover, the practical impact of budget and resource constraints, as well as the COVID-19 pandemic, are daily considerations for prioritizing the work of the courts. The net effect can be that judgment collection and enforcement litigation may not proceed at the pace a judgment creditor would prefer.
In state courts, debt collection challenges may arise out of commercial, business or consumer transactions or, more commonly, in the collection of money judgments obtained after trial or pursuant to default judgments. Counsel must understand and be prepared to stay within the laws relating to fair debt collection practices, including key state and federal fair debt collection laws. Counsel must also understand the specific discovery tools available in the state where collection and enforcement are pursued, as well as any exemption statutes.
In federal courts, a money judgment—whether originating in the same district or registered in another district under 28 U.S.C. § 1963—is enforced by a writ of execution under Rule 69 of the Federal Rules of Civil Procedure, unless the court directs otherwise. Rule 69(a)(1) provides, however, that the procedure on execution—and in proceedings supplementary to and in aid of judgment or execution—must accord with the procedure of the state where the federal court is located, though a federal statute will govern to the extent that statute applies. With regard to discovery specifically, Rule 69(a)(2) provides that a judgment creditor may obtain discovery from any person, including the judgment debtor, as provided by the Federal Rules of Civil Procedure or by the procedure of the state where the court is located. So, a judgment creditor must take into account any federal statute that may govern, the full array of enforcement procedures and options otherwise available in the forum state, and the discovery mechanisms provided in the federal rules. In many cases involving a default judgment debtor, enforcement efforts may culminate in a motion for a finding of contempt and sanctions against the judgment debtor for failing to comply with court orders governing discovery in aid of execution. In such instances, counsel may also need to understand the requirements of 28 U.S.C. § 636 as they relate to proceedings before United States Magistrate Judges and the special procedures therein concerning contempt proceedings.
Considering that judgment collection and enforcement can be every bit as complex and challenging as the proceedings that gave rise to the judgment in the first instance, if not more, it should come as no surprise that effective judgment collection is fairly characterized as an art that necessitates a degree of mastery from practitioners.
The United States Supreme Court upheld the District Court’s judgment vacating the Centers for Disease Control and Prevention’s (CDC) second eviction moratorium. The second moratorium had prevented the eviction of any tenants who live in counties that are experiencing substantial or high levels of COVID-19 transmission and who make certain declarations of financial need. Alabama Association of Realtors v. Department of Health and Human Services, 21A23 (Aug. 26, 2021) (AAR). Among other things, the Court held that the CDC lacked the authority to issue the injunction, and invited Congress to enact the eviction moratorium with proper legislation.
In March 2020, at the start of the pandemic, Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act to alleviate the burdens caused by the COVID-19 pandemic. One of the programs was a 120-day eviction moratorium for properties that participated in federal assistance programs or were secured by federally backed mortgage loans. See CARES Act, § 4024. Congress did not extend the eviction ban when it expired on July 25, 2020. The CDC stepped into the void and issued an order temporarily halting residential evictions to prevent the further spread of COVID-19. 85 Fed. Reg. 55292 (2020). The CDC order broadly covered all residential properties nationwide and imposed criminal penalties on violators.
Congress extended the CDC eviction moratorium for one month in the Consolidated Appropriations Act, 2021, Pub. L. 116-260, § 502. When that expired, the CDC extended the eviction moratorium through March, then through June, and then through July 2021, when it expired.
Several appellate courts considered the CDC’s eviction order. In AAR, the trial court entered a judgment barring enforcement of the CDC order, 1:20-cv-03377-DLF (D.D.C. May 5, 2021), but stayed its order pending appeal. On June 29, 2021, the Supreme Court considered the order and left the stay in place because, among other reasons, the order expired by its own terms on July 31, 2021, and the stay would give time for landlords and tenants to apply for federal rental assistance funds. The Supreme Court also invited Congress to act. On July 14, 2021, the Eleventh Circuit rejected a landlord’s appeal of a denial of a request for a preliminary injunction before trial staying the CDC’s eviction order. Brown v. Secretary U.S. Department of Health and Human Services, 1:20-cv-03702-JPB (11th Cir. 7-14-21). However, on July 23, 2021, the Sixth Circuit affirmed the district court’s decision finding that the CDC overstepped its rulemaking authority and was not authorized by explicit language in the statute to issue an eviction moratorium order. Tiger Lily, LLC v. United States Department of Housing and Urban Development, 2:20-cv-02692, 21-5256 (6th Cir. 7-23-21).
When the CDC’s Eviction Moratorium expired on July 31, 2021, Congress did not reauthorize it. Instead, on August 3, 2021, the CDC issued a new order temporarily halting residential evictions in communities with substantial or high levels of community transmission of COVID-19. 86 Fed. Reg. 43244 (Aug. 6, 2021). The order provided that a landlord, owner of a residential property, or other person with a legal right to evict may not evict a tenant who completes a specific financial declaration and otherwise qualifies under the CDC order. At the same time, several federal rental assistance programs exist to help tenants pay their rent, including the American Rescue Plan’s Homeowner Assistance Fund, and the Emergency Rental Assistance (ERA) programs, which are administered by the Treasury Department through states, local governments, territories, tribes and tribally designated housing entities, and the Department of Hawaiian Home Lands. The programs have been slow to start and have distributed approximately one-tenth of the allocated funds.
Realtor associations and rental property managers in Alabama and Georgia again sued to enjoin the CDC’s new (“second”) moratorium. The District Court entered judgment for the landlords, and the Supreme Court affirmed. The Supreme Court stated that the CDC’s eviction order was based on the Public Health Services Act, which provides in relevant part:
The Surgeon General, with the approval of the [Secretary of Health and Human Services], is authorized to make and enforce such regulations as in his judgment are necessary to prevent the introduction, transmission, or spread of communicable diseases from foreign countries into the States or possessions, or from one State or possession into any other State or possession. For purposes of carrying out and enforcing such regulations, the Surgeon General may provide for such inspection, fumigation, disinfection, sanitation, pest extermination, destruction of animals or articles found to be so infected or contaminated as to be sources of dangerous infection to human beings, and other measures, as in his judgment may be necessary.
AAR, at 2, citing 42 U.S.C. § 264(a). The Court acknowledged the CDC’s authority to take action to prevent the interstate spread of disease by identifying, isolating, and destroying the disease itself. However, the Court stated that the CDC’s order was too indirect. It attempted to regulate evictions of a subset of tenants who might move from one state to another, with some smaller subset possibly being infected with COVID-19. The Supreme Court found that Congress could speak clearly when authorizing an agency to exercise the powers of vast economic and political significance that the CDC exercised in its order, but Congress had not done so. In addition, the CDC order “intruded” in an area that is the particular domain of state law: the landlord-tenant relationship. Absent clear Congressional authority, which was lacking, the CDC order was too broad and was properly struck down.
Following the Supreme Court’s ruling, the Secretary of the Treasury, Janet L. Yellen; the United States Attorney General, Merrick B. Garland; and the Secretary of the Department of Housing and Urban Development, Marcia L. Fudge, issued a letter to all State Governors, City Mayors, County Executives, and Chief Justices and State Court Administrators requesting help preventing unnecessary evictions during the pandemic. The letter requested that all evictions be stayed until the occupants have a chance to apply for rental assistance, permitting continued occupancy while a pool of federal money is accessed to pay the rent. The agencies also asked that: (i) states and localities enact eviction moratoriums during the remainder of the pandemic; (ii) landlords be required to apply for Emergency Rental Assistance funds before filing any eviction actions; (iii) eviction actions be stayed while the ERA application is pending; and (iv) that the ERA and American Rescue Plan State and Local Fiscal Recovery Funds be used to support the right to counsel and eviction diversion strategies. In short, the federal government wants tenants, landlords, and courts to ensure that federal funds are used to help renters before landlords pursue evictions for non-payment of rent.
Congress failed to act when the CDC’s eviction moratorium expired on July 31, 2021. It is unknown whether Congress will act now that the Supreme Court has again invited it to do so. Without Congressional action, there is no current federally imposed eviction moratorium. Landlords may proceed with residential evictions unless a state or local eviction moratorium applies. Nevertheless, landlords are encouraged to apply for ERA funds to satisfy their tenants’ rent obligations before they initiate an eviction action, which could prove to be a benefit to both the tenant and the landlord.
While employee benefits and executive compensation issues rarely drive a transaction, one issue that should be discussed at the beginning of every deal is whether there are any payments that could trigger taxation under Section 280G.[1] Ignoring this Code section or waiting until a few days before closing to address potential Section 280G issues could result in a large tax bill for impacted individuals, as well as a loss of deduction for the corporations involved and angry clients and executives.
Section 280G and its counterpart, Section 4999, were enacted by Congress in 1984 to address Congressional concerns and the then-common belief that corporate executives were receiving financial windfalls in the deluge of mergers and acquisitions occurring in the ‘80s, which in turn was impacting shareholder value and potentially could have a cooling effect on M&A activity. As with many provisions of the United States Tax Code, Section 280G and its counterpart Section 4999 attempt to curtail behavior by (i) imposing an excise tax on certain compensation received in connection with the change of control by the executives under Section 4999; and (ii) causing the corporation to lose its deduction under Section 280G for any compensation that subject to such taxation. While the concept of taxation and loss of deduction sounds simple, the application creates a web of complexity that requires someone familiar with these rules to navigate its application in corporation transactions. This article endeavors to assist practitioners unfamiliar with this area in identifying issues in transactions by providing a brief overview of Section 280G and how it can be avoided or if avoidance is impossible, how to offset it or mitigate its impact.
OVERVIEW OF SECTION 280G
Practitioners often refer to the complications caused by Sections 280G and 4999 simply as “280G,” but as noted above, these are two distinct Code sections that work in tandem to penalize both the impacted individual and the corporation. Section 4999 imposes a 20% excise tax on the disqualified individual (referred to as “disqualified individuals” and discussed more in depth below) payee of an “excess parachute payment.” Section 280G disallows a deduction for the payor of such “excess parachute payment.” The 20% excise tax under Section 4999 and the disallowance of deduction under Section 280G only apply if there is an “excess parachute payment,” and there can only be an “excess” if there is first a “parachute payment.”
Determining whether a parachute payment exists depends upon calculation of the disqualified individual’s “base amount.” In general terms, payments and other benefits provided as a result of a change of control will not be subject to these provisions if they do not equal or exceed three times the disqualified individual’s five-year average compensation (“base amount”) using compensation for the five most recent tax years ending before the change of control. See Treas. Reg. §1.280G-1, Q&A-34. If the disqualified individual receives parachute payments in excess of three times the base amount, a 20% excise tax will apply to any amount paid that is in excess of one times the base amount, and the corporation will lose the corresponding deduction for the amount that is subject to the tax. For example, if the disqualified individual’s five-year average compensation was $500,000, and she received a parachute payment of $2,000,000, the 20% excise tax (and corresponding corporate deduction) would apply to $1,500,000 of the excess parachute payment.
Generally, the disqualified individual’s Form W-2 – Box 1, or for independent contractors or outside directors, Form 1099 – Box 1, is used to determine the compensation for purposes of calculating the base amount. However, if the disqualified individual has not performed services for the entire five-year period, his or her total employment period during such five-year period will be included with compensation for any partial year being annualized. Treas. Reg. §1.280G-1, Q&A-35. If the disqualified individual was hired in the year of the change of control (and had no other compensation from the corporation during the five prior taxable years), generally the individual’s base amount will be his or her annualized compensation that was includible in his or her gross income for the period prior to the change of control that was not contingent on the change of control. Treas. Reg. §1.280G-1, Q&A-36. Also, benefits provided to a disqualified individual which have not yet become taxable, such as unexercised stock options or deferred compensation, will have a direct impact on this calculation. If a disqualified individual earns $500,000 a year, and exercised stock options in the year prior to the change of control resulting in additional compensation income of $1,000,000, that disqualified individual’s base amount will be increased by $200,000 (assuming he has worked for the corporation for at least five years).
Further, if the disqualified individual has changed positions during the five-year period, for instance from outside director to CEO, the base amount may be artificially low. For example, assume an outside director has been receiving director fees of $50,000 per year for the past five years, and then is promoted to the position of CEO with compensation of $1,000,000 in January of 2020 and then a change of control occurs in July of 2020. The base amount for this newly-appointed CEO will be three times the average base compensation he received as a director (3 x $50,000) and would not even consider his compensation as CEO.
It is also important to remember that Sections 280G and 4999 apply to both public and private corporations. The term “corporations” for purposes of these Code sections includes publicly-traded partnerships, Section 854(a) real estate investment trusts, mutual or cooperative corporations, foreign corporations and tax-exempt Section 502(a) corporations. Generally, payments made by partnerships, limited liability companies taxed as partnerships, S corporations, and corporations that could elect to be S corporations (even if they have not done so) are not subject to Sections 280G and 4999. Treas. Reg. §1.280G-1, Q&A-6. However, if an entity is part of an affiliated group that includes a corporation, there may be issues under Sections 280G and 4999 even if the actual payor of the compensation is an entity not otherwise subject to these provisions. Parties in transactions that include affiliated groups should make sure that counsel familiar with these sections advises on the transaction.
Practitioners also should tread carefully if non-U.S. entities are involved in the transaction. There is no specific exemption from Section 280G for non-U.S. corporations. It is possible for the sale of a foreign subsidiary of a U.S. corporation parent to trigger a change of control for Section 280G, or vice versa.
Who Is a “Disqualified Individual”?
There is a common misconception that Section 280G only applies to “executives,” but in reality, Section 280G can potentially impact non-executive level employees, consultants, directors and shareholders. A disqualified individual includes any individual (employee or independent contractor) who is an officer, shareholder, or highly-compensated individual with respect to the corporation. Section 280G(c); Treas. Reg. § 1.280G-1, Q&A-15(a). Additionally, directors are considered disqualified individuals if the director is also a shareholder, officer, or highly-compensated individual with respect to the corporation. Treas. Reg. § 1.280G-1, Q&A-15(b). While an individual may fall within more than one of these categories, all that is required is that the individual fall into one of these three categories within the 12-month period immediately prior to the change of control, and as a result, even former service providers could have concerns under these sections. For example, an individual who terminated employment six-months prior to the change of control, and was a 1% shareholder, would be treated as a disqualified individual for purposes of the change of control. Personal service corporations providing services to the corporation are also treated as “individuals” when determining who is a disqualified individual. Treas. Reg. §1.280G-1, Q&A-16. The fact that a consultant has used his or her own single-member limited liability company to provide services to the corporation does not avoid the tendons of Sections 280G and 4999.
Highly-compensated individuals are persons within the lesser of (i) the highest paid 250 employees; or (ii) the highest paid 1% of employees of the corporation. Treas. Reg. § 1.280G-1, Q&A-19. A shareholder, for these purposes, is only considered a disqualified individual if the shareholder provides services to the corporation (either as an employee or independent contractor, including outside directors) and owns more than 1% of the fair market value of the outstanding shares of all classes of the corporation’s stock. In determining stock ownership, the attribution rules of Section 318(a) apply. Stock underlying a vested option is considered owned by the individual who owns the vested option (and stock underlying an unvested option is not considered owned by the holder of the unvested option). If an unvested option to purchase a corporation’s stock automatically vests upon a change of control, the stock underlying such option is considered owned by the holder of the option for purposes of these rules. Treas. Reg. § 1.280G-1, Q&A-17.
The determination of whether an individual is an officer is based on the facts and circumstances in each particular case (such as the source of the individual’s authority, the term for which the individual is elected or appointed, and the nature and extent of the individual’s duties). Treas. Reg. §1.280G-1 Q&A-18(a). Generally, the term “officer” means an administrative executive who is in regular and continued service. Any individual who has the title of officer is presumed to be an officer unless the facts and circumstances demonstrate that the individual does not have the authority of an officer. However, an individual who does not have the title of officer may nevertheless be considered an officer if the facts and circumstances demonstrate that the individual has the authority of an officer. The term “officer” includes individuals who are officers with respect to other members of the acquired corporation’s controlled group. Treas. Reg. §1.280G-1 Q&A-18(b). Treasury Regulations limit the number of employees of the corporation and its controlled group that can be treated as disqualified individuals solely by reason of being an “officer” to the lesser of (i) 50 employees; or (ii) the greater of 3 employees or 10% of employees of the controlled group, rounded up to the nearest integer. Treas. Reg. §1.280G-1 Q&A-18(c).
What Is a “Parachute Payment”?
Under Section 280G(b)(2), a parachute payment is any payment in the nature of compensation to (or for the benefit of) a “disqualified individual” if (i) the payment is contingent on a change of the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation; and (ii) the aggregate present value of the payments in the nature of compensation which are contingent on such change equals or exceeds three times the individual’s base amount. Section 280(G)(2)(b).
Virtually all payments of cash or valuable property to an employee or independent contractor will be considered to be in the nature of compensation, including bonuses, severance pay, fringe benefits, pension benefits, and other deferred compensation. Treas. Reg. § 1.280G-1, Q&A-11. More difficult questions arise in the categorization of items such as stock options, restricted stock, and other benefits subject to vesting or forfeiture, particularly the determination of when a payment has been made and whether a payment is contingent upon a change of control. Property transferred in connection with services is generally subject to taxation under Section 83, and becomes taxable when it is transferred if it is substantially vested and has an ascertainable value. However, if the property is subject to forfeiture at the time of transfer or does not have a readily ascertainable value, taxation will occur at a later date. If property previously transferred to a disqualified individual becomes vested as a result of the change of control, it will be included in the parachute payment computation unless exempt as reasonable compensation for services rendered before the date of the change of control. Treas. Reg. § 1.280G‑1, Q&A-12. This result applies even if the disqualified individual made a Section 83(b) election to tax the property as compensation income at the time it was actually transferred to him. Treas. Reg. §1.280G-1, Q&A-34(d).
A special rule applies with respect to non-qualified stock options. Under Q&A-13 of the regulations, an option is treated as a payment in the nature of compensation at the time the option vests (regarding of whether the option has a readily ascertainable fair market value as defined in Treas. Reg. § 1.83-7(b)). Treas. Reg. §1.280G-1, Q&A-13. If an option is fully vested and also has an ascertainable value prior to the change of control, it will not be considered in the calculation of the parachute payment; similarly, if the option would become substantially vested without regard to the change of control and its value is ascertainable, it would not be included in the calculation. For parachute payment purposes, an option which vests upon a change of control is valued on the basis of all facts and circumstances, including the option spread at that time, the probability that the spread will increase or decrease, and the length of the option exercise period. Valuation of such options may be challenging, especially when a disqualified individual’s employment agreement or severance agreement contains a golden parachute cap which is intended to limit the amount of “compensation” he receives as a result of a change of control. (See the discussion below regarding cut-backs).
Practitioners should continue to ask the parties to the transaction whether there are any new payments being made to any service provider throughout the transaction until to the closing. A client may advise at the beginning of a transaction that it has none of the payments that would be treated as parachute payments, but as the transaction progresses, decide to pay large change of control bonuses to employees. Even a small bonus could create a Section 280G issue when added to already existing parachute payments.
What Transactions Trigger Section 280G?
The term “change of control” can have many meanings, both under the law, and in written agreements between the parties. In any corporate transaction, it is important to review all change of control definitions in the various agreements to determine whether the proposed transaction would actually constitute a change of control for purposes of the agreements. In addition, it is important to determine whether the transaction would constitute a “change of control” for purposes of Section 280G (because in some cases, what is a change of control under a written agreement may not be a change of control under Section 280G and vice versa).
“Change of control” is not specifically defined in the statute, other than to provide that transactions that are a change in the “ownership or effective control of the corporation” or “in the ownership of a substantial portion of the assets of the corporation” would constitute a change of control. See Section 280G(b)(2)(A)(i). The Treasury Regulations, specifically, Q&A-27, do provide some guidance regarding what constitutes a change of control. Generally, a change of control occurs under Section 280G on the date that any one person, or more than one person acting as a group, acquires ownership of stock of the corporation that, has more than 50% of the total fair market value or total voting power of the stock of such corporation, referred to as a change in the ownership of a corporation. However, a change of control also is presumed to occur if there is a change in the effective control of the corporation, which means that there has been either (i) an acquisition of 20% or more of the total voting power of the corporation by any person or group; or (ii) the replacement of a majority of the board members of the corporation (other than the directors whose appointment is approved by a majority of the current board). This presumption may be rebutted if the parties can establish that the acquisition of stock or replacement of a majority of the board did not result in a transfer of power to control (directly or indirectly) the management and policies of the corporation from any one person (or more than one person acting as a group) to another person (or group). See Treas. Reg. §1.280G-1, Q&A-28. Further, a change in the effective control does not occur if the changes do not occur within a 12-month period (for instance, a person could not purchase 10% of the stock in three separate years and trigger a change of control).
Finally, a change of control occurs when there is a change in the ownership of a substantial portion of the corporation’s assets. A “substantial portion” means assets having a total gross fair market value equal to or more than one-third of the total gross fair market value of all of the assets of the corporation immediately prior to the acquisition. Treas. Reg. §1.280G-1, Q&A-29. A transfer of assets will not be treated as a change of control for Section 280G purposes if the assets are transferred to (i) a current shareholder of the corporation in exchange for or with respect to its stock; (ii) an entity if 50% or more of the voting power is owned (directly or indirectly) by the impacted corporation; (iii) a person that owns 50% or more of the total voting power of all the outstanding stock of the impacted corporation; or (iv) any entity for which 50% or more of the total value or voting power is owned by any of the entities described in (i), (ii) or (iii).
When analyzing whether a change of control has occurred in a controlled group of corporations, it generally must be a change of control of the parent entity. The sale of a subsidiary of the parent would not trigger a change of control unless the subsidiary’s assets equal more than one-third of the parent’s assets. It is important to identify which entity is undergoing the change of control so that the proper analysis can be completed for Section 280G purposes.
What Is an “Excess Parachute Payment”?
Loss of deductibility and application of the excise tax only apply to the “excess parachute payment.” Once it has been determined that there is a parachute payment (that the payments contingent on change of control exceed three times the base amount), the excess of such contingent payments over one times the base amount will be considered the “excess parachute payment” to which the excise tax and loss of deduction apply. In other words, going one dollar over the three times base amount threshold results in the entire amount of the contingent payments, reduced only by one times the base amount, being subject to these tax provisions.
What Payments Are Contingent on a Change of Control?
As noted previously, the payments must not only be in the nature of compensation, but also must be contingent on the change of control. Most executive employment agreements and compensation plans (i.e., severance agreements, bonus plans, nonqualified deferred compensation plans, stock option plans) contain change of control provisions that will most likely be triggered by a merger, asset sale or stock sale, resulting in bonus payments, higher severance payments and acceleration of equity in connection with the transaction. These types of payments, that clearly are triggered on the change of control, are easy to identify, but rarely are the only payments that are treated as contingent on a change of control.
Whether a payment is contingent on a change of control is generally determined under a “but for” test. To exclude the payment, it must be substantially certain, at the time of the change, that the payment would have been made whether or not the change occurred. Acceleration of vesting or acceleration of the time for payment will cause the payment to be treated as contingent upon the change, at least to some extent. Treas. Reg. §1.280G-1, Q&A-29. The portion of the payment treated as contingent is the amount by which the payment exceeds the present value of the payment absent the acceleration. Treas. Reg. §1.280G-1, Q&A-24. However, if the payment of deferred compensation was not vested (for example, it would have been forfeited had the disqualified individual terminated employment prior to age 65), the entire amount of the payment will be included in the computation if the change results in substantial vesting.
If a payment is merely accelerated by a change of control, it will not be treated as contingent upon the change of control if the acceleration does not increase the present value of the payment. These calculations are complicated if the payment that is accelerated would have been paid without regard to the change so long as the individual continued to perform services for a specified period of time. In that event, the value of the acceleration will take into account not only the value provided to the disqualified individual by earlier payment, but also the value added by elimination of the risk of forfeiture for failure to continue to perform services. If the disqualified individual and the employer are unable to establish a reasonably ascertainable value for both of these elements, then the entire amount of the accelerated payment will be included in the computation. This typically occurs with respect to performance-based bonuses or awards that are accelerated and vested upon the change of control regardless of whether the performance criteria have been achieved, in which case the entire amount of the payment would be treated as the parachute payment.
The present value of a payment which is to be made in the future is determined as of the date on which the change of control occurs, or on the date of payment if the payment is made before the change of control. First, the payment is discounted at a rate equal to 120% of the applicable federal rate. Treas. Reg. §1.280G-1, Q&A-32. Secondly, if the payment is contingent on an uncertain future event or condition, then the likelihood of whether the payment will be made must be reasonably estimated. If it is reasonably estimated that there is a 50% or greater probability that the payment will be made, then the full amount of the payment is considered for purposes of the 3-times the base amount test and the allocation of the base amount. Treas. Reg. §1.280G-1, Q&A-33. If it is reasonably estimated that there is a less than 50% probability that the payment will be made, the payment is not considered for either of these purposes. If the likelihood estimate is later determined to be incorrect, the 3-times the base amount test must be reapplied (and the portion of the base amount allocated to previous payments must be reallocated (if necessary) to such payments) to reflect the actual timing and amount of the payment.
For example, if a disqualified individual will be entitled to payment of $1,000,000 in the event his employment is terminated within one year after a change of control, and the corporation reasonably estimates that there is a 50% probability the disqualified individual’s employment will be terminated within one year, then the entire payment would be considered. If the timing of the payment can also be reasonably estimated, an additional discount may be applied. The determination of the likelihood of an event occurring can be made as late as the date the corporation files its income tax return for the year in which the change of control occurs. For example, if a change of control occurs on June 1 and the corporation files its income tax return in April of the following year, the corporation can look back and determine whether or not the event has occurred or has become likely to occur.
AVOIDING, OFFSETTING AND MITIGATING THE IMPACT OF SECTION 280G
Once the parties have identified that there are payments that may trigger taxation under Sections 280G and 4999, the next step is to outline those potential payments and determine whether there is any way to avoid, offset or mitigate the potential impact of these sections. It is important to note that while legal counsel can certainly run some initial calculations, most often an accounting firm is charged with running the final calculations that will be relied upon for analyzing the Section 280G issues, withholding taxes, and filing returns.
There are three primary approaches to avoiding, mitigating or offsetting Section 280G liability: (i) if it is a non-public corporation, relying upon the shareholder vote exception; (ii) reducing the amounts payable to the disqualified individual to one dollar less than the amount that would trigger the excise tax (called a “cut-back”); or (iii) “grossing-up” the payments so that the disqualified individual receives the same amount after application of the excise tax under Section 4999 as he or she would have received had Section 4999 not applied.
Law firms often work closely with the accounting firms and clients to determine the best approach to avoid, mitigate, or offset Section 280G liability. The law firms also will draft the documents outlined below (whether it be the documents for the shareholder vote, cut-back, or gross-up language for agreements with the disqualified individuals). Both counsel for the buyer and the seller will review these documents, so practitioners should focus on getting documents drafted with enough time for both sides to review and provide comments. This process is generally collegial when both law firms handle a high volume of deals but becomes more challenging when one side’s counsel is unfamiliar with Section 280G or does not have executive compensation counsel assisting with the transaction.
Private Companies with Shareholder Vote
As noted earlier, part of the reason Section 280G and 4999 were adopted was to protect shareholders from executives diverting value from shareholders and into their own pockets. Since shareholder protection was one of the primary goals, if the shareholders do not have an issue with the payments, then there is no reason for the taxes to apply. Congress included the shareholder vote exception in Section 280G for this exact reason. Under this exception, payments with respect to a change in ownership of a private company are not treated as parachute payments if the payments are approved by 75% of the shareholders entitled to vote immediately before the change in ownership, after adequate disclosure to all shareholders entitled to vote. Section 280G(b)(5) and Treas. Reg. §1.280G-1, Q&A 6 and Q&A 7. For these purposes, shareholder approval can be retroactively obtained. In order to rely on this exception, neither the company undergoing the change of control nor any members of its controlled group can be publicly-traded.
The shareholder population means the shareholders of record, as determined no more than six months before the date of the change in ownership or control. If a substantial portion of the assets of an “entity shareholder” (within the meaning of Treas. Reg. § 1.280G-1, Q&A-7(b)(3)) consists (directly or indirectly) of stock in the corporation undergoing the change in control (i.e., the total fair market value of the stock held by the “entity shareholder” in the corporation undergoing the change in control equals or exceeds one-third of the total gross fair market value of all of the assets of the “entity shareholder” without regard to any liabilities associated with such assets), approval of the payment by that “entity shareholder” must be made by a separate vote of the persons who hold, immediately before the change in control, more than 75% of the voting power of the “entity shareholder” (unless the entity shareholder owns, directly or indirectly, 1% or less of the total value of the corporation undergoing the change in control). Shares owned (directly or constructively) by a person who is to receive a payment that would be a parachute payment if shareholder approval is not obtained are not eligible to vote (and are not counted as outstanding for purposes of the vote). As a practical matter, practitioners may find it challenging to determine whether a shareholder constructively owns shares, making it crucial that parties start evaluating this issue as soon as the disqualified individuals are identified.
In order for the disclosure to the shareholders to be adequate, the “disclosure must be full and truthful disclosure of the material facts and such additional information as is necessary to make the disclosure not materially misleading at the time the disclosure is made.” Treas. Reg. §1.280G-1, Q&A 7(c). The description needs to include: (i) a description of the event triggering the payment(s); (ii) the total amount of the payment(s) that would be parachute payment(s) if the shareholder approval requirements are not satisfied; and (iii) a brief description of the payment(s) (e.g., accelerated vesting of options, bonus, or salary). The disclosure should give information on the effect of approval or disapproval. In addition, the disclosure must be delivered to all shareholders, not just the 75% needed to approve the payments.
The shareholder vote must be meaningful, which means that the amounts being approved must be at risk. Typically, if the disqualified individual has an existing contractual right to the payment being approved, the individual will be asked to sign a waiver agreement prior to the shareholder vote. The waiver agreement will provide that if the shareholders do not approve the payments, then any payments in the nature of compensation being paid in connection with the change of control will be reduced to one dollar less than the amount that would otherwise trigger the excise tax. Further, the shareholder vote must be independent of the shareholders vote on the underlying transaction. It is not permissible to include as a closing condition to the transaction that the shareholders have approved the payments. The only requirement that can be included in the purchase agreement is that the seller provide evidence that they conducted the shareholder vote in accordance with the requirements of Section 280G.
If the seller is owned by a small number of shareholders or only a handful of shareholders own the required 75% of the vote needed and the shareholders are supportive of the executive team, obtaining the shareholder vote tends to be a rather routine part of the deal that merely requires deal counsel to get the proper disclosures, waivers and resolutions timely drafted and submitted to the shareholders. However, if there are a large number of shareholders or the shareholders have an adversarial relationship with management, the shareholder approval approach may not work. In such cases, the parties need to look at potentially cut-back the payments or grossing up the payments as discussed below.
Cut-backs, Gross-Ups and Best Net Clauses
For public corporations, or private corporations where the shareholder vote is not a viable alternative, the parties have two primary options to address Section 280G issues: (i) cut-back the payments so that Section 280G and the taxes under Section 4999 are not triggered; or (ii) gross-up the payments. Before deciding on which approach to use, practitioners should first review the relevant agreements to determine whether Section 280G was addressed in the contract when signed. Often employment agreements and severance agreements will include paragraphs that specifically address how the compensation will be treated under Section 280G in the event of a change of control. If the parties want to take an approach that differs from the underlying agreements, the disqualified individual subject to the agreements will need to consent to the new approach. The disqualified individual’s consent may not be easy to obtain if the disqualified individual will receive less compensation under the new approach.
Cut-back. If the parties elect to use the cut-back approach, the disqualified individual’s parachute payments are reduced to an amount that is one dollar less than the amount that would trigger the 20% excise tax. A disqualified individual without a gross-up agreement may prefer to have his or her payments capped if it appears likely that he or she will be close to the three times base amount threshold or just over that threshold. For example, a disqualified individual with a base amount of $300,000 could receive contingent payments of up to $899,999 without being subject to the 20% excise tax. However, if that disqualified individual receives contingent payments of $900,001, he or she would be subject to an excise tax of $120,000 ($600,001 times 20%). By agreeing to give up $2, the disqualified individual saves $120,000. However, if that same individual was entitled to contingent payments of $1,100,000, the excise tax would be $160,000 (an excess parachute payment of $800,000 multiplied by 20%), and the disqualified individual would receive $40,000 more by taking the payment rather than having it capped. The corporation will generally prefer to cap the benefits, because going over the three times base amount threshold by $1 results in loss of the deduction for the entire amount of the excess parachute payment. However, if capping or cutting back the compensation would result in payments being less than the disqualified individual would receive if the full amount was paid and the 20% tax was applied, he or she may not be willing to agree to a cut back.
Gross-up. Even if the amount would not be less under the cut-back, the disqualified individual may feel like the corporation is breaking its promise to the individual of a certain amount of compensation in the transaction, and that the corporation should have warned the individual at the time the promise to pay the compensation was made that the amount might be substantially less because of Section 4999. In such cases, the parties may consider adding a gross-up so that once the taxes under Section 4999 are deducted, the disqualified individual receives the same amount he would have received had the excise tax not applied. If the disqualified individual is provided a full gross-up, the cost to the employer can be significant, because not only will the initial 20% excise tax be paid by the corporation (and non-deductible), but also all income tax and additional excise taxes applicable to the gross-up amount must also be paid. Because of this increased cost to the employer, gross-up clauses have been attacked as excessive pay practices by Institutional Shareholder Services and other similar institutional shareholder watch-dog organizations. If either corporation in the transaction is a publicly-held corporation that has a large percentage of shareholders following ISS or other such organizations, use of a gross up can result in significant shareholder backlash, and potentially a “no” vote recommendation on other matters.
Best net. A third option, which is often used by publicly-held corporations, is to apply a “best net” approach to the payment. Under the best net approach, the disqualified individual receives the greater of the (i) full amount of the payments, less the 20% excise tax; or (ii) one dollar less than the amount that would trigger the 20% excise tax. This approach could still result in a loss of deduction for the corporation if the greater amount is the full amount of the payment less the excise tax, but many corporations still agree to this approach because it is better than a gross up and usually satisfies the disqualified individual once the individual understands the potential backlash causes by a gross up payment.
It is not often easy to determine whether a disqualified individual will be close to his or her threshold amount, significantly under it, or significantly over it. Questions may arise about inclusion of certain benefits and payments in the calculation of the base amount. Moreover, as noted above, calculation of the present value of future contingent payments may be quite difficult and subject to adjustment based upon later events, and treatment of particular payments as contingent on a change of control may not be certain. If this issue is addressed sufficiently far in advance of the effective date of the change of control, each disqualified individual can review his or her own situation and work with the buyer and seller on the best approach for all parties.
Reasonable Compensation
If it has already been determined that a disqualified individual has an excess parachute payment, the amount of that excess parachute payment may be reduced by the portion of the payment that the disqualified individual establishes by clear and convincing evidence is reasonable compensation for services prior to or after the change of control. Treas. Reg. §1.280G-1, Q&A 3, 9, 24(a)(2) and 39.
Only payments that can be established by “clear and convincing evidence” to be reasonable compensation for services rendered are not treated as parachute payments. Section 280G(b)(5) and Treas. Reg. § 1.280G-1, Q&A-6 and Q&A-9. The determination of whether a payment is “reasonable” is based on the facts and circumstances relating to each payment and each disqualified individual. Treas. Reg. §1.280G-1 Q&A 40. The regulations issued under Section 280G provide that the relevant factors to the determination of whether a payment is reasonable compensation include, but are not limited to, (i) the nature of the services rendered or to be rendered; (ii) the individual’s historic compensation for performing such services; and (iii) the compensation of individuals performing comparable services in situations where the compensation is not contingent on a change of control. Treas. Reg. § 1.280G-1, Q&A-40(a).
All payments in connection with a change of control are presumed unreasonable. For purposes of determining whether a payment is contingent on a change of control, there is a presumption that any payment that is made within the period beginning one year before and ending one year after the date of the change in ownership or control is made in connection with the change of control. Treas. Reg. §1.280G-1, Q&A-22(b)(3). Conversely, there is a presumption that any payment made outside of this two-year time period is not made in connection with a change of control.
There also is a distinction between the treatment of compensation for services rendered before the change of control and compensation for services rendered on or after the change of control. Payments of compensation that were clearly earned before the change of control generally are considered reasonable compensation for personal services actually rendered before the change of control if the payments qualified as reasonable compensation under Section 162. Treas. Reg. §1.280G-1, Q&A-43. Examples of payments that are commonly treated as payments for services rendered include bonuses paid in the ordinary course in accordance with the corporation’s bonus plan in the year prior to the change of control, or pro rata bonuses paid to an employee prior to the change of control based on actual performance. The Treasury Regulations also provide that a showing that payments are made under a nondiscriminatory employee plan or program generally is considered to be clear and convincing evidence that the payments are reasonable compensation. Treas. Reg. § 1.280G-1, Q&A-26. Examples of nondiscriminatory employee plans include group term life instance, cafeteria plans, and educational assistance plans.
However, new programs or increases in base salary that occur within the one-year period prior to a change of control can be problematic. The parties to the transaction should use care to support any large increase or adoption of new programs with market data and other objective evidence to show it is comparable to other peer group members when trying to argue it is reasonable compensation.
Payments for services rendered within the one-year period prior to the change of control are considered “parachute payments,” but are not considered “excess parachute payments” to the extent they are reasonable compensation. Section 280G(b)(4)(B) and Tress. Reg. §1.280G-1, Q&A-3. Thus, payments for services rendered in the one-year period before a change of control (i) are included for purposes of determining whether all payments received in connection with a change of control exceed the three times base amount threshold; but (ii) are exempt from the 20% excise tax; and (iii) may be deducted by the payor. Again, the burden is on the corporation to establish by clear and convincing evidence that these payments are reasonable compensation for services rendered prior to the change of control.
If payments are received for services rendered on or after the change of control (e.g., continued salary, post-transaction consulting arrangements, bonuses for performance periods after the change of control) or pursuant to an agreement entered into after the change of control, they generally are not considered “parachute payments,” and thus are excluded from the determination of whether all payments in connection with a change of control exceed the three times base amount threshold. Section 280G(b)(4)(A) and Treas. Reg. §1.280-1, Q&A-9 and Q&A-23. One exception to this general rule is if the payments are made pursuant to an agreement that is executed after a change in ownership or control pursuant to a legally enforceable agreement that was entered into before the change, in which case, the agreement is considered to have been entered into before the change. Treas. Reg. §1.280-1 Q&A 25. For instance, if the purchase agreement requires the buyer to provide retention bonuses to the seller’s employees that it hires, and the buyer enters into those agreement post-closing, the agreement would be treated as entered into prior to the change of control. In addition, if the disqualified individual post-closing gives up a right made under an agreement that was entered into prior to the change of control in exchange for benefits under a post-closing agreement, the new agreement will only be treated as a post-closing agreement to the extent the value exceeds the value of the payments under the pre-closing agreement. Treas. Reg. §1.280-1 Q&A 25.
In the event the agreement entered into prior to the change of control includes severance payable after the change of control and a non-compete provision, the parties may be able to argue that some portion of the severance is reasonable compensation as a payment made in exchange for a covenant not to compete. Under the Treasury Regulations, payments that can be established to be made in exchange for a covenant not to compete are reasonable compensation for services to be rendered on or after the change of control. Treas. Reg. §1.280G-1, Q&A-40(b) and PLR 9314034 (1/8/1993). However, this does not mean that the entire amount of the payment that is linked to the non-compete is automatically excluded. The non-compete must be enforceable, which means it must be both enforceable in the jurisdiction where it applies, and the corporation must not have a history of waiving non-competes. If the corporation never enforces non-competes, then the payments will not be deemed reasonable compensation. Further, the parties must consider the amount of damage the disqualified individual may inflict on the business if he or she competes. This value might be different for each disqualified individual, and likely has a higher value for someone in his or her 40s versus an 80-year-old disqualified individual who intends to retire after the transaction. Typically, accounting firms value the non-compete and determine what, if any, value can be treated as reasonable compensation. It is important to make sure both the seller and the buyer agree to the value. If the buyer does not agree with the value and determines later when taking the deduction that the assigned value was too aggressive, it could result in an increase in the parachute payments and tax liability for the disqualified individuals after the transaction closes.
Conclusion
Navigating the issues raised by Section 280G and 4999 can be complicated. However, if issues are addressed early in the transaction, then all parties involved can better understand the impact of the excise taxes, or the actions the parties need to take in order to mitigate or offset the impact of these sections. With time, and careful planning, the parties can avoid the pitfalls outlined above, and prevent these sections from unduly burdening a transaction.
[1] All references to Section mean a section of the U.S. Internal Revenue Code of 1986, as amended.
Historically, escrows have served as a classic deal protection mechanism in mergers and acquisitions (M&A) transactions. Recently, however, representations and warranties (R&W) insurance has emerged as an escrow alternative, offering seller-friendly terms and competitive premiums. Is there room for two products on the market? Is one better than the other? Bottom line, it all depends. In this article, we will explore some areas to consider when evaluating the optimal deal protection mechanism for your transaction.
ESCROWS: A primer
Holdback escrows are generally used by Buyers to segregate a portion of the purchase price for various reasons, with the most common reasons being to:
Provide a means for the Buyer to claim back a portion of the purchase price for breaches of representations and warranties from the Seller.
Secure post-close purchase price adjustments until finalization of such amounts.
Escrows can also be used for other M&A purposes:
Good Faith Deposit: can demonstrate serious interest and/or comply with regulations (e.g., if government approval is needed); can also be used to hold potential termination fees.
Closing Agent / Paying Agent: can centralize funding sources and enable funds to be on hand prior to close; can also facilitate exchange of company stock from Seller for payment of cash from Buyer.
R&W INSURANCE
While there are Seller and Buyer R&W policies, the latter is more common. Under a buy-side R&W policy, the Buyer in an M&A transaction recovers directly from an insurer for losses arising from certain breaches of the Seller’s representations and warranties in the purchase agreement. By shifting the risk of such losses from the Seller to an insurer, a policy can limit the Seller’s liability for certain representation breaches. The Buyer retains the risk of receiving payment from the insurer for any claims submitted.
Claim Event Comparison (Escrow agent not involved in claim resolution)
Vital Parameters to Consider
CLAIM COVERAGE
For both escrows and R&W policies, claim coverage is particularly important for a Buyer seeking to mitigate risk in its acquisition. In general, an escrow can provide a clear solution to resolve risks between the parties and may be customized to facilitate a comprehensive coverage model. Conversely, many R&W policies cover only specific, targeted areas.
Currently, in a typical R&W policy, known issues may be excluded, whether or not reported to the insurer or included in a due diligence memo. In addition, in many instances R&W policies will not cover breaches of covenants, forward-looking statements, or purchase price adjustments. Depending on the specific policy, common indemnity claim types such as tax, litigation / product liability, collectability of accounts receivable, pension underfunding issues and environmental liabilities may require separate policies or increased premiums.
CLAIM PAYOUTS
Traditionally, claim payouts are not influenced by the escrow agent, as it serves as a neutral third party, acting generally on joint instructions to release funds. Existing R&W insurance studies provide limited visibility on claim payouts and timing. This calls into question whether or not certain R&W providers will face increased pressure to pay on claims and potentially to increase premium fees to ensure claim payouts.
COST
R&W premiums vary based on the level of coverage but are generally a certain percentage of required coverage. On the other hand, escrow fees are nominal, and larger escrow deposits generally do not result in higher fees. Additionally, in the current low-interest-rate environment, the opportunity costs of having funds on deposit in escrow are relatively low. Escrow will likely continue to be a less expensive risk mitigation tool regardless of whether claims increase over time.
DUE DILIGENCE
When circumstances change, escrow does not require a separate due diligence work stream like R&W insurance does, and it will typically be quicker and simpler to execute a new escrow agreement vs. an R&W policy. As a result, escrow can provide much-needed flexibility when quick turnaround is needed or to resolve last-minute negotiation issues that come up between the Buyer and Seller.
Choosing a Mechanism for Your Deal
Despite their recent emergence, most R&W policies only cover certain types of breaches for representations and warranties, though added coverage may be available, potentially for an additional cost. Claims may be paid but sometimes at the expense of increased legal fees and the extent of recovery. The ability to close within timeframes desired by Buyers can also be impacted. On the other hand, many transactions, even those with R&W policies, involve some form of escrow to help cover and protect the gaps left by R&W policies.
Escrow can offer flexibility, low cost and broad security, such as extending coverage through the “interim period” (time between signing and closing) via a good faith deposit.
Bottom Line
Each transaction and its requirements are unique, and understanding the needs of your transaction — including what it will cost, how long it will take, the extent of its coverage provided, the user experience and quality of digital offerings and certainty of enforceability — will drive towards a coverage model that makes the most sense for you.
* Nicholas Scarabino and John Thomas contributed to this article.
Nicholas Scarabino, Managing Director, Wholesale Payments, Global Escrow Services Sales at J.P. Morgan. Nick has been with J.P. Morgan for over 31 years in Sales and Marketing.
He is currently the Global Sales Manager for the Escrow Services department within the Corporate and Investment Bank’s Wholesale Payments division. The 25+ member team focuses on building relationships and delivering innovative escrow, depositary and agency solutions to corporations, investment banks, law firms and other financial intermediaries.
John Thomas, Executive Director, Wholesale Payments, Global Escrow Services Product Management. John has been with J.P. Morgan for over 13 years in Product Management.
He is currently the North America Product Management lead for the Escrow Services department within the Corporate and Investment Bank’s Wholesale Payments division. The Product Management team focuses on supporting, developing, and expanding escrow solutions and digital escrow applications for institutional clients and law firms.
On July 13, 2021, the U.S. Securities and Exchange Commission (“SEC”) announced charges against:
Stable Road Acquisition Corp. (“SRAC”), a special purpose acquisition company (“SPAC”);
SRAC’s proposed merger target, Momentus Inc. (“Momentus”);
SRAC’s CEO and Momentus’s CEO; and
the SPAC’s sponsor, SRC-NI Holdings, LLC (“Sponsor”),
in connection with misleading claims made by SRAC and Momentus about Momentus’s propulsion technology and national security concerns associated with Momentus’s CEO.
Momentus is an early-stage space transportation company that intends to provide satellite positioning services with in-space propulsion systems powered by proprietary microwave electrothermal thruster (“MET”) water plasma thrusters. In October 2020, Momentus and SRAC entered into a merger agreement and SRAC executed subscription agreements in connection with a $175 million private investment in public equity (“PIPE”) that was set to close simultaneously with the merger.
In its Order Instituting Cease-And-Desist Proceedings (the “Order”),[i] the SEC states that Momentus and SRAC misled investors regarding:
the extent to which Momentus’s propulsion technology had been “successfully tested” in space; and
the extent to which national security concerns involving Momentus’s CEO hindered Momentus from obtaining necessary governmental licenses critical to its operations.
The SEC went on to state that as a result of its failure to conduct adequate due diligence, SRAC compounded these disclosure violations by repeating materially false and misleading statements in materials presented to investors.
The SEC claims that these failures amounted to violations of Section 10(b), Rule 10b-5, Section 14(a) and Rule 14a-9 of the Securities Exchange Act of 1934 (the “Exchange Act”); and Section 17(a) of the Securities Act of 1933 (the “Securities Act”).
Without admitting or denying the SEC’s findings, all parties, except for Momentus’s CEO, have agreed to settle these charges with the SEC, with the following penalties being imposed:
Momentus, SRAC, and SRAC’s CEO paid civil penalties of $7 million, $1 million, and $40,000, respectively;
all subscribers in the PIPE were given the opportunity to terminate their subscription agreements;
the Sponsor forfeited 250,000 founder shares in SRAC; and
Momentus has undertaken substantial enhancements to its disclosure controls, including the creation of an independent board committee and the retention of an internal compliance consultant for a period of two years.
The merger of SRAC and Momentus was consummated on August 12, 2021. PIPE subscribers representing an aggregate of $118 million in the original PIPE investment elected to terminate their subscription agreements. While SRAC was able to obtain subscription agreements from new PIPE subscribers, the overall size of the PIPE was decreased from $175 million to $110 million. In addition to the PIPE shares, SRAC agreed to issue each remaining PIPE subscriber warrants to purchase its common stock at a price of $11.50 per share in an amount equal the number of PIPE shares purchased by such subscriber (11,000,000 additional warrants in total).
The SEC has separately filed litigation against the former CEO of Momentus.
Momentus’s and SRAC’s Statements
Propulsion Technology Failures
In both the investor presentation materials provided to potential PIPE investors and the registration statement on Form S-4 filed in connection with the stockholder vote to approve the merger, Momentus and SRAC repeatedly claimed that Momentus had “successfully tested” its “cornerstone” propulsion technology in space and that the test satellite was “still operational today.” In fact, Momentus had conducted only one in-space test of a preliminary version of its technology in 2019, and that test had failed to meet even Momentus’s own internal definition of “mission success.” Momentus had sought to achieve “100 individual burns of one minute or more.” Out of 23 attempts, only three generated plasma, and none generated any measurable thrust. None of the burns lasted a full minute. Momentus was not able to attempt the remaining 77 burns because it lost contact with the satellite partway through the testing. As of July 13, 2021, this test satellite remained in space but was not functional. Even if Momentus had achieved its “mission success” criteria, the preliminary version of the technology was not powerful enough to be commercially viable.
By misleading investors about the results of the in-space test, the SEC found that the registration statement and other public filings falsely assured investors that Momentus was farther along toward commercial deployment of its technology than it actually was.
U.S. National Security Concerns
Momentus and SRAC also failed to disclose the extent to which the CEO’s involvement with Momentus was jeopardizing its chances for success. Because Momentus’s former CEO is a foreign national, he required an export license in order to access parts of Momentus’s technology, and he was required to hold a valid visa in order to work in the United States. Various U.S. governmental agencies had not only repeatedly denied the CEO such licenses, but also had revoked his work visa- in each case, because of “national security concerns.” The CEO had also previously been required by the U.S. government to divest his holdings in another U.S.-based space technology business, again for “national security reasons.” Importantly, these issues were affecting Momentus by slowing down its development process. Following the announcement of the merger with SRAC, the U.S. Federal Aviation Administration (“FAA”) twice denied approval for scheduled launches of new satellites in 2021 because of the CEO’s holdings in Momentus. These launches were critical for Momentus, as they were to be its first commercial flights. The denials by the FAA caused Momentus to reforecast its expected launch dates from 2021 to 2022.
Most of the foregoing information was omitted from SRAC’s initial filings of its registration statement. The initial filings failed to disclose that the CEO was considered a national security risk by various U.S. governmental agencies and, thus, was less likely to be granted asylum or an export license. Instead, the disclosure stated that the CEO had not “yet” obtained an export license, even though at the same time it was becoming clear that his application would be denied. Finally and importantly, the registration statement’s financial projections for Momentus did not take into account the delays it was experiencing as a result of the FAA’s denials.
SRAC’s Due Diligence Failings
While the SEC noted most of the omitted information was kept from SRAC by Momentus, the SEC found that SRAC “conducted inadequate due diligence” and adopted Momentus’s disclosures when the SPAC included these statements in its PIPE investor presentation and its initial drafts of the registration statement. The SEC found that SRAC’s diligence efforts were undertaken in a “compressed timeframe and unreasonably failed both to probe the basis of Momentus’s claims that its technology had been ‘successfully tested’ in space and to follow up on red flags concerning national security and foreign ownership risks.” As a result, SRAC’s marketing materials and its disclosures caused investors to be misled about material aspects of Momentus’s business.
Key Takeaways
Filings made in the context of business combinations undertaken by SPACs face similar scrutiny from the SEC Staff as do the filings made in connection with traditional initial public offerings (“IPOs”) and should be prepared with the same level of rigor. The notion, suggested by some in the popular press, that private companies combining with SPACs do not face the same liability as companies that undergo traditional IPOs, should not be relied upon. As emphasized by the SEC Staff:
“[a]ny material misstatement in or omission from an effective Securities Act registration statement as part of a de-SPAC business combination is subject to Securities Act Section 11. Equally clear is that any material misstatement or omission in connection with a proxy solicitation is subject to liability under Exchange Act Section 14(a) and Rule 14a-9, under which courts and the Commission have generally applied a “negligence” standard. Any material misstatement or omission in connection with a tender offer is subject to liability under Exchange Act Section 14(e) . . . . Given this legal landscape, SPAC sponsors and targets should already be hearing from their legal, accounting, and financial advisors that a de-SPAC transaction gives no one a free pass for material misstatements or omissions . . . .”
The SEC expects SPACs and their sponsors to conduct due diligence on the target in connection with an initial business combination. In a traditional IPO, the due diligence undertaken by underwriters serves an important investor protection function, and the SEC Staff has publicly lamented the absence of this structural component in de-SPAC transactions. Indeed, holding the SPAC accountable for its due diligence failures hearkens back to statements made by the Staff of the SEC’s Division of Corporation Finance asking whether the SEC should “reconsider the concept of ‘underwriter’ in [de-SPAC] transactional paths.”
Related to the point above, the SEC also is focused on the misalignment of incentives arising from the SPAC structure. SPAC sponsors stand to obtain substantial profit from the completion of a successful business combination, even if the resulting combined company fails to prosper following the business combination. On the other hand, if a SPAC does not complete a business combination within a specified timeframe, SPAC sponsors stand to lose millions of dollars in invested capital. These powerful financial incentives coupled with:
the limited time period a SPAC has to complete an initial business combination; and
the increasingly competitive market for targets
have caused the SEC to be concerned that sponsors will conduct cursory due diligence, overlook red flags uncovered during the diligence process, and fail to make the necessary disclosures to their stockholders, all in the interest of getting a favorable stockholder vote.
The SEC’s Order should also be viewed in the wider context of the SEC’s heightened scrutiny of SPACs in the first half of 2021, and statements made by SEC Staff, including the following:
The SEC’s Public Statement on Financial Reporting and Auditing Considerations of Companies Merging with SPACs (March 2021);[ii]
The SEC Staff’s Statement on Select Issues Pertaining to Special Purpose Acquisition Companies (March 2021);[iii]
The SEC Division of Corporation Finance’s Public Statement on SPACs, IPOs and Liability Risk under the Securities Laws (April 2021);[iv] and
The SEC Staff’s Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (April 2021).[v]
The SEC’s stated regulatory agenda includes addressing rules related to SPACs.[vi] Although the agenda does not specify the aspects to be addressed, given statements by the SEC Staff, statements made by SEC Chair Gary Gensler, and areas addressed in proposed SPAC related legislation in Congress, the SEC is likely to address liability issues, whether relating to the use of projections and the availability of the safe harbor for forward-looking statements. In the meantime, we expect additional guidance and additional actions related to SPACs from the SEC in the near future.
This article is the second in a two-part series exploring the implications of President Biden’s executive order on cybersecurity. In the first installment, available here, William R. Denny discusses the role the executive order plays in the federal government’s commitment to modernize cybersecurity defenses.[1]
Recent cyber-attacks, such as the SolarWinds[2] and Kaseya[3] supply chain attacks, which affected thousands of entities, and the ransomware attack on Colonial Pipeline,[4] are stark reminders of the tremendous and growing cyber threat both to the public and private sectors. The level of sophistication of these attacks make it ever more difficult for enforcement agencies to detect and prevent these incidents. On May 12, 2021, just days after the attack on Colonial Pipeline, President Biden released a comprehensive executive order (EO)[5] intended to improve U.S. cybersecurity infrastructure and protect the federal government’s networks. While this is an ambitious step by the administration, there is still a need for public-private partnerships to reduce the risk of future attacks. The President noted in the EO that “[t]he private sector must adapt to the continuously changing threat environment, ensure its products are built and operate securely, and partner with the federal government to foster a more secure cyberspace.”
In our previous article, we discussed the elements of the new EO, highlighting remarks made by Dan Sutherland, Chief Counsel for the Cybersecurity & Infrastructure Security Agency (CISA), and Jen Daskal, Deputy General Counsel at the Department of Homeland Security (DHS). The speakers emphasized that ransomware was a massive national security problem requiring both a “whole of government” and a “whole of private sector” approach. Ransomware often strikes the weakest links in information systems. While the government is investing in strengthening resiliency, the private sector must also play a role in helping to protect against cyberattacks. This article focuses on the implications of the EO for the private sector.
While EOs do not have the effect of law, they serve as a roadmap for federal agencies to regulate themselves. The President can require that certain terms be included in federal contracts and can use EOs to bolster this agenda. For private sector businesses interested in competing for federal contracts, the President’s “procurement power” creates a powerful catalyst for change. And because the federal government is such a significant purchaser of private IT services, new federal standards will have a powerful ripple effect on cybersecurity in the private sector.
The EO’s commitment to public/private partnerships is evident through the demands it places on private sector contracting partners. The EO mandates the removal of barriers that prevent private businesses (who contract with the government) from sharing cybersecurity and breach information, and mandates contract provisions that require the reporting of such information.
For private sector businesses, the EO indicates the increased likelihood of new cyber-related legislation and heightened regulation of existing cybersecurity laws and policies. While the EO broadly applies to the federal government, it provides several best practices that the private sector should consider emulating to enhance its own cybersecurity readiness.
1. Modernize Private Sector Cybersecurity
The EO directs agencies to prioritize the adoption and use of cloud technologies to store data. Businesses should likewise invest in cloud technologies for data storage, as this could help ensure that businesses are consistently up to date with the latest security tools. Businesses should, in the same vein, consider intermittently conducting a thorough procedure of identifying the types of data they store and assessing the sensitive nature of the data. During this process, businesses should identify data that is no longer needed and dispose of it. In the event of a cyberattack, businesses should be better able to tell which data may have been compromised.
The EO also directs the creation of policies for logging data, including retention and management of the logs, to ensure centralized access to critical data for analysis in case of a cyberattack. The EO provides a valuable outline of the types of security controls that should be considered. These include endpoint protection, access controls, network security, email security, logging, monitoring and threat hunting. The private sector can take a cue from the government and adopt some of these security controls. Businesses should also get in the habit of training their employees on cybersecurity and the importance of protecting their data.
2. Enhance Software Supply Chain Security
The Fact Sheet following the EO states that the EO will:
improve the security of software by establishing baseline security standards for development of software sold to the government, including requiring developers to maintain greater visibility into their software and making security data publicly available. It stands up a concurrent public-private process to develop new and innovative approaches secure software development and uses the power of Federal procurement to incentivize the market.
The Biden Administration plans to utilize the purchasing power of the government to implement updated security measures from software vendors who contract with the government. Businesses can follow suit and require security standards from third-party vendors with whom they transact business. Businesses should consider conducting due diligence on third parties to ensure that they have the appropriate IT security measures in place to mitigate the risk of a cyber incident. Businesses should inquire about the measures their third-party vendors have in place such as multifactor authentication and encryption. Doing so enables businesses to identify possible risks and find remedies before their data is potentially compromised. Businesses should also get into the habit of including contract provisions that obligate their third-party vendors to notify them of any unauthorized disclosures of their confidential information. With this information, businesses could act quickly in the event of an attack and attempt to minimize harm from a breach.
3. Develop an Incident Response Plan
The EO instructs federal agencies to develop, within 120 days, a “playbook” to be utilized in the planning and conducting of cybersecurity vulnerability and incident response activities. Private sector organizations should also develop their own incident response plans. An incident response plan outlines a course of action in the event of a significant incident. It assigns roles and creates an incident recovery team, comprised of key professionals within the organization as well as outside experts. It also prepares employees for any possible attacks. Having an incident response plan would enable businesses to respond more quickly and effectively to a cyberattack. After a cyber incident, businesses should reflect on lessons learned, revisit their best practices and modify any elements of their incident response plan that need to be updated.
4. Establish a Cyber Safety Review Board
The EO directs the establishment of a Cyber Safety Review Board co-chaired by government and private sector leads that may convene following a significant cyber incident to analyze the attack and provide concrete recommendations for improving cybersecurity. Similarly, the private sector should cooperate to establish a similar review board to conduct security threat assessments, identify potential vulnerabilities and make recommendations.
5. Engage In-House Counsel or External Counsel
Because of the increasing sophistication of cyber risks, businesses should engage with general counsel to set governing principles that balance protecting data with ensuring that the businesses are complying with privacy and regulatory principles. General counsel could also be instrumental in assisting their businesses to understand the cyber landscape and assisting management in making decisions about cybersecurity measures. Business attorneys can assist organizations in drafting contracts that include the above-mentioned reporting requirements. Businesses should take a holistic approach in addressing cybersecurity breaches in a way that addresses employee and client privacy and governance.
The federal government will continue to make cybersecurity a priority to protect the United States, its infrastructure, and its citizens. For the private sector, the new EO provides a comprehensive guideline for strengthening their cybersecurity. By modernizing cybersecurity measures, enhancing software supply chain security, developing an incident response plan, establishing a cyber safety review board and engaging in-house counsel, businesses will be better prepared to mitigate cybersecurity risks and respond effectively in the event of cyberattacks.
CISA recently launched a new webpage focused on ransomware, https://www.cisa.gov/stopransomware, that includes guidelines that would be extremely beneficial to businesses. CISA itself is also strategically designed not just to work on cyber defense and resiliency, but also to improve public-private partnerships. When there is an incident, quick action is needed, and CISA wants businesses and governmental agencies to know that it has resources to assist.
[1] Maame Nyakoa Boateng, a third-year student at Penn State Dickinson Law, contributed to both articles.
