The eponymous characteristic of the limited liability company (LLC) is that the LLC, as a separate legal entity, is liable for its obligations to others and that no other person, whether as owner or agent, is vicariously liable for those same obligations. Of course, an LLC, like any legal entity, must act through individuals or other legal entities with the authority to act on behalf of the LLC. The individual or legal entity with this authority may be known by a number of designations: managers, managing members, authorized persons, officers, or employees, or simply as agents (collectively “Actors”). Under all LLC statutes, the general rule is that the members of the LLC are not personally liable for obligations of the LLC, subject to such exceptions as personal guarantees or “piercing” of the organizational veil. This article discusses a different aspect of vicarious liability: when an Actor will be liable to a third party for actions taken on behalf of the LLC. It does not address the liability of the LLC (or its owners qua owners) to the third party or the relationship between the LLC and its Actors.
Whether an Actor will be personally liable to the third party for an obligation incurred by the Actor while acting on behalf of the LLC is a complex question which will turn on: (1) whether the obligation is based in contract or in tort; (2) whether the duty breached by the Actor is a duty to the LLC or to the third party; and (3) if the obligation is a liability for damages, whether the damages are physical harm to the person or property of the third party or for economic loss suffered by the third party.
Contract
Actors, in their capacities as agents of an LLC, are generally subject to the same rules applicable to other agents. The Restatement (Third) of the Law of Agency (“Restatement of Agency”) § 6.01(2) provides the general rule that an agent (here the Actor) is not a party to – and thus is not liable to – a third party on a contract between a fully-disclosed principal (here, the LLC) and a third party, even if the agent, in its representative capacity as such negotiates and performs the contract. This rule is based on the concept that the agent, in contracting, is creating a contract that is binding on its principal and that the third party is relying on the principal for performance under the contract. Thus, other than the agent’s duty to the principal and the agent’s warranty of authority to the third party insuring that the agent does have the legal power to bind the principal (Restatement of Agency § 6.10), the agent does not have an individual role in the contract between the principal and the third party.
This result can be modified by the agreement of the agent, as, for example, where the agent has agreed to become a party to, or guarantee, the contract. But as a general rule, when an Actor on behalf of an LLC enters into a contract with a third party, the third party’s relief under the contract is limited to the LLC. The Actor’s conduct in entering into or performing the contract is immaterial to the liability for breach and the third party’s exclusive remedy is against the LLC. If the Actor is performing the contract on behalf of the LLC, the only person to whom the Actor is answerable is the LLC.
Tort
The Restatement of Agency has a different rule when an agent commits a tort that results in damage to a third party. Section 7.01 of the Restatement of Agency provides that an agent is liable to a third party harmed by the agent’s tortious conduct, irrespective of whether the agent is acting in a representative capacity or whether the principal is also liable to the third party. This rule is well-demonstrated by the idea that an Actor who negligently causes an automobile accident while driving in the course of his or her duties as Actor on behalf of an LLC is nonetheless personally liable to the third party injured in the accident. This is true regardless of whether the LLC is also liable to the injured third party. As discussed below, many LLC acts recognize this rule, although they recite it in different ways.
Not all tortious conduct of an agent that results in liability to a third party will subject the agent to liability to the third party. As explained in Section 7.02 of the Restatement of Agency, the tort must violate a duty owed directly by the agent to the third party. Thus, an agent (or any other person) who operates a motor vehicle on a public highway owes a duty to others on the highway not to cause damages to them through negligence. Section 7.02 notes that an agent’s breach of a duty owed to the principal is not an independent basis for the agent’s tort liability to a third party. For example, when a basketball player’s agent negotiates a contract with a third party for the player’s services and then negligently fails to inform the player about the contract or the player indicates he cannot perform, but the agent fails to inform the third party, the third party may not recover damages for agent’s negligence because the agent owes duties to the player but not the third party.
Physical Harm vs. Economic Loss
Even if the third party has a claim in tort for negligence, the liability of both the Actor and the LLC may be limited by a general rule that has developed significantly over the past few decades. The “Economic Loss Rule” is expressed in case law and described in the Restatement (Third) of Torts: Liability for Economic Harm (“Restatement of Torts: Liab. for Econ. Harm”), which is currently being completed by the American Law Institute. The Restatement describes the Economic Loss Rule as holding that there can be no liability in tort for causing pure economic loss. The definition of “economic loss” for purposes of this rule is generally defined as a loss or damage other than one resulting from personal injury to the plaintiff or physical damage to the plaintiff’s property, and encompasses such matters as lost profits, diminution in value, lost opportunity, and other monetary losses. The Economic Loss Rule is sometimes stated as precluding an action in tort by a party suffering only economic loss from a breach of an express or implied contract absent an independent duty of care under tort law.
The Restatement of Torts: Liab. for Econ. Harm § 3 Comment a expressly does not adopt the Economic Loss Rule, which it characterizes as the “minority view” and proposes a much more limited rule. Restatement of Torts: Liab. for Econ. Harm §§ 1 (“an Actor has no general duty to avoid the unintentional infliction of economic loss on another”) and 3 (“there is no liability in tort for economic loss caused by negligence in the performance or negotiation of a contract between the parties”). While the basic rules governing economic loss are neither settled nor simple, they do represent an important current in rules governing liability. The rationale for the rules dealing with economic loss or economic harm is that, in matters involving economic loss (generally, pecuniary damage other than that arising from damage to the plaintiff’s person or property), the contract between the parties, as opposed to general tort law, should govern, even where the damage results from the negligence of one of the parties. The basis supporting this rationale is that the parties may readily establish the standards of conduct and protect themselves from the failure to meet those standards under the contract between them, so there is no need for a tort remedy.
When this limitation on tort liability is combined with the general rule that an agent (here the manager or other Actor) is not liable to a third party on a contract between a fully disclosed principal (here the LLC) and a third party, this concept, even as defined by the Restatement of Torts: Liab. for Econ. Harm, will further limit the liability of an Actor to the third party.
While the Economic Loss Rule and the Restatement of Torts: Liab. for Econ. Harm both protect Actors from tort liability for economic loss arising in the course of negotiating or performing contracts, there are important exceptions to this protection. Not surprisingly, the protection does not apply to professional services (thus, an attorney may be liable in tort for economic loss arising from the attorney’s negligence) or fraud. The Restatement of Torts: Liab. for Econ. Harm also provides an extensive discussion of the sort of fraudulent or negligent misrepresentations (including promissory fraud) that will subject an Actor to liability in tort even if the tort occurred in the negotiation or performance of a contract.
Application of LLC Statutes
All of the concepts discussed above will be generally applicable to persons acting on behalf of limited liability partnerships and corporations, and, with respect to all such persons other than general partners, limited and general partnerships. Those rules that are based on agency principles will apply to all agents. There are some additional rules that may have unique application to LLCs as a result of state LLC legislation. Many – but not all – of the LLC statutes have an express statement to the effect that Actors (sometimes limited to statutorily-defined managers, sometimes including employees and other agents) are not liable solely by reason of being or acting as an Actor. The statutes tend to divide into three general categories: (1) silence on the liability of Actors, (2) a general statement that managers are not liable for the obligations of the LLC, or (3) a statement that managers (or, in some cases, all Actors) are not liable for the obligations of the LLC “solely by reason of” (being or acting as) a manager (or other Actor). In addition, some of the statutes providing for non-liability of managers or other Actors include an express exception for Actors who are professionals. For a table showing the different formulation of these provision in different states, see Larry E. Ribstein and Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies at Appendix 12-3.
Recently, a few cases have considered the liability of managers or managing members under statutory language stating that a member or manager is not liable for a debt or obligation solely by reason of being or acting as a member or manager. In Dass v. Yale, 2013 IL App (1st) 122520 appeal denied, 117224, 2014 WL 1385161 (Ill. Mar. 26, 2014), the court held that the manager of an LLC was not personally liable in connection with a warranty of condition of certain sewer lines and promise to conduct further testing of those lines made by an LLC of which the defendant was manager. Similarly, in 16 Jade St., LLC v. R. Design Const. Co., LLC., 398 S.C. 338, 728 S.E.2d 448 (2012), reh’g granted (May 4, 2012), opinion withdrawn and superseded on reh’g sub nom. 405 S.C. 384, 747 S.E.2d 770 (2013), after a somewhat convoluted appellate history concluded that the defendant (a member of the LLC that acted as contractor on a construction project) owed no duty to plaintiff (the property owner) for certain construction defects.
Both of these cases looked at certain legislative history in the Uniform Limited Liability Company Act (1996) which provides: “A member or manager, as an agent of the company, is not liable for the debts, obligations, and liabilities of the company simply because of the agency. A member or manager is responsible for acts or omissions to the extent those acts or omissions would be actionable in contract or tort against the member or manager if that person were acting in an individual capacity.” This language, appears to be a clumsy restatement of the concept better enunciated in Restatement of Agency § 7.02 (“An agent is subject to tort liability to a third party harmed by the agent’s conduct only when the agent’s conduct breaches a duty that the agent owes to the third party.”). As such, the manager in Dass and the member in 16 Jade Street were not held individually liable for negligence that occurred in the LLC’s discharge of its contract with the plaintiff.
Conclusion
Much attention has been given to the vicarious liability of members qua owners of an LLC because members are not vicariously liable for the obligations of the LLC solely by reason of their status as owners – thereby distinguishing them from general partners in general and limited partnerships. Only recently has the liability of Actors in LLCs and other organizations for actions taken on in their capacity as agents of the organization become the subject of extensive legal analysis. Recent case law, statutory provisions, and the Restatement of Torts: Liab. for Econ. Harm have focused greater attention on this issue and provided some guideposts that may help in developing a clear set of principles. As a general matter, the following rules should apply:
To the extent that an LLC’s obligation to third party liability arises under a contract between the LLC and the third party, the Actor will not be liable even if the Actor is instrumental in entering into or performing the contract for the third party
To the extent that an Actor is negligent in performing his or her duties for the LLC, the Actor will not be liable to a third party for any damage incurred by the third party unless the Actor owed an independent duty to the third party.
To the extent a third party sustains economic harm (i.e., harm other than personal injury or injury to the third party’s property) as a result of the negligence or other tort committed by an Actor in the course of negotiating or performing a contract between the LLC and third party, the Actor will not be liable to the third party under the Economic Loss Rule or the Restatement of Torts: Liab. for Econ. Harm.
Notwithstanding the rules set forth above, an Actor will be liable to a third party for damages resulting from the Actors actions if: (1) the Actor is a professional in the context of the LLC’s rendition of professional services to the third party or (2) the Actor has made fraudulent misrepresentations (including promissory fraud).
Each of these rules are general statements of principles that are subject to many exceptions, qualifications, and nuances. They do not deal with the liability of the Actor to the LLC or the liability of the LLC to the third party.
Further, there are many other factors that may have an impact on the liability of the Actor to the third party. For example, while as a matter of common law an agent may not have obligations under a contract between the principal and the third party, the agent may agree to become a party to that contract or may be subject to liability under other state statutory or common law.
In addition, as noted above, the Economic Loss Rule varies from the rules with respect to economic harm articulated in the Restatement of Torts: Liab. for Econ. Harm. The rules under the Economic Loss Rule and those under the Restatement differ on the extent to which the Actor is protected in the case of economic harm (under the Restatement, the protection is limited to economic loss caused by negligence in the negotiation or performance of a contract between the parties while the economic loss rule has been read as broadly as to eliminate liability in tort for causing any economic loss to another), and the extent to which the damages that the third party has sustained constitute “economic loss” or “economic harm” (the Restatement attempts to clarify the distinction between “economic loss” and injury to the plaintiff’s person or property in a way that is more rigorous than that employed by the common law of some states). Thus, the liability of the Actor may turn on whether the jurisdiction in which the claim is determined has adopted the Restatement of Torts: Liab. for Econ. Harm or some variation on the “Economic Loss Rule.”
Nonetheless, the important lesson that may be taken from this Sturm und Drang of varying rules is that the liability of a manager or other Actor for actions taken on behalf of the LLC of which he or she acts is neither automatic nor totally precluded. In determining that liability, a court will need to analyze the nature of action (i.e., tort or contract), to duties owed by the Actor and to whom the duties are owed, the nature of the damages sustained by the third party (i.e., whether they are “economic” or not), and the language and intent of the state LLC statute. The cost and uncertainty of this analysis, as well as the clear encouragement that all of the rules provide for the parties to anticipate these problems before they arise, all strongly argue for contractual undertakings involving principals, agents, third parties, and – if appropriate – insurers at the outset of the transaction. As stated in the Restatement of Torts: Liab. for Econ. Harm § 3 Comment b:
When a party’s negligence in performing or negotiating a contract causes economic loss to the counterparty, remedies are determined by other bodies of law: principally the law of contract, though sometimes also the law of restitution or relevant statutes. The law of contract and the law of restitution have been developed for the specific purpose of allocating economic losses that result from the negotiation and performance of contracts. They provide a more extensive and finely tuned apparatus for the purpose than the law of torts, which has developed primarily to address injuries that occur outside contractual relationships.
Möbius strip, a one-sided surface that can be constructed by affixing the ends of a rectangular strip after first having given one of the ends a one-half twist. This space exhibits interesting properties, such as having only one side and remaining in one piece when split down the middle.
Klein bottle, topological space, named for the German mathematician Felix Klein, . . . not constructible in three-dimensional Euclidean space but [with] interesting properties, such as being one-sided, like the Möbius strip; being closed, yet having no “inside” . . . ; and resulting in two Möbius strips if properly cut in two.
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Back in the day – say, 1990 – limited liability companies (LLCs) were the cutting edge of business entity law. Today, LLCs dominate entity formation, and the cutting edge has moved further out – to the notion of a “series,” a quasi-separate, quasi-person existing within an LLC.
Business lawyers are generally familiar with series of stocks and bonds, but those series have nothing to do with the LLC series discussed in this article. To avoid confusion, this article refers to protected series, which, as we will see, are the Mobius strips or Klein bottles of entity law.
The Protected Series Construct
The protected series comprises an identifiable set of assets segregated within a limited liability company (or also, under Delaware law, within a limited partnership), with the following features:
Those “associated” assets constitute the series, and a series is empowered to conduct activities in its own right. A series and its associated assets are responsible only to persons asserting claims pertaining to those assets or activities.
The associated assets are not responsible to persons asserting claims arising from the assets or activities of the LLC itself or from any other set of assets segregated within the LLC (i.e., from any other series within the LLC).
One or more members of the LLC may be, but are not necessarily, associated with the series.
The profits of the series inure to the benefit of only the members associated with the series, or if there are none, the LLC itself.
Thus, an LLC that has protected series perforce has “internal shields” – i.e., the partitions confining the assets and liabilities of each series to that series alone. These shields are conceptually and practically quite different from the shield that protects the owners of an entity from automatic liability for the entity’s obligations.
As detailed below, no one knows whether the internal shields will work in bankruptcy. Accordingly, this article is a warning label, not an operator’s manual.
What’s Old and What’s New?
The protected series has long existed in the context of series of investment trusts (particularly Delaware statutory trusts) and in the kindred context of captive insurance companies. However, in those contexts:
the construct has the blessing (and supervision) of the relevant regulators; and
the internal shields are not at issue, because:
involuntary creditors are as plentiful as unicorns; and
voluntary creditors will promise not to challenge the internal shields.
In 1996, Delaware amended its LLC and limited partnership statutes to provide for protected series. At that time, the thought seemed to be a combination of “why not?” and “perhaps in some circumstances an LLC or LP might work marginally better than a series within a Delaware statutory trust.” None of the key architects of the series provisions of the Delaware LLC and LP statutes then envisioned, let alone advocated, using series to compartmentalize the activities of operating businesses.
That attitude may well remain “best practices.” For example, the LLC Committee of the ABA Business Law Section has begun drafting a model operating agreement for a multi-member Delaware LLC with protected series. The project assumes that the LLC will be an investment vehicle and not an operating business or holding company.
However, anecdotal evidence suggests that many “series LLCs” are indeed used for operating businesses and holding companies and that many lawyers are recommending (or at least countenancing) such purposes.
Twelve states, the District of Columbia, and Puerto Rico now have series provisions in their respective LLC acts, and on Google the hits for “series LLC” go on almost endlessly. More than 25,000 series now exist under Illinois law alone.
These developments are occurring even though the efficacy of a protected series’ internal shields remains in doubt and many other important question are as yet unanswerable.
The Import of the Series Construct in Other Areas
Outside the realm of investment funds and captive insurance companies, the protected series is one of the most significant developments in the law of business organizations since the advent of the LLC. The series:
pushes the conceptual envelope of entity law by providing for a quasi-distinct legal construct existing within an overarching entity; and
establishes a new type of liability shield – rather than protecting the owners of an organization from vicarious liability for the organization’s debts, the “internal shields” of a protected series protect the assets of one protected series from the creditors of the overarching entity and any other protected series of that entity.
Enter the Uniform Law Commission
The Uniform Law Commission (“ULC” or “Commission”) (formerly known as the National Conference of Commissioners on Uniform State Laws), is a long-established (est. 1892) non-profit that develops and supports the enactment of uniform state statutes. The Commission’s most famous uniform act is the Uniform Commercial Code. The Commission’s earliest business organizations act was the 1914 Uniform Partnership Act.
In 2011, the ULC established a study committee to consider whether to draft a uniform act providing for protected series. A Drafting Committee began work in 2013 and is expected to finish work in 2015.
The committee’s work has been complicated, because a uniform business entity act must be “self-executing” – that is, the act must (1) take into account that most business entities are formed without legal advice, and (2) provide sufficient “default rules” so as to allow an entity to function without its owners having specified the rules that govern their inter se relationship. As a result, the Drafting Committee is identifying and addressing numerous issues that current series statutes address vaguely or not at all. As explained below, a uniform act can resolve some of those issues but not all.
ULC Drafting Committee Key Issues
Will the Internal Shields Hold?
No series act can directly answer these questions, because they implicate the Supremacy Clause (bankruptcy law) and choice of law doctrine (states without series legislation). The “internal affairs” doctrine does not control the choice of law question, because the internal shields dramatically affect the rights of creditors in a quite novel way.
As for the internal shields under bankruptcy law, no directly relevant case law exists. The safest approach would be to characterize the protected series as a separate entity and provide the series the full spectrum of entity powers. However, most series statutes duck the characterization issue, declining even to define a series as a separate “legal person.” As for entity powers, a series can contract, own property, and sue and be sued, but cannot exist except within the overarching organization (i.e., an LLC, or under some statutes, a limited partnership).
For investment trusts and captive insurance companies, a “non-entity” approach is essential for regulatory reasons. But outside those contexts the aversion to entity status remains unexplained – even though this aversion might conceptually undermine the shields. Moreover, there may be practical problems with saying, “It looks like a duck, quacks like a duck, swims like a duck, but it’s not a duck. Mobius strips and Klein bottles may seem real to mathematicians, but the series as non-entity, non-person may be so counter-intuitive to judges as to encourage piercing, substantive consolidation, and other theories of affiliate liability.
In sum, with regard to the internal shields, the only thing we know for sure is that we know nothing for sure.
The Drafting Committee’s current approach: A protected series is a person distinct from the series organization, other series of the organization, and the owners of the organization. A series cannot exist on its own.
Will Other Important Areas of Business Law Accommodate the Series?
The California Franchise Tax Board has decided to treat protected series as separate entities for filing and tax purposes, and the U.S. Treasury Department has formally proposed to treat each protected series as a separate taxpayer. However, it is uncertain how series will interrelate with other important areas of business law.
The two most important examples are bankruptcy law and Article 9 of the Uniform Commercial Code. As noted above, if bankruptcy law does not respect the internal shields, the shields are worthless. Moreover, if a series cannot enter bankruptcy on its own, the situation will be messy at best.
As for Article 9, that law – not series law – determines where to file a financing statement on assets associated with a series. The determination depends on the Article 9’s characterization of the debtor, and for a protected series that characterization involves three questions much at issue under most series statutes: (1) Is a series a distinct entity or at least a juridical person? (2) Does the formation of a series require the filing of a document with the government? (3) Precisely what “interest” does a series have in property associated with the series?
Other examples are perhaps less dramatic, but nonetheless involve serious practical questions. For instance: How does a person make service on a series? How do statutes requiring foreign organizations to register to do business in a state apply to series? For the purposes of establishing personal jurisdiction over a series or an LLC with series, are the activities of the “parts” aggregated in a whole?
The Drafting Committee’s current approach: A series is a person whose formation requires the public filing of a document. One serves a protected series by serving the LLC. For purposes of foreign registration and personal jurisdiction, each series is distinct from the LLC and any other series of the LLC.
Who Owns Property “Associated” with a Protected Series?
To indicate that a particular protected series encompasses particular assets, series statutes use “associate” as the term of art. However, these statutes do not describe a series as “owning” associated assets. The statutes refer instead to “assets of a series.”
If “assets of a series” means something less than ownership, the phrase is at best ambiguous. For the internal shields to function as intended, a series must have exclusive rights in its associated assets vis-à-vis the LLC and any other series of the LLC. Only in this way can those assets be made available solely to the series’ creditors, safe from competing claims from creditors of the LLC and other series. To have exclusive rights in property means to own the property.
The Drafting Committee’s current approach: “Property associated with a protected series is owned by the protected series.”
How Property is Associated with a Protected Series
Associating property with a protected series is a matter of recordkeeping. Property is associated when the LLC’s records adequately identify the property and the series that owns the property. Series statutes delineate adequacy in various ways, but in all events the standard is objective. No existing statute requires associated property to be titled in the name of a series, even if the property is subject to a public recordation system (e.g., land, motor vehicles).
Inadequate documentation imperils the internal shields, but to what extent? Current statutes appear to take an all or nothing approach. Either a series maintains generally adequate documentation and its internal shield works generally, or not. That is, generally inadequate documentation removes the shield even as to property documented with superlative specificity.
In the alternative, adequacy could be determined asset by asset and the shield applied accordingly.
The Drafting Committee’s current approach: Adequate documentation and shield protection are determined asset by asset. No consensus has yet formed around the recordation issue.
Duties of Those Who Manage a Protected Series
Absent a contrary agreement, as a matter of agency law, a person who manages a protected series owes fiduciary duties. But who has standing to enforce those duties: The series itself? The members associated with the series? The LLC?
In entity law generally, standing belongs to the person directly injured, subject to an owner’s right to bring derivative claims. This approach may well be apt for protected series.
The Drafting Committee’s current approach: In general, whatever rules of standing apply to the LLC apply as well to each protected series. However, a member not associated with a protective series has no standing to bring a derivative claim pertaining to the series.
Competition Between an LLC and its Protected Series
No current statute addresses this issue; resolving the issue is accordingly the burden of those who draft operating agreements providing for protected series. The “rub” is likely to occur when the LLC manages more than one of its series.
The Drafting Committee’s current approach: “A series manager of one protected series of a series organization does not in that capacity owe any fiduciary duties to another protected series of the organization or [to] the owners associated with another protected series.” The Committee has instructed the Reporter to draft around “the Sinven problem.” Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) (shareholders of one corporate subsidiary [Sinven] brought derivative claims against the parent in part because the parent had allocated a business opportunity to another subsidiary).
Relationship of an LLC’s Operating Agreement to a Protected Series
Even though their formation requires a public filing, LLCs are very much creatures of contract. The same is true for protected series. Accordingly, once an LLC has established a series with at least one associated member, myriad contract issues arise. They include:
novel complexities of contract interpretation;
the need for a default rule for amending a provision of the operating agreement specific to one series;
the need to address the consequences when an amendment to a generally-applicable provision of an operating agreement disproportionately prejudices a series or its associated members.
No current statute addresses any of these issues.
The Drafting Committee’s current approach: The committee is aware of these issues but has not yet reviewed any proposed statutory language.
What Does the Public Need to Know About a Protected Series?
Following Delaware’s lead, almost every current series statute empowers an LLC to establish a protected series through a private document (the operating agreement), so long as the LLC’s articles of formation state that the LLC has the power to establish series. Illinois law takes the opposite approach; an LLC must make a separate public filing to establish each series.
From a transparency perspective, the Illinois approach seems a foregone conclusion. From a political science perspective, the Delaware approach is revolutionary; the sovereign delegates to a private organization the power to equip a private enterprise with a liability shield that abrogates traditional liability rules.
The transparency question informs two issues relating to names. Should the name of a protected series: (1) indicate that the series is a series (a “designator” requirement); and (2) include the name of the LLC as part of the series name?
The Drafting Committee’s current approach: To form a protected series requires a publicly filed document, albeit a very simple one. The name of a protected series must include the name of the LLC.
Business Needs Served by the Protected Series Construct
Outside the contexts of investment trusts and captive insurance companies, the special advantages of the protected series remain obscure. For example, an LLC with series can compartmentalize various divisions of an operating company or function as a holding company. But what advantage does the series provide over traditional structures that use separate affiliates to compartmentalize risk?
Though placed last in this article’s list of issues, this question may be the most important facing the ULC Drafting Committee. Absent a persuasive answer, skeptics will analogize the protected series to a shell game played to the prejudice of creditors.
Saving filing fees and paperwork cannot alone justify the protected series construct, especially given the uncertainty as to (1) the efficacy of the internal shields; and (2) how series provisions interrelate with important areas of business law. In fact, paperwork requirements for series may be more demanding than for other affiliate structures, because the requirements for associating assets are quite stringent.
Likewise, saving filing fees seems a rather small tail for a rather large and potentially risky dog. For one thing, state governments have a way of noticing when fee revenue decreases. For example, as mentioned above, the State of California has acted proactively to protect its filing revenues (and franchise taxes as well).
Perhaps the protective series remains attractive because it is novel, appears efficient, and “none of the chickens (open questions) have yet come home to roost.” The directly relevant case law consists of just two cases, neither of which answers any of the important questions.
The ULC Drafting Committee continues to inquire into the question of “series advantages,” not only as a response to “shell game” skeptics, but also because a statute should be shaped in light of its primary purpose.
Going Forward
The Drafting Committee’s next meeting is March 20–21, 2015. The next draft will be publicly available at the beginning of March. Comments are welcomed.
With ever-increasing frequency, clients are seeking advice about reporting and communication on sustainability issues. “What are we legally required to communicate?” “What are we permitted to communicate?” “What can or should we say to stay competitive and protect business relationships, profitability, and our social license to operate?” “What standards should we use?” This article will help lawyers understand and advise clients on their sustainability communications pressures and needs.
Corporate sustainability is a business management practice. When used strategically, it enhances business value. As a practice, it involves assessing and managing risks and opportunities that arise from environmental, social, and economic impacts of the company and its industry. Assessment is done for short-, medium-, and long-term time horizons. This broader and longer-term perspective is essential to realizing value from sustainability management.
As a practical matter, the concept of sustainability management may conflict with some aspects of current corporate law and behavior. These conflicts can be generalized by the reality that most of corporate America focuses on a market-imposed, short-term, single bottom line. But the marketplace is in flux. Perspectives are changing in response to climate change, population growth, constrained resources, globalization of supply chains, and more transparent and ubiquitous communications. The upshot is growing pressure on businesses to evolve toward a triple bottom line approach: considering social, environmental, and economic impacts over a longer term, and their implications for governance. As lawyers, we will be called upon to help navigate these shifting influences on business management and success.
What’s Going On?
Macro Drivers for Sustainability Reporting Pressure
The drivers that are creating pressure on companies to address and communicate more and more about sustainability issues arise from a number of factors, including from a variety of external and internal stakeholders. There are four primary macro drivers that have had, and will continue to have, wide-ranging social, environmental, and economic impacts with the potential to affect businesses everywhere. Being attuned to, and mitigating the risks of, or adapting to those impacts is a key attribute of a sustainable company.
Concern about climate change and greenhouse gas emissions: Rising levels of greenhouse gasses in our atmosphere are driving increases in average temperature on the planet. This warming leads to changes in our climate and natural systems, resulting in sea level rise, droughts, floods, severe weather, wildfires, and ocean acidification. Even 2°C of warming will have a significant adverse impact on human health and well-being.
Population growth and resource constraints: World population is on track to reach 9 billion by 2050 and 10 billion by 2100. The global middle class is expected to triple by 2030. At today’s pace, global energy demand will increase by 57 percent over the next 25 years. Water use is expected to increase by 50 percent in developing countries and 18 percent in developed countries by 2025. Our current level of consumption utilizes 1.5 Earths to provide resources to meet current demand and absorb waste. These factors will drive prices of all commodities up and lead to serious problems without corrective actions and creative solutions. Businesses have significant risks and opportunities in this respect. See, World Business Council on Sustainable Development; Energy Information Agency; Geo-4 – Global Economic Outlook; Global Footprint Network.
Organizational and global interdependence: Large companies used to have several hundred partners and suppliers; today they have thousands, and they are spread across the globe. Companies of all sizes are outsourcing noncore functions, partnering for some core functions, and building larger business networks in general. The greater the number of outside suppliers and service providers upon which a company relies, the more difficult it is to manage the associated risks across multiple geographies. This is true from both a supply chain and reputation management perspective.
Social license and accountability to stakeholders: Public demand for transparency and accountability has increased markedly. An instant information society has emerged from widespread access to social media, the Internet, and cable news. A single individual now has the ability to communicate instantaneously and globally to influence public opinion on a topic or a business. Multiplicities of stakeholders are affected by and interested in how a company manages sustainability issues. Consumers and investors are increasingly factoring a company’s ethics, sustainability, and social responsibility into their buying and investment decisions.
Stakeholder Perspectives
Sustainability reporting serves the needs and interests of a wide and growing variety of stakeholders, ranging from investors, employees, customers, and suppliers, to governments, regulators, local community groups, and nongovernmental organizations. Stakeholder reasons for seeking information on sustainability issues, the information they seek, and the lens through which they view the reported information varies. The number and variety of information requests about environmental, social, and governance (ESG) activities is a significant burden for many companies. Accordingly, companies must balance how and to whom they respond.
Investors and customers are the two stakeholder groups that garner the most attention. Companies are influenced by their own investors to pursue sustainability into their supply chains. As a result, understanding what is driving the investment community to care about sustainability activities and reporting is key.
In many cases, institutional investors care about medium- and long-term value and whether the companies in which they invest are contributing to systemic problems or are conducting their business in a way that helps solve those problems. This is not to say that short-term financial returns are unimportant to institutional investors, but rather, that more and more institutional investors are taking into account a broader range of factors in their investment decisions. Company performance on ESG factors are being included because they are outperformance indicators. Robert G. Eccles, Ioannis Ioannou, and George Serafeim, The Impact of Corporate Sustainability on Organizational Processes and Performance, first published November 01, 2011 (dated 11/23/11). In the words of Thomas P. DiNapoli, New York State Comptroller and Sole Trustee of the New York State Common Retirement Fund: “Our goal is simple: we want long-term sustainable economic growth. And we have found from experience that comprehensively integrating environmental, social and governance considerations into the investment process is essential to achieving that goal.” Peter Ellsworth and Kirsten Snow Spalding, The 21st Century Investor: Ceres Blueprint for Sustainable Investing, 2013, Forward, www.ceres.org.
Pressures to Report; Understanding the Reporting Landscape
Clients are measuring their reporting against that of their peers and competitors. They are gauging social pressure to demonstrate responsible corporate behavior. There have been significant reporting developments, both in terms of the growth in reporting and the number and quality of reporting requirements, standards, or frameworks.
The arguments for not reporting are shrinking day after day for companies that have yet begun to report on their sustainability progress. Now that 53% of the S&P 500 and 57% of the Fortune 500 are reporting on their Environmental, Social, and Governance impacts, the non-reporters are now in the minority. We believe this minority will continue to shrink as it has in the past few years. The benefits of sustainability reporting will become increasingly obvious as more time passes and the long term benefits are easier to measure.
Once a company decides to report to stakeholders about its sustainability activities, risks, and opportunities, legal questions arise. Public-facing information about sustainability often starts as a marketing initiative in response to customer interest or as a means of demonstrating social responsibility and philanthropy. This type of information can then become the basis of requests to “verify” information gathered by a rating systems that will report with or without company input or corrections. Other reporting systems, like the CDP (formerly the Carbon Disclosure Project), will request formal reporting and publicize a failure to respond or report. As soon as investors or rating systems get involved, or customer pressure takes the form of supply chain requests, the focus rapidly shifts from a marketing effort. Management begins to ask what the company is legally required to report and what the company should report to support reputation, stakeholder relationships, and business development.
Mandatory Reporting Requirements
1. SEC Filings.
Companies subject to the Securities and Exchange Commission (SEC) filing requirements must disclose material information in their SEC filings, such as the Form 10-K. Various rules and regulations, including Regulation S-K, may require the disclosure of material sustainability information in the Form 10-K and other periodic SEC filings, depending on the circumstances. Securities Act Rule 408 and Exchange Act Rule 12b-20 require a registrant to disclose, in addition to the information expressly required by line-item requirements, “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.”
Over the past several years, the SEC has struggled with how best to address evolving concerns with climate change and sustainability in the agency’s disclosure requirements. The SEC attempted to address the issue of climate change by publishing an interpretive release providing specific guidance as to how existing rules may require disclosure of information relevant to climate change. Release No. 33-9106, Commission Guidance Regarding Disclosure Related to Climate Change (February 2, 2010). The interpretive release identifies how climate change disclosures may be required under particular disclosure items in Regulation S-K, depending upon a company’s circumstances. These disclosure items include Description of Business (Item 101 of Regulation S-K), Legal Proceedings (Item 103 of Regulation S-K), Risk Factors (Item 503(c) of Regulation S-K), and Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 303 of Regulation S-K). The principles that the SEC articulated in the climate change interpretive release can be applied in other contexts related to sustainability in determining if a public company has any disclosure obligations with respect to such matters.
The SEC’s interpretive release addresses four topics that companies should consider when evaluating the need for, and appropriate level of, disclosure related to climate change matters:
The impact of legislation and regulation regarding climate change, including the potential impact of pending legislation.
When material, the impact on their business of treaties or international accords relating to climate change.
Whether legal, technological, political, and scientific developments regarding climate change will create new opportunities or risks, including reputational risks.
The actual and potential material impacts of the physical effects of climate change on their business, such as the effects of severe weather, sea levels, arability of farmland, and water availability and quality.
In other sustainability areas, Congress has recently amended the federal securities laws to impose disclosure obligations regarding certain types of human rights and other issues of interest to specific groups. Recent examples include disclosure regarding the sourcing of certain “conflict minerals” (Section 13(p) of the Securities Exchange Act of 1934 (“Exchange Act”), which was implemented by the SEC by rule), payments to governments by resource extraction issuers (Section 13(q) of the Exchange Act, which is in the process of being implemented by SEC rule), and business with certain governments, persons, and entities subject to specific U.S. trade sanctions (Section 13(r) of the Exchange Act, which was effective upon enactment).
2. State and Local Requirements.
Other requirements for reporting on sustainability issues may arise at the state or even local level, or come into play by virtue of the geographic scope of a company’s business. For example, the California Transparency in Supply Chains Act requires every retail seller and manufacturer doing business in the State of California and having worldwide annual revenues of $100 million or more to disclose their specific actions to eradicate slavery and human trafficking in their direct supply chains for tangible goods offered for sale.
For a regulatory example, the insurance commissions in six states (California, Connecticut, Illinois, Minnesota, New York, and Washington) require insurance companies with direct written premiums of $100 million or more in their state to complete an annual climate risk disclosure survey.
3. International Requirements.
In spring 2014, the European Parliament passed a law requiring publicly traded companies with more than 500 employees to report on nonfinancial sustainability factors. The law will go into effect in 2017, and will require nearly 7,000 companies to include this new information in their annual financial reports – 4,500 more than are doing so today. The new law requires affected companies to report on ESG factors, including human rights impacts, diversity, and anticorruption policies. Companies will be expected to describe their business model and the outcomes and risks of their policies. Companies will also be required to include their supply chain in reporting. This will likely have a trickle-down impact, forcing smaller and medium-sized private companies and multinational companies upstream in the value chain to report even though the law does not apply them.
Under Canadian securities laws, public companies must disclose all material information, including material information about environmental and social issues, and there are additional disclosure obligations under the TSX and TSX Venture Exchange timely disclosure policies.
In October 2010, the Canadian Securities Administrator published Staff Notice 51-333, Environmental Reporting Guidance to provide guidance on continuous disclosure requirements relating to environmental matters under applicable Canadian securities laws and to assist issuers in determining what information about environmental matters needs to be disclosed and about enhancing or supplementing their environmental disclosures. The staff notice was motivated by the impact of environmental matters on reporting issuers, the changing regulatory landscape, and increasing investor interest in environmental matters.
Quasi-Voluntary and Voluntary Reporting
There are many stakeholder and other organizations that pressure companies for ESG information. Among the many means used to gather this information are a myriad of investment screening tools, rating organizations, and reporting frameworks that aggregate public information or provide vehicles for sustainability reporting. Below is a brief overview of the most prominent among these organizations, tools, and reporting frameworks.
Investors use ESG screening to measure or assess how a company manages social and environmental impacts. This screening focuses on whether a company identifies and either mitigates risks or seizes opportunities with respect to ESG indicators.
Investment screening tools are flourishing:
The Bloomberg ESG Valuation Tool and its ESG Score has experienced significant interest. This tool “enables users to apply a financially-based methodology to assess and value the impact of ESG factors on a company’s Earnings Before Interest and Taxes (EBIT) performance and share price.” PWC, Do Investors care About Sustainability? Seven Trends Provide Clues (March 2012).
MSCI has several screening tools/indices, including its ESG Impact Monitor.
FTSE4Good revamped and expanded its screening process. Companies are required to publicly disclose a broad array of sustainability information to gain and maintain listing on the index.
GS SUSTAIN is another index that incorporates ESG into its analysis. Like MSCI and FTSE4Good, GS SUSTAIN submits information it has gathered from the public realm for company review, correction, and supplementation.
The CDP, a global not-for-profit organization, operates a reporting framework and rating system. The CDP holds the largest and most comprehensive collection of primary climate change, water, and forest-risk information. Investors representing more than a third of the world’s capital request corporate accountability on climate change through the CDP reporting framework.
Global Reporting Initiative (GRI) is the globally-recognized “gold standard” for sustainability reporting. The framework includes reporting guidelines and sector/industry guidance. It requires a high degree of organizational transparency and accountability. The uniform indexed reporting structure provides stakeholders a capacity for year-over-year analysis and easy comparison of reports from different companies. When investors pressure companies to report, they most often request reporting using the GRI framework.
On the leading edge of the reporting industry, and in support of an emerging interest in integrating financial and non-financial reporting, the International Integrated Reporting Council (IIRC) has developed the Integrated Reporting Framework. This includes guidance for how publicly traded companies can integrate sustainability into their annual reports so that the public can understand the value of sustainability initiatives and can effectively compare one company to the another. The stated purpose of integrated reporting is to show how a company creates value of the short, medium, and long term. http://www.theiirc.org/resources-2/faqs/.
Voluntary Standards to Support Mandatory Reporting
The Sustainability Accounting Standards Board (SASB) is developing voluntary standards, which identify industry-specific, sustainability-related issues that may give rise to material information for companies to disclose. The intent is for companies to reference the standards as a guide when making sustainability disclosure decisions for mandatory filings to the SEC. The complete set of guidelines is scheduled for release in early 2016. Seewww.sasb.org. The SEC has not acted on incorporating the SASB standards into any disclosure requirements.
The Lawyer’s Response
The manner in which sustainability issues are reported or communicated to stakeholders and others must align with the type and purpose of the report or communication. Mandatory reporting should follow SEC or other governing requirements. Voluntary reporting should, on its face, be readily distinguishable from such mandatory reporting. Lawyers should recommend that language be used that reflects the standard and the audience for the reporting venue. Counsel will need to weigh litigation risks that voluntary reporting may carry for reported information that is significant, but not material, and therefore not included in mandatory reporting.
This is of primary significance because of the ways in which differing concepts of materiality are incorporated into mandatory and voluntary reporting requirements:
Under the GRI reporting framework, information is considered material and should be included in a report if it “may reasonably be considered important for reflecting the organization’s economic, environmental and social impacts, or influencing the decisions of stakeholders.”
The IIRC deems information to be material if “it is of such relevance and importance that it could substantively influence the assessments of providers of financial capital with regard to the organization’s ability to create value over the short, medium and long term.”
For SEC reporting purposes and under the voluntary SASB standards, information is deemed to be material if there is “a substantial likelihood” that a “reasonable investor” would view the information as “significantly alter[ing] the ‘total mix’ of information made available.” TSC Indus. v. Northway, Inc., 426 U.S. 438, 449 (1976).
Disclosures under the U.S. federal securities laws are a mixed question of law and fact. The SEC has noted that the issuer is in the best position to know what is likely to be material to investors. “[A] corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact.” Richman v. Goldman Sachs Group, Inc., et al., 10 Civ 3461 (June 21, 2012, United States District Court for the Southern District of New York).
Companies are required to disclose material information only where the federal securities laws or other applicable legislation specifically impose such a duty to disclose. The analysis should focus on whether or not the information is material by securities law standards and whether there is a prima facie duty to disclose the information.
Because a number of recognized standards for sustainability reporting outside of the SEC’s disclosure requirements reference different concepts of “materiality,” counsel must be cognizant of those varying definitions while remaining focused on the specific duties and obligations that are currently contemplated by the U.S. federal securities laws. Understanding these nuances enables lawyers to help clients clearly identify the importance ascribed to information by reference to the standard and audience. For example, a company could use the concept of materiality for investor-related information that is included in required reporting to the SEC. Other information should be identified using words like “significant,” “important,” or “key,” or as being relevant to stakeholders other than investors. The company could add disclaimers or cautions where appropriate.
All reporting standards require that a company’s sustainability disclosures – even where there is no duty to disclose under the U.S. federal securities laws – be both accurate and complete. To effectively manage sustainability reporting and communication, companies must build appropriate reporting capacity (including disclosure controls and procedures) to identify and vet sustainability issues. The development and implementation of sustainability management systems will serve to provide a company with a process for measuring, monitoring, and improving sustainability reporting and performance. These systems should encompass an internal educational component to ensure awareness of sustainability activities and reporting needs.
Companies ask their lawyers to review mandatory reporting disclosures as a matter of course. Given the complexity of sustainability issues, there is also a role for lawyers in reviewing and advising on voluntary reporting. Counsel should help clients weigh liability risks against reputational, relational, and other benefits of voluntary reporting. Understanding the drivers for that reporting noted above should guide that review and inform giving advice that protects client interests, while enabling them to respond to real and significant social and business pressures.
A corporation’s main objective, and many would agree, legal obligation, is to make money and maximize profits for its shareholders, but should more be asked or required of today’s successful businesses? For an ever increasing segment of society, the answer without a doubt is “yes.” The concept, commonly referred to as corporate social responsibility (CSR), extends beyond compliance with legal mandates or even charitable donations and good deeds. CSR advocates believe a company has a clear duty of care to all stakeholders connected to or impacted by a company’s operation.
A number of green issues are emerging as key components in a more global initiative to hold corporations socially, and if possible, financially responsible for their actions and inactions. Sustainable development, as a critical component of CSR, takes into account social, economic, environmental, and natural resource issues potentially affected by business. With growing awareness worldwide of environmental concerns, the CSR component of sustainability is focused on environmental sustainability. Environmental sustainability generally addresses how the needs of the present can be met without compromising the ability of future generations to meet their own needs with emphasis on protection of natural resources and the environment.
CSR and environmental sustainability at first blush appear newer, more trendy philosophies, but in reality are deeply rooted in the kinds of challenges companies have confronted over the last century such as pollution, corruption, child labor, and poor worker conditions. Similar challenges exist today as companies seek new international markets and expand globally into areas that present not only business opportunities but also more operational risk. This is particularly evident in the environmental arena where critical business needs for water, energy, and raw products must coincide and be balanced with care for stakeholders and the environment. How companies manage these modern-day challenges does matter, as evidenced in a new study by Nielsen. This year’s Nielsen Global Survey on Corporate Social Responsibility polled 30,000 consumers in 60 countries to understand how passionate consumers are about sustainable practices when it comes to purchase considerations; which consumer segments are most supportive of ecological or other socially responsible efforts; and, which social issues/causes are attracting the most concern. One key finding is that 55 percent of global online customers are willing to pay more for products and services provided by companies that are committed to positive social and environmental impact.
This article will examine environmental sustainability and why it matters for business. The authors will detail key environmental sustainability focus areas and outline a roadmap of essential considerations companies should incorporate into any environmental stewardship initiatives. Lastly, we conclude that there is a business case for environmental sustainability that will improve financial performance.
What is Environmental Sustainabiltiy?
The terms “environmental sustainability” or “sustainable development” are widely used, but the United Nations World Commission on the Environment and Development is credited with developing these concepts in its 1987 report titled Our Common Future. In that report, the World Commission defined “sustainable development” as development which “meets the needs of the present without compromising the ability of future generations to meet their own needs.” The greening of the U.S. economy has focused increased scrutiny on environmental issues, laws, and policies and focused much more attention and emphasis on environmental sustainability initiatives. In a recent report titled Taking Flight: Environmental Sustainability Proposals Gain More Attention, it is interesting to note that Ernst & Young found the three largest sustainability topics were all environmental issues including climate change/sustainability, energy efficiency/recycling, and energy extraction risks.
While environmental sustainability appears a new concept, it really has roots in conservation, land management, and protection of natural resources which are age-old mandates in the United States. In 1966, Lyndon B. Johnson commented on environmental conditions and even on the sustainability of the environment: “. . . To sustain an environment suitable for man, we must fight one-thousand battlefields. Despite all of our wealth and knowledge, we cannot create a redwood forest, a wild river or a gleaming seashore. But we can keep these we have.”
Understanding what environmental sustainability means, its priorities, and how the same are measured remain an ongoing challenge. The Global Reporting Initiative (GRI), a well-known leader in developing a sustainability reporting framework, incorporates key environmental performance indicators into its sustainability guidelines:
Materials
Materials used by weight or volume.
Percentage of materials used that are recycled input materials.
Energy
Direct energy consumption by primary energy source.
Indirect energy consumption by primary source.
Energy saved due to conservation and efficiency improvements.
Initiatives to provide energy efficient or renewable energy-based products and services, and reductions in energy requirements as a result of these initiatives.
Initiatives to reduce indirect energy consumption and reductions achieved.
Water
Total water withdrawal by source.
Water sources significantly affected by withdrawal of water.
Percentage and total volume of water recycled and reused.
Total weight of waste by type and disposal method.
Total number and volume of significant spills.
Weight of transported, imported, exported, or treated waste deemed hazardous under the terms of the Basel Convention Annex I, II, III, and VIII, and percentage of transported waste shipped internationally.
Identify size, protected status, and biodiversity value of water bodies and related habitats significantly affected by the reporting organization’s discharges of water and runoff.
Biodiversity
Location and size of land owned, leased, managed in, or adjacent to, protected areas and areas of high biodiversity value outside protected areas.
Description of significant impacts of activities, products, and services on biodiversity in protected areas and areas of high biodiversity value outside protected areas.
Habitats protected or restored.
Strategies current actions and future plans for managing impacts on biodiversity.
Number of IUCN Red List species and national conservation list species with habitats in areas affected by operations, by level of extinction risk.
Emissions, Effluents, and Waste
Total direct and indirect greenhouse gas emissions by weight.
Other relevant indirect greenhouse gas emissions by weight.
Initiatives to reduce greenhouse gas emissions and reductions achieved.
Emissions of ozone-depleting substances by weight.
NO, SO, and other significant air emissions by type and weight.
Total water discharge by quality and destination.
Products and Services
Initiatives to mitigate environmental impact of products and services, and extent of impact mitigation.
Percentage of products sold and their packaging materials that are reclaimed by category.
Transport
Significant environmental impacts of transporting products and other goods and materials used for the organization’s operations, and transporting members of the workforce.
Compliance
Monetary value of significant fines and total number of nonmonetary sanctions for noncompliance with environmental laws and regulations.
Overall
Total environmental protection expenditures and investments by type.
These environmental performance indicators serve as an important reference for an interpretation and understanding of environmental sustainability concepts.
The Importance of Environmental Sustainability
For businesses, being a good corporate citizen certainly is part of the CSR philosophy encouraging companies to give back in the communities where they live and work. CSR and environmental sustainability go beyond the “good corporate citizen” approach, however, and motivate companies to develop environmental and community outreach initiatives and to establish related policies applicable not only to company personnel but downstream suppliers and other vendors.
Almost three-quarters of the U.S. companies on the S&P 500 publish corporate sustainability reports according to research from the Governance & Accountability Institute. Despite growing pressure from green investor groups and organizations like the GRI, sustainability reporting in any meaningful way remains a largely voluntary effort on the part of American companies. New European Union requirements for sustainability reporting going into effect in 2017 will convert these voluntary efforts into legally mandated ones. These new reporting requirements will apply to 6,000 companies in the EU and will impact a number of U.S. businesses. The GRI sustainability reporting framework has been recommended as a possible platform for the EU reporting obligations. Similar to GRI reporting requirements, the EU directive will seek disclosure on policies, risks, and impacts regarding human rights, diversity, environmental matters, and other social considerations.
Increased or legally mandated sustainability reporting may actually help promote and enhance performance measures for companies that have made environmental sustainability a core element of their business strategies. A recent GreenBiz blog by Daniel Esty highlights the common disconnect between sustainability-related competitive strengths versus improved shareholder value – a concern that better sustainability reporting might improve. In his blog, Mr. Esty identifies several problems that need to be addressed regarding environmental, social, and governance (ESG) data currently available.
“Value” investors in the past wanted to exclude polluting companies and other bad actors from their portfolios. A wider range of investors today are interested in sustainability-driven growth, productivity gains, and risk reduction. The new “value” investors need a different set of sustainability metrics, including indicators tightly focused on financial results.
The sprawling nature of data available lacks clarity on what is important or possibly material. Mr. Esty notes “. . . What is critical to engaging the broad investor community are metrics that are meaningful from an investor perspective rather than from an environmentalist point of view. Thus, we argue for a ‘value driven model’ that centers on a core set of sustainability metrics cast in language familiar to the Wall Street world.”
Existing ESG data is not action or results oriented in a manner useful to investors.
Concern exists over the quality of data often self-reported by companies.
Significant research exists supporting the competitive advantage benefits of environmental sustainability. Commonly cited improvements include enhanced corporate reputation, better employee retention and engagement, cost effectiveness, risk avoidance and mitigation, innovation, market expansion and greater access to capital. While these benefits appear impressive, a new language must be developed to translate these impacts into positive financial results if environmental sustainability efforts are to gain marketplace traction.
Key Environmental Sustainability Areas – What Matters?
The environmental sustainability journey is not one-size-fits-all. Each business needs to be clear on why it is making the effort, what it hopes to accomplish, and the scale of its commitment. Having said that, there are a number of typical focus areas. Comparable to most business initiatives, what we measure gets managed. Key performance indicators (KPIs) should be customized to the business needs. Common environmental sustainability concerns include the following.
Energy/Greenhouse Gases/Climate Change
Many businesses have chosen energy use as their first “toe in the water” on the environmental sustainability journey. Energy reduction is usually a “win-win” due to the positive impact on overhead, cost, return on investment (ROI), and commensurate reduction of greenhouse gas emissions. Utility, local, and state incentives are often available and can make the ROI even more attractive.
Energy use is frequently considered in terms of direct and indirect energy or energy used or generated on site and energy used or generated offsite.
Successful energy reduction programs are best started with an energy audit. This can be performed by competent internal facilities personnel, but is more commonly performed by outside consultants or utility representatives. The resulting report should document information on each identified issue including potential cost savings, incentives available, and cost to implement.
Greenhouse gas reductions go hand-in-hand with most energy-reduction strategies. For many manufacturing operations, releases of greenhouse gases from the manufacturing processes are a significant proportion of the overall footprint. As such, a reduction in the amount of energy used has a direct effect on the amount of greenhouse gases resulting from operations.
When deciding on how to approach identification, tracking, and goal setting on greenhouse gases, decisions will need to be made on what to count. Some businesses choose to only count those greenhouse gases arising from operations within their four walls. Others look at issues as far reaching as employee travel, fleet emissions, and life cycle product impacts. Numerous vendors provide greenhouse gas tracking software, which assists in the conversions of different types of energy uses into carbon dioxide equivalents.
Water Use
Water use is an environmental sustainability concern that has recently taken on increased relevance. Drought conditions and the prospects for increased weather severity has caused communities, industry, and regulators to place additional efforts into conservation strategies. Water resources have become increasingly stressed by population growth, contamination of resources, and depletion of groundwater supplies.
Conservation strategies have included closed-loop water cooling, low-flow fixtures, onsite treatment and reuse, gray water collection for irrigation, and xeriscaping.
Water use KPIs include total water used, water used per production unit, water used as a percentage of sales, and percent water reduction.
Products and processes require resource inputs. Furthermore, processes are never 100 percent efficient, so there is waste. Some excess can be reused in product, some can be profitably sold to other businesses, some can be given away or sold at a loss, and some will have to be disposed.
The company on the sustainability journey will seek to improve their resource use to product conversion ratio. A hierarchy of environmental preference can be established to guide the process. It is generally easiest to start with reuse and recycling of materials. Large gains can also be made by working with the supply chain on the reduction of packaging materials being received. Additionally, the types of packaging materials can be specified in order to reduce the volume, improve recyclability, and support reuse for outgoing shipments.
Common measurements may include percent waste recycled, waste per production unit, and total waste disposed to landfill.
Toxics Use Reduction or Elimination
Toxic materials are used to make and are found in many products. There are a host of reasons for reducing the toxicity or minimizing toxic materials, including workers exposure, emissions from our factories, and, ultimately, the health of our customers. This is an area that continues to see traction and has resulted in such things as the organic foods movement and calls for regulating plasticizers in children’s toys. Eliminating toxins can be an admirable goal, may be essential to compete, and may also be challenging. Companies can chose to substitute less toxic materials in both the process and the product. This has also become an area of regulatory exposure as the European Union has implemented regulations such as REACH.
Emissions and Effluents
Toxic air emissions and contaminated wastewater are common byproducts of manufacturing. While they may be legal and released under a permit, they still have impact and are increasing the level of pollutants in the environment. Industry is required to do an annual assessment of these releases and submit reports to their environmental regulators. These reports are public information and are often scrutinized by stakeholders as one indication of a company’s environmental performance. Many companies have made a significant effort to reduce emissions to be below reporting thresholds, or at least to be able to show progress on protecting the environment.
Common KPIs are tons released, tons per dollars of sales, and pounds per production unit.
Reduction strategies include substitution or elimination of toxic materials in process and product and process efficiency improvements.
Normalizing KPIs
It is key when selecting normalizing factors that they enhance understanding of performance, not obfuscate it. The clearer the correlation with processes or products, the better. An example from the automotive industry would be KPI per auto produced. Other common normalizing factors are employee hours, sales, or earnings.
Getting Goals Right
Goals drive performance. Properly designed goals have a positive impact on an organization in that they inform the employees that management has selected priorities, provide a frequent reminder of progress, and flow down in a way that identifies the role of each individual in meeting the objective. Where goals often fail is the lack of a plan to achieve them. The plan needs to define actions, individual responsibilities, and timeframes.
KPIs also need to be well defined so that results across the organization are based on the same data inputs. For example, a water use KPI could include water embedded in the product, used for cooling machinery, sanitary facilities, or growing crops.
It is important to make sure that goals are contextually meaningful. KPIs and goals for some facility locations may not have the same relevance and importance as at another. Back to the water example again: facilities in the arid regions of the American Southwest and facilities on the shore of a large lake may not warrant the same use reduction objectives.
A Simplified Road Map to Implementation
Start with a shared vision: Each enterprise needs to start with the development of their environmental sustainability vision. As stated earlier, this requires that top management identify their level of commitment to the sustainability journey. This will be influenced by the business culture (or the culture they are trying to achieve), stakeholder interest, the potential to strengthen brand, personal values of leadership, and considerations of moral or ethical positions.
Communicate the vision: Leadership is responsible for the culture in any business and it is no exception for implementing a sustainability program. A successful sustainability program launch requires commitment to communication.
Develop an implementation strategy: It’s a project, so manage it with the same rigor you would manage any other important initiative. Identify personnel, resources, objectives, targets, schedule and milestones.
Decide what is important: Once there is a vision, a materiality inventory will help direct the implementation strategy. A company may find that it has very low reportable air emissions, but produce large amounts of toxic waste. The air emissions may not be material and the toxic waste is likely material. There is no requirement that a company work on all material impacts concurrently. A strategy of focusing on the most material issues can be an effective approach.
Determine what to measure and how to measure performance: What are your key performance indicators? How will you normalize? What is your reporting frequency and how will you share this information? Data will need to be collected on each of the target areas. This can get challenging for some aspects, but is commonly available for energy, water, wastewater, hazardous waste, and recyclables. Also be aware that this data should be of a quality that could be audited if you will be communicating it externally.
Develop strategies for each KPI: Affecting the KPIs requires actions. Appropriate teams for each KPI can develop and implement plans to achieve the desired results.
Spend the money but spend it consistent with your values: Nothing can put the brakes on a sustainability program faster than a lack of appropriate resources. Having said that, many businesses look at ROI for various projects. Hurdle rates are sometimes relaxed for projects that have significant brand, employee morale, or stakeholder importance.
Start winning: Early success breeds enthusiasm. As one sustainability director at a large corporation said, “Simple wins are gateway drugs.”
Communicate: There is a theme here – it is pretty hard to overcommunicate when engaged in change. Of course, there is ineffective communication. Do not expect high levels of readership for sustainability e-mails and newsletters. Internal communications are best done at all appropriate levels of management by management.
Continually improve: Turn your implementation into an annual cycle with a goal of improving each year.
Communicate: Will you share your environmental sustainability progress outside your organization? Most companies publish a sustainability report or a CSR report. Get familiar with organizations which are involved in reporting on environmental performance. As discussed earlier, the GRI, the Carbon Disclosure Project, and the Dow Jones Sustainability Index are examples from a growing list of organizations that have sustainability reporting standards.
Conclusion
According to the United Nations Principles for Responsible Investment (UNPRI), over $34 trillion (approximately 15 percent) of the world’s investment assets are managed by signatories to the UNPRI who have committed to adopting policies and procedures that factor ESG issues into investment decisions. While not all investors and financial market analysts are convinced that environmental sustainability delivers shareholders value, there is growing belief that companies that are successful in avoiding environmental risks while taking advantage of ESG opportunities will outperform over the long term. The UNPRI economic marketplace statistics support this investment trend.
Moving toward environmental sustainability should work for even the most prudent or conservative business leaders, as implementing environmental sustainability practices present few if any risks to business operations. Moreover, early start-up initiatives easily can be managed in house including identification of key environmental sustainability areas important to your business, assessing sustainability reporting opportunities and other means of communicating environmental sustainability efforts to stakeholders, and development of KPIs and financial performance impacts.
It appears a virtual certainty that environmental sustainability will increasingly move from voluntary to legally mandated initiatives, including sustainability reporting requirements. The critical inquiry for business is no longer if, but how and when to launch a meaningful environmental sustainability program. There is a growing business case for environmental sustainability. It is an added bonus that addressing these business challenges not only will enhance financial performance over time, but is simply the right thing to do as well.
The general view of human trafficking is that it is something only occurring “over there,” in places such as Africa and India. However, this perception is wrong. Trafficking is a problem not just “over there,” but right here, right now. Indeed, trafficking and child labor abuses are part of our lives right here, right now.
For example, slavery may taint the computer, smartphone, or tablet that you are using right now. A recent NGO study by Verité shows that one in three Malaysian electronics workers toil at forced labor. Slavery may have tainted the shrimp that you enjoyed last week. A recent investigation by The Guardian cited evidence that threats of extreme violence may have forced slaves to toil without pay for years harvesting shrimp in Thailand for sale abroad. The bad news is that these and other similar situations exist. The good news is that as businesspeople, there is something that we can do about it. As an example, The Guardian reports on efforts by businesses to form a task force to address the shrimp issue.
You might be wondering, is this really an article in Business Law Today? Did I click the wrong link? You’ve got the right link. This article addresses two significant initiatives of the Business Law Section: its Corporate Social Responsibility Law Task Force and its Working Group on Model Business and Supplier Policies on Labor Trafficking and Child Labor. These supply chain and corporate social responsibility initiatives work together. While basic social decency demands elimination of labor trafficking from supply chains, corporate social responsibility supplies the business case for doing so.
The Supply Chain Issue
The International Labor Organization (ILO) estimates that 20.9 million individuals worldwide are victims of human trafficking. Of that number, 14.2 million are victims of forced labor or labor trafficking, and 4.5 million in sex trafficking or forced prostitution. As illustrated above, many of these slaves support the supply chains of products that we all use. As further confirmation, one only need look at the December 2014 version of the U.S. Department of Labor List of Goods Produced by Child Labor or Forced Labor to identify 136 goods in 74 countries produced in this manner (child labor is estimated by the ILO at 168 million).
Human trafficking and child labor are against the law everywhere. Yet the reality is that in the countries “over there” where trafficking is most prevalent, the rule of law isn’t what it is in this country. The problem is that slaves produce goods that enter the supply chains of goods made here, used here, worn here, and eaten here. True, the Supreme Court took the teeth out of the Alien Tort Claims Act with its Kiobel ruling. Yet Congress still knows how to write laws (like Dodd-Frank’s conflict-minerals provision) having extraterritorial reach. As I counseled students in my LL.M. course on Corporate Professional Responsibility, basing risk management on nonenforcement of existing laws is unduly risky business.
Responsible businesses already know about the supply chain problem and are trying to do something about it. They include a group that belongs to the Global Business Coalition Against Trafficking (gBCAT). Members include Carlson, Cison, Coca Cola, Delta Airlines, Hilton Worldwide, LexisNexis, Ford Motor Company, Manpower, NXP, and Travelport. The coalition has several worthwhile initiatives that dovetail nicely with the ABA Model Principles (Model Principles) and Polices (Model Policies) discussed below.
Trafficking’s and child labor’s tainting of supply chains starts here in the United States and in other mature economies with consumer demand for cheap goods and services. Demand drives corporations to exact lower prices from supply bases. Price pressure, exacerbated by globalization, outsourcing, and use of labor brokers lead to exploitation of workers. Foreign workers are easily exploited because so many are extremely poor. Among the laborers my wife and I encountered in India, 20 percent live on one dollar a day, 50 percent are malnourished, 67 percent can’t read, and 33 percent don’t have access to safe drinking water. Consider that the present value of a single slave working in early nineteenth century America would be $40,000, while today, a slave sells in the sex or labor-trafficking market for just $90. Noted slavery expert Kevin Bales understandably titles his book citing these statistics Disposable People.
Certainly, supply chain exploitation and other forms of trafficking like forced prostitution, which goes on both in the United States and abroad (see U.S. State Department Trafficking in Person Reports) conflict with the concept of human dignity that all major religions and atheists alike recognize. The Declaration of Independence provides “that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.” Similarly, the UN’s Universal Declaration of Human Rights states, “All human beings are born free and equal in dignity and rights. . . . Everyone has the right to life, liberty and security of person. . . . No one shall be held in slavery or servitude.”
The business question is whether moral considerations like those in the ABA Model Principles are enough to motivate a corporation to act. Maybe so, but maybe not. My experience is that in certain situations the personal moral standards of a CEO or board will lead a corporation to address social issues. Yet a surer way to ensure that responsible action survives leadership change or insensitivity is to base that action on a business case.
The Case for Corporate Social Responsibility
Corporations address social issues under the banner of corporate social responsibility (CSR), also known as corporate citizenship, corporate responsibility, sustainability, social enterprise, triple bottom line, or corporate ethics. A member of the Business Law Section’s CSR Task Force, Stanford Law School Professor Chip Pitts, coauthored the premier law school text on the subject, Corporate Social Responsibility: A Legal Analysis, urging that we view CSR as a set of assessment, strategic-development, and commitment practices.
The widely recognized Carroll Model defines CSR as “the economic, legal, ethical and philanthropic expectations placed on organizations by society at a given point and time.” The Carroll Model depicts a pyramid with the economic imperative to generate a profit at the base, on top of which lie legal obligations to obey the law, ethical obligations to do what is right and fair, and philanthropic obligations to be a good corporate citizen.
An alternative also puts economic obligations at the base, but then represents legal, ethical, and philanthropic obligations as concentric circles sitting on the base. This representation illustrates that while some CSR obligations fall squarely within one category, others overlap two.
Supply chain efforts to address trafficking primarily fall into the ethical area, because guides like the ABA Model Principles and Policies and UN Guiding Principles are voluntary. Yet California’s Transparency in Supply Chain Act is one state supply chain law already on the books. This law, like the proposed federal law H.R. 4842 discussed below, requires corporations to disclose actions to clean up the supply chain rather than actually undertaking actions to do so, as Dodd-Frank’s conflict minerals law requires.
Significant potential criminal penalties and civil liability already attend labor trafficking. Congress enacted the Trafficking Victims Protection Act in 2000. Offenders also violate Title VII, the Fair Labor Standards Act and state equivalents, and the Thirteenth Amendment. Corporations could also consider the social and ethical implications. They already do in the environmental arena, where although laws like the Clean Air Act, Superfund, Resource Conservation and Recovery Act, and Clean Water Act certainly provide heavy regulation, voluntary green initiatives in some instances nonetheless predominate.
Extensive discussion on the Business Law Section Model Policies Working Group website make more of the moral and social case for addressing trafficking in the supply chain.
The Business Case
We have yet to consider the business reasons why corporations would voluntarily model their supply chain policies after the ABA Model Principles and take appropriate action. The business risks include unstable supply chains. Worker unrest over trafficking or trafficking-related issues can lead to work stoppages, consumer boycotts, product quality issues, and product recalls. Even without direct economic impact, media reports that a company has slaves in its supply chain can cause huge reputational damage, loss of investor confidence, and enormous stock-value loss.
You should now clearly see the value to a proactive policy to eliminate trafficking and child labor from the supply chain. One sure way to address the issue is to adopt and implement the ABA Model Principles. By doing so, corporations can increase the supply chain stability and sustainability while increasing reputation for responsibility. Appealing to the growing number of socially conscious consumers can increase sales. Institutional investors are also becoming more socially conscious. Due in large part to the 2012 collapse of Bangladesh’s Rana Plaza, in which 1,100 workers lost their lives, institutional investors controlling $4.2 trillion in investments continue to advocate for worker safety while urging companies to commit to a trust fund established to provide victim and family assistance.
Legal Consequences Affecting the Business Case
Potential financial impacts from legal exposure are also growing. Beyond the Trafficking Victims Protection Act, the House of Representatives’ Business Transparency on Trafficking and Slavery Act bill (H.R. 4842) would, if enacted, require disclosure similar to California’s Transparency Act, although federal disclosure would be to the SEC. Ahem: the SEC. The administration also backs proposed regulations to implement President Obama’s Executive Order on Trafficking in Federal Contracts, which would in some cases require mapping the supply chain. Potential Foreign Corrupt Practices Act liability also exists when a company uses a labor broker.
State laws are also becoming tougher in this area. With the assistance of University of Michigan Law trafficking expert Bridgette Carr and others, Michigan’s Attorney General Bill Schuette led a group of legislators including State Senator Judy Emmons in securing the adoption of 22 provisions toughening existing laws fighting sex trafficking and protecting its victims. The National Association of Attorneys General remains engaged in fighting trafficking. While the present focus is on sex trafficking, labor trafficking could easily become more of a focus.
Internationally, law-reform advocates in 2013 approved the Uniform Law Commission Model Human Trafficking Law. Advocates also propose UN treaty negotiations to increase the responsibility of businesses to remedy of human rights violations. The European Union and India are each instituting corporate reporting on CSR issues.
Litigation on behalf of trafficking victims also increases as the movement identifies more trafficking victims. An EEOC lawsuit involving Henry’s Turkey Service of Texas led to $242 million in damages based on findings involving alleged abuse of 32 mentally disabled turkey plant workers whom employers for decades paid hourly rates as low as 41 cents. A recent class action lawsuit involving 350 Filipino teachers whom corrupt labor recruiters charging exorbitant fees allegedly lured to teach in Louisiana public schools returned $4.5 million in damages for the teachers. A prominent plaintiff’s lawyer noted at a recent conference that damages could easily exceed $150 million even in cases involving as few as 100 employees. The array of potential civil causes of actions includes a private right of action under the Trafficking Victims Protection Act, Thirteenth Amendment, Ku Klux Klan Act, Civil Rights Act of 1866, Alien Tort Claims Act, RICO, Fair Labor Standards Act, Title VII, and state labor codes, plus common law claims for intentional torts, negligence, and breach of contract claims.
Professional Responses
During the 2012 tenure of Laurel Bellows as ABA president, the American Bar Association formed a Human Trafficking Task Force to attack human trafficking from a professional standpoint. Efforts include training for lawyers and law enforcement officials who are often the first to respond to trafficking reports, strengthening pro bono networks to ensure that all civil legal needs of trafficking victims are addressed, and a media campaign including a video explaining how the legal community can help. See Laurel Bellows, “Breaking the Shackles: More Must Be Done to End Human Trafficking and Help Victims,” ABA Journal, Sept. 1, 2012.
President Bellows asked the ABA’s Business Law Section to develop business practices for corporations encountering and addressing human trafficking. While certain businesses have adopted and implemented codes of business conduct to address labor trafficking including child labor in their operations, other businesses have not done so. U.S. corporations have not yet widely adopted standard business conduct codes. Even corporations that do have codes in place can benefit from periodic policy review to reflect evolving best practices particularly around trafficking.
The Business Law Section responded to this request by creating a Working Group made up of over 50 leading business law experts who prepared the ABA Model Business and Supplier Policies on Labor Trafficking and Child Labor. The Model Policies consist of six parts: Part I Introduction, Part II Model Principles, Part III Model Business Policy, Part IV Model Supplier Policy, Part V Model Glossary, and Part VI Endnotes.
The Model Policies assist both corporations and their suppliers currently having labor trafficking and child labor policies in place, but wishing to update those policies, and also corporations and suppliers lacking any current policy. The Model Policies can stand alone or be adapted for particular industries and be incorporated into existing business codes of conduct.
The Model Principles form the centerpiece of the Model Policies. The ABA House of Delegates formally adopted the Model Principles as ABA policy, apart from the balance of the Model Policies. In addition to adopting the Model Principles as ABA Policy, the ABA House of Delegates in a second resolution urged businesses to adopt policies consistent with the Model Principles. Four Model Principles address both businesses and suppliers:
Principle 1 – The Business/Supplier will Prohibit Labor Trafficking and Child Labor in its Operations.
Principle 2 – The Business/Supplier will Conduct a Risk Assessment of the Risk of Labor Trafficking and Child Labor and Continually Monitor Implementation of this Policy.
Principle 3 – The Business/Supplier should: (i) Train Relevant Employees, (ii) Engage in Continuous Improvement, and (iii) Maintain Effective Communications Mechanisms with its Suppliers.
Principle 4 – The Business/Supplier will Devise a Remediation Policy and Plan that Addresses Remediation for Labor Trafficking or Child Labor in its Operation.
The Model Principles are consistent with the UN Guiding Principles on Business and Human Rights, which are the globally recognized guidelines on the roles of states and business enterprises in addressing human rights issues. The Guiding Principles recognize that: (1) states have existing obligations to respect, protect, and fulfill human rights and fundamental freedoms; (2) business enterprises including suppliers must comply with all applicable laws and respect human rights; and (3) rights and obligations should carry appropriate and effective remedies when breached.
The Model Policies’ Parts III and IV consist of two main parts. Four Model Business and Supplier Policies each relate to one of the Model Principles. Each Model Policy starts with a statement of the applicable Model Principle. A commentary and guidance section recommends provisions to use in a business enterprise’s policy or code of conduct. These Model Policies are not ABA policy in the same manner as the Model Principles, hence a business enterprise can modify any or all of the provisions to suit its environment.
The Model Policies’ Parts V Definitions and VI Endnotes are also part of the Model Policies and as such were not adopted by the ABA as policy.
Companies are undertaking more ethical activities related to trafficking, beyond those related to the ABA Model Policies. The Working Group plans a database of resources to permit companies to post their policies and other relevant materials for sharing with others. For example, Apple’s code of conduct requires suppliers to refund to workers any excessive recruitment fees. Since 2008, this initiative has resulted in $17 million going back to workers, $3.9 million during the last year.
Philanthropic Consequences
Corporations have demonstrated good corporate citizenship in this area. These efforts include the corporations mentioned earlier that formed the Global Business Coalition Against Trafficking. This initiative can become much more than philanthropic as this coalition develops additional tools. Some of those same corporations are signatories to the Luxor Implementation Guidelines to the Athens Ethical Principles, including the Gap, the Body Shop, Microsoft, and Manpower. Microsoft and Manpower are members of End Human Trafficking Now. Google had donated $11.5 million to Polaris and International Justice Mission to Fight Human Trafficking. Hilton Worldwide, Carlson/Radisson, and Delta Airlines have signed the ECPAT Code.
Conclusion
Lawyers discern the legal, financial, ethical, and moral risks of noncompliance with local, state, and federal laws, and international norms and rules, or the “rule of law.” We do not substitute the public good for shareholder return. CSR starts with a corporation’s economic interests and then moves through the legal, ethical, and philanthropic opportunities and concerns. Lawyers help corporate boards and CEOs recognize the risks of violating laws and the long-term reward of acting within those laws, even when others might pursue short-term rewards carrying unacceptable risks. Model Rule 2.1 permits lawyers to consider social and moral concerns relevant to its client’s situation in rendering legal advice. Yet lawyers should go beyond advocating correction of social or moral wrongs to also articulating a cogent business case. Lawyers can help corporate leaders communicate to shareholders broad and lasting value from eradicating trafficking from the supply chain. Doing so can build and protect equity while appealing to the growing number of customers, shareholders, and investors who care about human rights. Conversely, making a profit off of slavery presents unacceptable social, legal, litigation, and reputational risks that no corporation should accept as it could lead to significant erosion of a company’s business.
More than ever before, investors want nonfinancial information from companies in making investment decisions. Examples of nonfinancial information (also referred to environmental, social, and governance or sustainability information) include climate change, water quality and quantity, ethical business practices, cybersecurity, and supply chain management. What environmental, social, and governance (ESG) risks does the company face? How is the company managing these risks? How is the company performing on corporate social responsibility (CSR) and sustainability factors relative to its industry peers? This article addresses the growing interest of investors in nonfinancial information and implications for lawyers in advising their clients.
Nonfinancial information has legal and business dimensions. On the legal side, a company may, as appropriate, be required to disclose nonfinancial information regarding climate change, cybersecurity, environmental impacts, and social impacts under state and federal regulations. How the company responds to these requirements can create liability consequences. On the business side, how a company implements and represents its CSR and sustainability practices may affect its operations, financial performance, corporate governance, and reputation. These business aspects of nonfinancial information can also raise questions for lawyers.
With this context, this article proceeds as follows. First, the article examines the rise of fiduciary capitalism and investor interest in nonfinancial information. Second, the article discusses the implications for lawyers. Finally, the article provides thoughts on the future of nonfinancial information.
Institutional Investors and Nonfinancial Information
The Rise of Fiduciary Capitalism
In the early 1930s, Adolf Berle and Gardiner Means described the modern corporation as one of dispersed ownership by small shareholders who had little power relative to managers. Before the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, investors had little information about the companies they invested in, or thought about investing in, because companies had to report little about themselves to investors. The Exchange Act gave investors a window into the financial condition and operations of a company by mandating that registered companies periodically report information to the Securities and Exchange Commission.
Since the passage of the Securities Acts, the capital markets have experienced eras of industrial or managerial capitalism and, more recently, finance capitalism, which was dominated by financial intermediaries such as banks, asset managers, and brokers. Some observers see the financial crisis of 2008 as the beginning of a new age – the age of fiduciary capitalism. Fiduciary capitalism differs from the other ages of capitalism in that long-term focused institutional investors dominate the capital markets. The primary actors in fiduciary capitalism are pension funds, university endowments, foundations, and sovereign wealth funds. John Rogers, “A New Era of Fiduciary Capitalism? Let’s Hope So,” Financial Analysts Journal (May/June 2014), Volume 70, Issue 3.
In the United States, these asset owners have common law fiduciary duties of care and loyalty. The duty of care, or prudence, requires the fiduciary to invest and manage the investments, diversification, and risks of the fund as a prudent investor would, considering the purposes, terms, and distribution requirements of the fund.
The duty of loyalty binds the investor to remain impartial between beneficiaries, for example, different generations. This duty may influence how the fiduciary incorporates nonfinancial information into its investment calculus:
Given the potential for shifting of wealth, environmental remediation costs and climate risks between young and older generations, failures of fiduciaries to adopt a sustainable development investment approach has fiduciary duty implications and raises questions about the ability of fiduciaries to efficiently allocate investment capital to growth opportunities and manage risks to economic growth and future portfolio returns.
The Employees’ Retirement Income Security Act’s (ERISA) fiduciary standard applies to private pension funds. ERISA fiduciaries may not subordinate the economic interests of the plan to unrelated goals, and may not choose investments on factors other than the economic interests of the plan. Nonfinancial factors can be considered if they do not negatively affect risk and returns and if they are integrated into the financial and risk analysis to help choose an investment portfolio that meets the long-term investment objectives of the beneficiaries.
Although large, public pension funds are not subject to ERISA, they often follow the fiduciary standards of ERISA. The California Public Employees Retirement System (CalPERS), the largest public pension fund in the United States, explains how its sustainable investment approach supports its fiduciary duties:
CalPERS’ fiduciary duty is paramount to achieving our mission, which is to provide pension and health benefits to more than 1.6 million CalPERS members and their families. We clearly state that our focus is on the long term?–?which is both a responsibility and an advantage for a fund our size. . . . The Beliefs also elevate our framework for sustainable investment, recognizing that long-term value creation requires the effective management of three forms of capital: financial, physical, and human. This process has evolved our thinking on ESG issues into a core theme across our portfolio. The Beliefs flag important issues such as the multi-faceted nature of risk including climate change and resource availability, and the importance of managing costs.
The California State Teachers Retirement System (CalSTRS) requires its investment managers to assess ESG risks in making investments. CalSTRS explains why this approach is in its best interest:
Since CalSTRS is a long-term investor and may hold an investment in a corporation or entity for decade after decade, short-term gains at the expense of long-term gains are not in the best interest of the Fund. Sustainable returns over long period are in the economic interest of the Fund.
Materiality and Investor Interest in Nonfinancial Information: The NRDC Cases
Materiality is intrinsically tied to the reasonable investor. After all, what is material depends on what the reasonable investor would find important in his or her investment decisions. Yet, courts have not explicitly or clearly defined the reasonable investor. Instead, courts have attributed a number of traits to the reasonable investor, including rationality in investment decision making. (Tom C.W. Lin, “The New Investor,” 60 UCLA L. Rev. 678, 694–695 (2013)). Although the definition of the reasonable investor is not settled, the definition is intended to be objective. (Stephen Padfield, “Is Puffery Material to Investors? Maybe We Should Ask Them,” 10 U. Ap. J. Bus. & Emp. L. 339, 346, 365 (2008). The SEC explains that the reasonable investor has been viewed as a long-term investor going back to the Exchange Act. Regulation NMS, 70 Fed. Reg. 37,496, 37,500 (June 29, 2005).
Through a series of cases brought by the National Resources Defense Council (NRDC) against the SEC during the 1970s, the SEC provided insight how it thinks about the reasonable investor. The late 1960s and early 1970s saw shareholders and organizations ask companies to disclose more social, environmental, and civil rights information. For example, Campaign GM was a proxy proposal that involved General Motors shareholders asking the company to provide more information on its environmental and civil rights performance and on safety and design issues. In 1971, the NRDC brought a rule-making petition before the SEC, asking the commission to expand civil rights and environmental disclosure under the federal securities laws. NRDC v. SEC, 389 F. Supp. 689, 693–694 (D.D.C. 1974). After a number of investigations and public hearings spanning almost a decade, the SEC decided in administrative proceedings that the requested disclosures were not needed because only a small fraction of investors considered social and environmental information important. Two federal courts upheld the SEC’s rule-making authority and actions.
The district court ordered the SEC to work on two critical factual issues regarding materiality: first, the prevalence of ethical investor interest in greater environmental and civil rights disclosure, and second, what other avenues ethical investors can use to combat corporate actions that negatively affect the environment or the practice of equal employment. Regarding expanded social disclosure, the SEC found that about 0.0005 percent of the total value of stocks and bonds in the United States in 1974 was invested using ethical investing principles. Likewise, shareholder proposals on environmental and social received, on average, between 2 percent to 3 percent approval during the 1970s. These findings led the SEC to conclude that ethical investing was not an important or significant type of investing. Commission Conclusions and Rule Making Proposals, Securities Act Release No. 5627, Exchange Act Release No. 11773, [1965–1976 Transfer Binder] Fed. Sec. L. Rep (CCH) ¶ 80, 820 at 85,719-720 (Oct. 14, 1975).
The SEC’s decision turned on a level of interest insufficient to conclude that the reasonable investor was interested in social and environmental information. The commission’s analysis of what is material to the reasonable investor depended, to a large extent, on the portion of investors and assets under management interested in nonfinancial information. This suggests that when a sufficiently large percentage of investors and/or assets under management consider sustainability information to be material, sustainability disclosure would be justified because the reasonable investor views that information as decision-useful.
Because investors presumably invest primarily for economic gain, the commission decided to adhere to an economic understanding of materiality. Further, the SEC stated that it could not require disclosure solely for the purposes of changing corporate behavior, although it recognized that disclosure might have an indirect effect on such behavior. To require disclosure solely for the goal of changing corporate behavior would go beyond the commission’s authority to require disclosure that is “necessary or appropriate for the protection of investors or the furtherance of fair, orderly and efficient markets or for fair opportunity of corporate suffrage.” (Commission Conclusions, Securities Act Release No. 5627, at 85,713.) This reasoning, however, contradicts the legislative intent of the Securities Acts. Moreover, expanded social and environmental disclosure can provide useful information to investors that directly relates to the goals of investor protection and informed voting. Cynthia A. Williams, “The Securities and Exchange Commission and Corporate Social Transparency,”112 Harvard L. Rev. 1197, 1272-1273 (1999).
Increased Investor Interest in Nonfinancial Information Today
The level of investor interest in nonfinancial information has dramatically increased since the SEC’s market study of the 1970s. One reason is the growth of sustainable, responsible, and impact investing. According to US SIF (The Forum for Sustainable and Responsible Investment), at the beginning of 2014 approximately $6.57 trillion in assets under management was engaged in sustainable, responsible, and impact investing. This amount represents about 18 percent of the $36.8 trillion in total assets under management in the United States. The amount invested in sustainable investing practices increased 76 percent from $3.74 trillion in 2012. Since 1995, when US SIF first began tracking sustainable, responsible, and impact investing, the amount of assets engaged in this investment approach has increased over 900 percent from about $600 billion. Report on US Sustainable, Responsible and Impact Investing Trends 2014, US SIF, pg. 12–16 (2014).
In response to a 2013 survey conducted by Ernst & Young of more than 160 investors, analysts, and portfolio managers around the globe, nine out of 10 respondents stated that nonfinancial performance had played a pivotal role in their investment decision-making in the past 12 months. The report concluded: “This demonstrates that the analysis of nonfinancial issues can no longer be dismissed as a niche approach to investment.” EY, Tomorrow’s Investment Rules: Global Survey of Institutional Investors on Non-Financial Performance (2014).
How do investors benefit from nonfinancial information? In response to PwC’s survey in 2014 of institutional investors with $7.6 trillion in assets under management, 73 percent said that risk mitigation is the primary reason they consider sustainability information. Fifty-five percent said that avoiding unethical companies is a reason for their interest, and 52 percent said that financial performance is why they factor sustainability information into their investment decisions.
Despite investor interest in nonfinancial information, companies are not providing the information that investors want. Sixty-one percent of investors stated that they are dissatisfied with corporate disclosures of social and environmental information by U.S. companies. With respect to sustainability issues, investors expressed broad dissatisfaction with how U.S.-listed companies are disclosing information:
79 percent are dissatisfied with comparability of sustainability reporting between companies in the same industry.
74 percent are dissatisfied with relevance and implications of sustainability risks.
68 percent are dissatisfied with sustainability strategy that is linked to business strategy.
62 percent are dissatisfied with internal governance of sustainability issues.
57 percent are dissatisfied with process used to identify material sustainability issues.
Another reason for the increased interest in nonfinancial information is the greater presence of long-term oriented institutional investors today. Institutional investors own 70 percent of the largest 1,000 U.S. companies, and pension funds own almost 40 percent of this amount. Institutional investors incorporate sustainable, responsible, and impact principles into investment analysis and portfolio selection of $4.04 trillion, or about 60 percent of the total amount of assets under management investing using these principles.
At the same time, a growing number of investors has committed to the United Nations Principles for Responsible Investment (PRI). The PRI is a global framework for investors to include ESG information into investment analysis and decisions with the purpose of increasing returns and reducing risk. In 2009, 560 institutional investors with $18 trillion in assets under management had committed to the principles, while in 2014 over 1,200 investors with $34 trillion in assets under management had done so. The principles are based on the idea that ESG issues can affect investment performance and that consideration of these issues can help to produce superior risk-adjusted returns. For these reasons, nonfinancial information can fall squarely within investors’ fiduciary duties. The principles explicitly state they are to be applied only in a manner that is consistent with those duties.
In incorporating ESG information into fundamental equity analysis, investors use the information in several ways:
Economic analysis: To understand industry trends and externalities likely to affect the economic outlook and, therefore, value creation and capital formation.
Industry analysis: To understand factors driving competitiveness and the potential for sustained value creation in an industry, as well as externalities from an industry likely to affect other industries (and therefore portfolio risks).
Company strategy: To understand management quality and corporate strategy, and evaluate a company’s ability to respond to emerging trends.
Valuation: To adjust traditional valuation parameters and assumptions, including cash flow and weighted average cost of capital, to reflect performance on material sustainability issues.
The trend of increasing investor interest in nonfinancial information has many implications for how lawyers might advise their clients. With respect to disclosing nonfinancial information to investors, lawyers will need to consider how to advise companies on what kind of information to provide, in what level of detail, and in what format. Should the company provide information only on ESG issues that investors specifically ask about? Should the company provide information on the commonly sought types of information (e.g., climate change) for companies in its industry? How much information and at what level of detail (general initiatives or measurable performance) is enough to satisfy investors? Should the information be provided in voluntary sustainability reports or in SEC filings? A company may, under appropriate circumstances, need to disclose information on these issues in a company’s SEC filings under Regulation S-K. In other situations, a company may decide to report the information in voluntary reports, such as its corporate social responsibility, Global Reporting Initiative, or sustainability reports.
Since nonfinancial information is related to risk mitigation and value creation, the lawyer should consider reviewing the board’s role in overseeing the information. What kind of nonfinancial information, and how much, should management report to the board? Should an existing or dedicated committee be responsible for the oversight of nonfinancial information? Or should the entire board be responsible? Should the compensation of executives be tied to performance on nonfinancial matters? If so, over how long of a time period?
Finally, lawyers can help clients understand the liability implications of nonfinancial information. Companies that fail to disclose material sustainability information may face a higher risk of shareholder suits alleging that the company made materially misleading or false statements. Companies who consider disclosing nonfinancial information in SEC filings should examine the requirements and potential liabilities associated with signing Section 302 and 906 Sarbanes-Oxley certifications concerning the company’s disclosure controls and procedures. Lawyers can help companies assess the materiality of sustainability information and evaluate the risks of disclosing, or not disclosing, sustainability information.
Conclusion
With the growing prominence of fiduciary capitalism, nonfinancial information assumes greater significance for companies and investors. Investors want nonfinancial information that will help them reduce risk, improve returns, and make better informed investment decisions. How can they obtain the information in an effective, efficient manner that allows them to compare companies within industries? Companies need to find a way to address investor demand for nonfinancial information. How can companies collect, organize, and report information to investors in a cost-effective manner?
So long as fiduciary investors manage a substantial portion of assets under management, nonfinancial information is likely to remain important to the efficient operation of the capital markets and the formation of capital. Lawyers can play a critical role in advising companies and investors about the legal and business implications of nonfinancial information.
As a condition to the closing of many types of business transactions, one or more of the parties may be required to provide written opinion letters of counsel for the benefit of other parties to the transaction. These opinions are often referred to as “third-party” opinions because the opinion giver renders them to a party or parties other than the opinion giver’s own client. These opinions may cover a range of issues, including, among others, the entity status and power of, the due authorization, execution and delivery of the transaction documents by, and the enforceability of those documents against, the opinion giver’s own client in the transaction. Oftentimes the discussions regarding the scope of these opinions and the extent to which they will be qualified are time-consuming, and the resulting costs, borne by the client whose counsel is asked to render the opinions, increase substantially as negotiations proceed. This article, focusing on third-party opinions rendered in the context of U.S. commercial loan transactions, considers a number of qualifications that for various reasons, in the experience of the authors, opinion givers commonly include and opinion recipients and their counsel commonly accept. The authors believe that the identification of commonly used and accepted qualifications in the U.S. commercial loan market can help to streamline the opinion process in many transactions.
INTRODUCTION
Set forth below are qualifications that, in the authors’ experience, are commonly taken by opinion givers, and also commonly accepted by banks and other institutional lenders, in third-party legal opinion letters addressing the enforceability of financing agreements in the U.S. domestic loan context.2 In describing these qualifications, this article does not purport to reflect a statistical analysis of opinion practice or to analyze the need for or desirability of these qualifications under specific circumstances. Rather, it attempts to identify selected common qualifications, offer reasons for their being taken, and set forth common formulations for expressing them. The list of qualifications is neither exclusive nor suggestive of those that should be taken or accepted.3
Sometimes a qualification is included in a legal opinion to highlight a legal issue that could affect the enforceability of provisions of the covered agreement. Sometimes a qualification is necessary for an opinion to be correct; at other times, it clarifies how the opinion should be interpreted.4
In many cases, however, factors other than a perceived necessity for the qualification may account for the opinion giver’s taking the qualification, such as: a decision that engaging in the requisite research to resolve a legal issue is not justified on a cost-benefit or other basis; the unwillingness of the lawyer to make a determination that he or she views as factual (for example, whether a waiver is conspicuous or knowing, or whether liquidated damages are reasonable); the fact that the qualification is among those listed in one or more bar or other association reports; personal preference of the opining lawyer or law firm opinion committee policy; or an unwillingness on the part of one or more parties to modify the transaction structure or documentation to eliminate the need for the qualification.
Furthermore, as transactions become more complex and close more quickly, time constraints often make it difficult for an opinion giver to complete the legal research—or even to undertake the legal analysis—needed to narrow or eliminate qualifications upon which the opinion giver commonly relies. Cost-benefit considerations are another important reason that many of these qualifications have become common in the U.S. commercial loan context. In the process of preparing and negotiating legal opinions, opinion givers and recipients, to some extent, undertake a cost-benefit analysis to determine whether the cost of doing research, or undertaking careful legal analysis regarding a given set of legal issues, is justified by the benefit of receiving an opinion covering those issues.
Part of the explanation for the willingness on the part of recipients to accept qualifications identified in this article may also be found in the sophistication of many recipients who know that their rights are based on the law rather than on the wording of an opinion. In fact, experienced lenders and their counsel in the U.S. domestic loan market often have sufficient knowledge of, and experience with transactions under, the applicable law so as to have little need for the advice provided by a carefully drawn opinion. Further, while the remedies in question may be important enough to be addressed in the transaction documentation, they may not be core considerations for many lenders.
As to virtually all of the qualifications identified in this article, variations exist in the positions taken by the bar reports of different jurisdictions, as well as in the forms of expression used by different law firms, including firms practicing in the same jurisdiction. Some of these variations reflect real differences in law that require differences in wording. Others reflect different preferences or practices, whether in a particular area of practice, jurisdiction, or law firm. For example, some of the qualifications discussed below may be omitted from an opinion, not because the opinion giver has determined they are not appropriate or relevant, but because the opinion giver believes they are implicit and need not be expressly stated or are adequately covered by other qualifications contained in the opinion. Also, the wording of the agreement covered by an opinion may dictate either that a particular form of qualification be used or, alternatively, that none is needed.5
The inclusion of the common qualifications identified in this article and the form of their expression may not always be appropriate. In the end, each opinion will turn on the particular facts and circumstances presented as well as the relevant law covered by the opinion.6 The text and footnotes explain some of the relevant legal authority, including legal uncertainties, of the jurisdictions in which the authors practice. Differences or departures in law or practice in some states from the opinion language set forth in boldface type below are also noted in some of the related comments, either in the text or in the footnotes.
The qualifications to the remedies opinion covered in this article will come as no surprise to any practitioner with experience in the domestic commercial lending market. After a brief discussion of the bankruptcy and equitable principles qualifications, the article moves on to address a number of “usual suspects,” including qualifications relating to arbitration, choice of law, indemnification and exculpation, submission to jurisdiction and forum selection, venue, jury trial waivers, setoff, usury, and liquidated damages and penalty clauses. The final portions of this article address some matters commonly arising in loan transactions with an international dimension, such as qualifications relating to comity, sovereign immunity waivers, judgment currency, and currency indemnity, though always in the U.S. domestic loan context.
Each part of this article addresses a separate qualification and begins with a boldface sample formulation of the relevant qualification as it might be set forth in an opinion. The boldface statement of the qualification language reflects a typical formulation. It should be emphasized that each sample is posited as one of a number of possible formulations that either might be used, or are in fact often used, to express the same type of qualification. Following each sample qualification is a discussion of (i) the reasons why practitioners might consider taking the qualification and (ii) variations in law and practice among the seven states in which the authors practice. Additional detail on state law, including case citations, appears in footnotes.
The discussion on each subject in this article and the related footnotes provide summaries of the legal and opinion practice issues underlying the qualifications. The case citations and other state-specific details are intended to provide some sense of the issues or uncertainties that have been cited as a basis for taking a given qualification. It should be noted, however, that their inclusion is not intended to suggest that a qualification is necessary in all or even most transactions.7 In fact, it is hoped that the case authority and other state-specific details presented will not only explain some of the legal bases for these qualifications, but will also serve to help opinion givers navigate the law, and opinion recipients to understand the limits of what might reasonably be required, in those transactions where the parties determine, for whatever reason, that further work should be performed to try to narrow or even eliminate one or more of these qualifications. In some cases, the parties might decide to revise provisions in the transaction documents to avoid the legal uncertainties addressed in the footnotes to this article. In other cases, opinion givers might consider the state-specific authorities provided as starting points for analyzing whether it is possible to narrow or eliminate some of these qualifications. In still other cases, the parties might determine that a narrowing or elimination of the qualification will not, in fact, be required by the recipient.
The authors do not express any view on the practice of taking a qualification that might be narrowed or even eliminated, for whatever reason, especially when the recipient does not object. It seems clear that the parties to a transaction can agree to limit the scope of opinions as they might see fit. However, some practitioners believe the proliferation of unnecessary or overly broad qualifications burdens the opinion process unnecessarily by, among other things, making it more difficult to ascertain the meanings of the opinions that are rendered.
In recognizing that certain qualifications are often used, the authors do not intend to address what either does or should constitute customary legal opinion practice. Simply because certain qualifications to the remedies opinion have become common or frequent in a given context (whether as a consequence of cost-benefit considerations, law firm policies and procedures, time constraints, or other factors unrelated to the extent to which provisions of an agreement are enforceable as a matter of law), the use or acceptance of such qualifications should not be viewed as constituting or establishing customary legal opinion practice. Customary practice permits opinion givers and recipients to have certain common understandings about opinions in two principal ways: by providing guidance on the meaning of legal opinions that are requested and rendered and by identifying the scope of diligence expected to be performed in rendering those opinions.8 However, except for statements in the opinion literature that opinion requests should address matters that are relevant and opinions delivered should be within the professional competence of lawyers, as well as the “Golden Rule,”9 the authors are of the view that customary practice does not address the question of whether an opinion recipient should request or insist on any particular opinions, or of whether opinion givers should render or limit particular opinions when their omission or limitation in particular transactions might be acceptable.
This article is intended to help practitioners by describing certain qualifications to the remedies opinion that, for various reasons, opinion givers have tended to proffer, and recipients have tended to accept, in a particular market segment. The authors believe that identifying these types of qualifications can expedite the opinion process, especially for those who may be less experienced in handling U.S. commercial loan transactions. We happily leave to bar associations and other groups the more difficult questions relating to what customary legal opinion practice may require.
A. THE BANKRUPTCY AND EQUITABLE PRINCIPLES QUALIFICATIONS
1. Bankruptcy
Sample Qualification:
Our opinions are subject to the effects of applicable bankruptcy, insolvency, fraudulent transfer and conveyance, preference, reorganization, receivership, moratorium, and other similar laws affecting the rights and remedies of creditors generally.10
Comments
The bankruptcy qualification and the equitable principles qualification addressed in the following part, however formulated, are universally recognized opinion limitations, so much so that they are generally understood as applicable even when not expressly stated.11 Nevertheless, most opinion givers are more comfortable specifically stating these qualifications in their opinion letters. While directed most specifically to the remedies opinion, both the bankruptcy and equitable principles qualifications are recognized as having application more generally and are often so expressed.
The bankruptcy qualification excludes the effect of bankruptcy and similar creditors’ rights laws from the scope of the opinion. It also excludes the effect of such laws on matters such as non-consolidation of entities, fraudulent transfers and conveyances, and preferences. The bankruptcy qualification relates to a body of law rather than to a particular proceeding and includes not only federal bankruptcy law but also similar state or federal insolvency laws of general applicability.12
2. Equitable Principles
Sample Qualification:
Our opinions are subject to the effects of general principles of equity (whether considered in a proceeding at law or in equity), including but not limited to principles limiting the availability of specific performance and injunctive relief, and concepts of materiality, reasonableness, good faith, and fair dealing.
Comments
See Comments under the bankruptcy qualification above.
The above formulation of the equitable principles qualification is only one of many possible formulations. The equitable principles qualification may be phrased as simply as “except as may be limited by general principles of equity” and, indeed, like the bankruptcy qualification, is understood as a matter of customary usage to apply to all remedies opinions whether or not stated expressly.13 The equitable principles qualification relates to those principles that courts apply when, in light of facts or events that occur after the effectiveness of an agreement, they decline in the interest of equity to give effect to particular provisions in the agreement. For example, under circumstances that occur after the effectiveness of the agreement, a court may determine, based on equitable principles, that the agreement’s notice provision is too short or the withholding of consent under the agreement is unreasonable.
The equitable principles qualification applies to such court determinations grounded in the belief that it would be inequitable to enforce the literal meaning of an agreement in the particular context in which a dispute has arisen. However, if in the example in the prior paragraph an agreement’s notice provision would, in all circumstances, be held to be too short or if the withholding of consent under the agreement would in all circumstances be improper, the equitable principles qualification would not apply. Relief would be denied because of the invalidity of the provision, rather than because of the application of equitable principles, and a specific exception as to that provision (in addition to the equitable principles qualification) should be taken.14
The equitable principles qualification also covers, without so expressly stating, concepts of undue delay and the impracticability or impossibility of performance; limitations on the availability of equitable remedies, such as injunctive relief and specific performance; and the possible application of equitable defenses such as estoppel and the doctrine of unclean hands, as well as the discretion of courts sitting in equity.15
B. OTHER QUALIFICATIONS
1. Arbitration
Sample Qualification:
We express no opinion with respect to any provision requiring arbitration.
Comments
In the authors’ experience, opinion givers commonly exclude arbitration provisions from the scope of third-party closing opinions in U.S. commercial loan transactions. Furthermore, because arbitration provisions are often lengthy and frequently include specific agreements on the rules of arbitration and other procedural matters, in the unusual circumstance where the parties determine that the need for such an opinion justifies the cost and time required to analyze the arbitration provisions and render the opinion, the opinion giver will want to consider what qualifications (if any) may be required in connection with the arbitrability of matters covered by the arbitration agreement, as well as the rules and procedures set out therein.16
2. Characterization
Sample Qualification:
We express no opinion as to the characterization of any agreement for tax or accounting purposes [or with respect to whether any agreement is a true sale, an assignment for security, or a lease].
Comments
This qualification relates to transactions for which characterization, tax, or accounting considerations are relevant.
Lawyers, when asked by their clients and if they are experts, do sometimes render opinions regarding the tax characterizations of transactions and may even render opinions, typically reasoned (or explained) and sometimes qualified, regarding whether a transaction denominated as a “sale” or “lease” of goods is a true sale or lease versus a financing transaction with a retained security interest. However, in most U.S. commercial loan transactions, the opinion giver is not expected to address such matters.
In cases where there is concern that the tax or accounting characterization of the transaction is important (as may be the case in sale, structured finance, leasing, derivatives, and similar transactions), some opinion givers include a qualification, such as the example set out above, to underscore the fact that these types of matters are not being addressed. However, the authors believe that inclusion of an express qualification of this type is generally unnecessary because, as a matter of customary practice, legal opinions do not extend to tax matters unless specifically addressed, and they do not extend to accounting matters.17
The bracketed sample language set out above, which refers to a true sale, assignment for security, or lease, is applicable only in certain assignment or leasing transactions.
3. Choice of Law
Where no opinion is rendered on the choice of governing law under the agreement:
Sample Qualification:
We express no opinion with respect to any provision purporting to choose the [law of any jurisdiction to govern any matter][law of [chosen governing law] to govern the agreement].
For states having a statute permitting the choice of governing law under the agreement:
Sample Qualification:
Our opinion as to the enforceability of any provision purporting to choose the governing law of the agreement is given solely in reliance on [the relevant statute].18
For states where an opinion is given in reliance on the Restatement (Second) of Conflict of Laws19 (the “Restatement”) (and applicable case law applying the Restatement in those states) and not based on a statute permitting the choice of governing law under the agreement, opinion givers frequently give a qualified or reasoned opinion describing the Restatement tests in a manner such as the following:
Sample Qualification:
In a properly presented proceeding in a court of competent jurisdiction in this State for the enforcement of the agreement [and based on [factual statements or assumptions as to the reasonable relationship of the transaction to the chosen jurisdiction]],20 the court [would] [should]21 give effect to the provision of the agreement selecting the law of [the chosen jurisdiction] as the governing law, except to the extent (i) that any provision of the agreement is determined by the court to be contrary to a fundamental policy of the jurisdiction whose law would apply in the absence of that choice-of-law provision, and (ii) that jurisdiction has a materially greater interest in the determination of the particular issue than does the jurisdiction whose law is chosen.
Comments
Legal opinions frequently include qualifications with respect to the enforceability of provisions in covered agreements choosing the governing law. In cases where a choice-of-law clause selects the law of the jurisdiction that is otherwise covered by the opinion (the “Covered Law”), a remedies opinion regarding the covered agreement would implicitly contain an enforceability opinion on the “inbound” choice-of-law clause except to the extent that opinion is expressly disclaimed or qualified. In other cases, an opinion giver may be asked to address separately the enforceability under the Covered Law’s choice-of-law principles of “outbound” governing law provisions selecting the law of a jurisdiction other than the Covered Law.22
Sometimes, most commonly in the case of inbound choice-of-law clauses, the facts and circumstances may provide a clear basis for the parties’ contractual choice of governing law under the Covered Law’s choice-of-law rules. However, because choice-of-law matters can often be difficult, many opinion givers are hesitant to address them without qualification of some kind.
Some states, including New York, Illinois, Delaware, and California, have adopted statutes expressly authorizing, in commercial contracts exceeding a minimum dollar threshold, the inbound selection of that state’s own law as the governing law of the contract whether or not the parties or the transaction have any contacts with the state.23 In these jurisdictions, opinion givers commonly render choice-of-law opinions, relying on the relevant statute as to inbound choices of law.24 Many opinion givers render these opinions without qualification; others prefer to state expressly that their choice-of-law opinion is based on the relevant statute, as in the second sample qualification set out above. Sometimes, in these instances, opinions will also include assumptions about compliance with the statutory predicates (such as deal size) where such compliance is not readily apparent.25
In the absence of an applicable statute, a choice-of-law opinion may present additional difficulties because the opinion giver needs to evaluate the choice of law under common law. In the event an applicable statute does not apply (whether for inbound or outbound opinions), opinion givers commonly either (a) disclaim any opinion26 or (b) provide a reasoned or qualified opinion that reflects the relevant jurisdiction’s choice-of-law rules. The first sample qualification above is an example of a qualification disclaiming any choice-of-law opinion.
In states such as California, Delaware, Illinois, and North Carolina, which follow the approach set out in section 187 of the Restatement,27 in the event a statute does not apply, opinion givers often provide a reasoned or qualified opinion that reflects the rule of the Restatement as modified or supplemented by relevant case law. Such Restatement-based opinions, as illustrated in the third example set out above, often restate the requirements of the Restatement rule, but (because those requirements are fact based or otherwise difficult to determine) without expressing an opinion on whether they have been satisfied.28 Accordingly, an opinion based on the Restatement is often effectively qualified to the extent any provision of the covered agreement is determined by the court to be contrary to a fundamental policy of a jurisdiction whose law would apply in the absence of the choice-of-law clause and which other jurisdiction has a materially greater interest in the determination of the particular issue than does the state whose law is chosen.29
Note that, in the sample Restatement opinion qualification set out above, the bracketed language relates to the question of how to address the Restatement requirement that the applicable transaction bear a reasonable relationship to the chosen law state.30 Sometimes an opinion giver will implicitly address, based on either known or assumed facts, the question of whether such a reasonable relationship exists under applicable law. Often, however, opinion givers do not wish to address this reasonable relationship requirement, in which case a further express assumption is included to make that clear. The hesitancy on the part of many opinion givers to address this and other Restatement requirements for a valid choice of law often renders a Restatement opinion of limited utility to the recipient.31
Sometimes an agreement is phrased so as to choose the law of a specified jurisdiction while excluding that jurisdiction’s choice-of-law rules. For example, the agreement may provide that the chosen law is the “substantive” or “internal” law of the chosen jurisdiction without regard to the application of that jurisdiction’s choice-of-law rules. While it may not be necessary to do so,32 some opinion givers choose either to qualify their opinions to point out that certain mandatory choice-of-law provisions may nonetheless apply or to request rephrasing of the agreement to avoid the need for this type of qualification. For example, Article 1 of the Uniform Commercial Code imposes mandatory choice-of-law rules for the perfection of security interests.
Further, some opinion givers also include some type of opinion qualification if an agreement’s choice-of-law clause purports to govern matters beyond the interpretation or enforceability of the contract, such as related tort disputes.
4. Indemnification, Exculpation, and Waivers of Damages
Sample Qualification:
We express no opinion with respect to provisions purporting to indemnify, release, exculpate, hold harmless or exempt any person or entity from liability for [gross] negligence, willful misconduct, intentional harm, criminal violations or other wrongdoing or strict product liability or for any liabilities arising under securities laws.33
Comments
Jurisdictions vary in the enforceability of indemnification and exculpation provisions where the effect of the indemnity or exculpation is to shield a party from the consequences of its own actions. In the case of intentional conduct, such as willful misconduct, violations of law, and other wrongdoings, as well as in the case of gross negligence, these types of provisions are generally unenforceable and an exception from a remedies opinion is regularly taken. In the case of ordinary negligence, courts in many states often enforce indemnification clauses, though some states impose requirements for enforceability that opinion givers may be reluctant to address.34
In states that permit indemnification or exculpation as to a party’s own ordinary negligence, the exclusion from the opinion may be limited to “gross” negligence, hence the inclusion of the bracketed reference to “gross” in the sample qualification set out above. Some states, however, permit an agreement to indemnify or exculpate a party for its own ordinary negligence only if that agreement is stated expressly or conspicuously or in some special way; and opinion practice varies as to whether opinion givers will opine on the satisfaction of these types of express negligence rules, and, in some instances, a broader qualification on the subject is taken.35 On a separate point, indemnification and exculpation with respect to securities law liabilities are also generally carved out from the opinion in light of the uncertainty of the enforceability of such provisions under both federal and state law.
Many loan documents also contain exculpation provisions exempting lenders from liability for various types of damages that are neither actual nor direct, such as special, indirect, consequential, or punitive damages. Sometimes these provisions state that the lenders shall in no event be liable for such damages. Sometimes they are couched, instead, as the borrower’s waiver of the right to assert a claim for these types of damages. In either case, opinion givers commonly do not express opinions about the enforceability of these types of exculpation provisions.36
5. Jurisdiction or Venue of Courts; Service of Process
Sample Qualification:
We express no opinion with respect to any provisions relating to the jurisdiction or venue of courts or service of process.
Comments
Commercial contracts frequently contain provisions pursuant to which the parties agree to litigate disputes relating to the contracts in the courts of specified jurisdictions. Some of these provisions are permissive, allowing the parties to bring an action in the chosen jurisdiction or elsewhere, while others are mandatory and require that suit be brought only in the chosen jurisdiction. These provisions are also sometimes accompanied by clauses pursuant to which the parties submit to the jurisdiction of the specified courts,37 waive the doctrine of forum non conveniens and other objections to the venue of chosen courts, and agree to one or more methods of service of process in actions brought in the chosen courts. Provisions relating to submission to jurisdiction are often referred to as forum selection clauses,38 although some authorities use other descriptive terms.39 In this article, unless otherwise required by the context, these provisions will be referred to as “forum selection clauses.” As discussed in greater detail below, except where there is clear statutory authority, opinion givers commonly do not opine on forum selection clauses and the agreements and waivers ancillary thereto. By referring to “provisions relating to the jurisdiction or venue of courts or service of process,” the sample qualification set forth above is intended to be broad enough to cover forum selection clauses and any such ancillary agreements and waivers, although the sample language is only one of many possible formulations of such a qualification.40
The enforceability of a forum selection clause generally turns on such factors as whether the clause is permissive or mandatory, whether the selection is accompanied by a waiver of the doctrine of forum non conveniens (either expressly or impliedly), and whether the chosen jurisdiction has subject matter jurisdiction. Historically, most states have taken the position that, whatever the agreement might specify, courts should be free to determine for themselves whether to accept cases brought before them based on such factors as the sufficiency of contacts, the burden on the court, convenience, and the availability of other forums.41 The sample qualification set out above reflects this historical concept that courts have generally reserved to themselves the power to accept or reject cases for a variety of reasons, notwithstanding the agreement of the parties.42 While some states have adopted a more modern view in cases involving contractual forum selection clauses, sufficient uncertainty remains in some states such that opinion recipients in those states commonly accept the kind of broad qualification set out in the sample above.43
More recently, in recognition of the right of parties to order their affairs by contract, some states, including California, Delaware, Illinois, and New York, have enacted very generous forum selection statutes that validate the enforceability of most inbound forum selection clauses in large commercial transactions. Under this type of state statute, a forum selection clause choosing courts in that state will be upheld so long as the clause is in a contract that satisfies the specified statutory conditions and that also selects the law of such state to govern the contract.44 Texas, in contrast, has adopted a somewhat different type of statute that honors both inbound and outbound forum selection clauses in some circumstances.45 While these statutes make it easier for opinion givers to render enforceability opinions on forum selection clauses covered by the statutes, it is common, given the uncertainty of the enforceability of forum selection clauses generally and historically, even when rendering an opinion based on these inbound and other statutes, to exclude from the remedies opinion those actions or matters not specifically covered by the statute, such as matters relating to the jurisdiction of federal courts and mandatory (i.e., exclusive) forum choices.46
In addition, with respect to service of process, the states of Illinois and New York permit the parties to a contract, in connection with a party’s inbound submission to jurisdiction pursuant to statute, either to provide in the contract a method for service of process upon such party or its agent or to remain silent in the contract as to service of process, with the state’s service-of-process statute providing a method for service of process.47 Thus, in those states, opinion givers commonly do not take exceptions with respect to service of process relating to inbound forum selection clauses pursuant to statutes of the type discussed above. California permits process to be served in several ways, including in the manner provided by statute for service in California, in the manner provided by law in the place where service is effected (in the case of foreign jurisdictions, subject to the satisfaction of specified requirements of due process), and by prepaid first class mail with return receipt requested.48 It is very rare that an agreement specifies a manner of service that is not in accordance with applicable statutory provisions, and California opinion givers commonly do not take exceptions with respect to service of process.
Delaware also permits parties to a contract in connection with the parties’ inbound submission to jurisdiction pursuant to Delaware’s choice-of-law statute49to provide in the agreement a method of service of process. Alternatively, the requirements of the Delaware statute will be satisfied, and the parties’ inbound submission to jurisdiction will be effective, if each party can otherwise be served with legal process in connection with an action in a Delaware court. Any Delaware entity or non-Delaware entity qualified to transact business in Delaware can be served with legal process through its registered agent. However, non-Delaware entities that are not qualified to do business in Delaware (and non-resident persons) may not be subject to service of process absent appropriate provision in the agreement for such service. Consequently, in Delaware, agreements generally provide for service of process, usually by certified or registered mail with return receipt requested. When agreements contain such a provision, opinion givers will generally not take a qualification. However, absent such a provision, opinion givers will commonly take an exception with respect to inbound forum selection clauses relating to non-Delaware entities (or individuals who are not Delaware residents).
In the case of service-of-process agreements relating to outbound proceedings not covered by the types of inbound statutes described above, opinion givers in California, Delaware, Illinois, and New York commonly exclude such agreements from the coverage of the remedies opinion. In other jurisdictions, including Florida, North Carolina, and Texas, opinion givers commonly do not opine on either inbound or outbound contractual service of process agreements. For these reasons, service of process is included in the sample qualification set out above.
6. Jury Trial Waivers
Sample Qualification:
We express no opinion with respect to waivers of the right to trial by jury.
Comments
While many jurisdictions permit the waiver of the right to trial by jury in advance in commercial contracts, this result is not universal. Even in jurisdictions that generally sustain such waivers, the case authority is often ambiguous and the effectiveness of such waivers is often conditioned on matters as to which opinion givers are not generally expected to opine. Accordingly, jury trial waivers are commonly excluded from the scope of the remedies opinion.
In some jurisdictions, such as California and North Carolina, all predispute contractual jury trial waivers are simply unenforceable,50 and remedies opinions given under those states’ laws can be expected to include an exception, similar to the sample qualification set out above, as to any waiver of jury trial included in the transaction documents.
In many states, however, jury trial waivers are not flatly prohibited. Rather, their enforceability is conditioned on factual matters that may be easily satisfied as a business matter, but which opinion givers may not expect to address in a legal opinion, such as whether the waiver is expressed in a conspicuous manner, or is knowingly granted. Whether opinion givers in such a jurisdiction include an exception for jury trial waivers in transaction documents will turn on their willingness to address these types of factual matters, as well as on how clearly and consistently the courts in that jurisdiction have defined and applied the relevant conditions to enforceability.
Sometimes opinion givers are comfortable addressing the satisfaction of these conditions and take no qualification as to jury trial waivers.51 In New York, for example, where courts have upheld mutual jury waiver provisions that are clear and not obscurely placed in an agreement between parties represented by counsel,52 opinion givers commonly consider the satisfaction of these factual conditions to be legally determinable and so avoid opinion exceptions for mutual jury waiver agreements that effectively choose New York law.53
In many instances, however, opinion givers are reluctant or unwilling to address the satisfaction of these types of conditions other than by a complete exclusion from the enforceability opinion. In these instances, even though the jury trial waivers in the agreements are not unenforceable on their face, opinion givers will nonetheless commonly take a complete exception such as the sample qualification set out above and (for one or more of the reasons set out in the introduction to this article) opinion recipients commonly accept this type of broad qualification.54 Sometimes, when these types of conditions to the enforceability of a jury trial waiver apply, opinion givers will take a narrower exclusion from the opinion, thereby giving a somewhat limited opinion on the subject, by opining on the waiver only to the extent that certain stated legal requirements have been met.55 An example of such a qualification might be: “We express no opinion as to the enforceability of any waiver of the right to trial by jury except to the extent it is determined to be [unambiguous, knowing and conspicuous] [with the specified conditions varying to reflect state specific requirements].” Under this type of qualification the opinion giver is advising the recipient as to the requirements that must be satisfied for the jury trial waiver to be given effect.
7. Receivers (Appointment of )
Sample Qualification:
We express no opinion with respect to any provision providing for the appointment of a receiver.
Comments
If an agreement provides for the appointment of a receiver, a qualification such as the one set out above is commonly taken. Generally, the decision to appoint a receiver is a matter reserved to the discretion of the court before which the request for such an appointment is being heard, and, accordingly, most courts do not consider themselves bound by such agreements.
8. Setoff
Sample Qualification:
We express no opinion with respect to any provision relating to any right of setoff.
Comments
Under applicable common law in most jurisdictions, the setoff of mutual and matured debts is enforceable, with the result that a bank may generally set off funds in a depositor’s account against matured debts owed by the depositor to the bank. Many credit agreements, however, seek to expand the common law rule by contract, providing that a lender or lender affiliate may, upon the occurrence of an event of default, set off against obligations of the borrower under the credit agreement, or any of the borrower’s affiliates, any deposits at any time held and other indebtedness at any time owing by such lender or lender affiliate to or for the credit of the borrower or any of its affiliates, whether matured or unmatured. In some jurisdictions, such as California and Illinois, prevailing principles of freedom of contract seem not to preclude many of these types of contractual setoff rights, and some opinion givers in those jurisdictions will not take the kind of broad qualification as to setoff set out above, or even any qualification at all, in reliance on available case law.56 Even in these states, however, many practitioners commonly do take a broad exception from their opinions for these types of provisions, partly because of the potential for inequity inherent in the breadth of such setoff provisions, partly because the applicable law in their respective jurisdictions is not definitive,57 and partly for some of the other reasons discussed in the introduction to this article. Some bar reports, due to the absence of clear authority in their respective jurisdictions, have recommended a broad qualification similar to the following: “We express no opinion as to provisions that purport to create rights of setoff otherwise than in accordance with applicable law.”58
While there is clearer support under applicable New York law for contractual setoff clauses, a notice requirement does apply.59 Accordingly, where no notice of setoff is provided in the agreement, New York lawyers may phrase the qualification more narrowly, as, for example: “We express no opinion with respect to section __ of the agreement to the extent that such section permits setoff to be made without notice.”
9. Statute-of-Limitations Waivers
Sample Qualification:
We express no opinion as to any waiver of any statute of limitations.
Comments
Many jurisdictions limit or restrict waivers of statutes of limitations. For example, Delaware, New York, and Texas limit the enforceability of an agreement to waive or not to plead the statute of limitations to an expressly made undertaking of reasonable duration pertaining to disputes or claims existing at the time such waiver is made.60 Other states, such as California, impose statutory restrictions on waivers of the statute of limitations.61 Opinion givers in each of the jurisdictions discussed above commonly take a broad qualification, such as the sample set out above, so as to carve out any opinion as to the enforceability of waivers of statutes of limitations.62
A related issue may arise when provisions of an agreement indirectly have the effect of extending a statute of limitations. In 2014, the Delaware legislature amended section 8106 of title 10 of the Delaware Code to permit the parties to a contract involving at least $100,000 to bring an action based on the contract within a period specified in the contract provided it is brought prior to the expiration of twenty years from the accruing of such cause of action.63 Prior to the amendment to section 8106, Delaware law did not permit the extension of the statute of limitations by contract,64 though, as noted above, it could be waived under circumstances where the claim had already accrued.65 Under both prior and current law, the Delaware statute of limitations can be contractually shortened.66 In contrast to Delaware law, a Massachusetts court recently held that a contract provision not permitting a reasonable period to discover a breach is not enforceable in that state.67
An unenforceable alteration of the statute of limitations may occur in ways that are not immediately obvious. Under Delaware law, for example, a claim for breach of representations or warranties can accrue at closing. Thus, in the event a borrower were to breach its representations or warranties at the closing of a term loan, a provision in the loan agreement obligating the borrower to indemnify the lender for losses arising from such a breach for more than the applicable statute of limitations could constitute an impermissible attempt to extend the statute of limitations by contract, absent a basis for tolling of the statute.68 Given the amendment to section 8106, this may no longer be a practical problem in Delaware; however, it may still be of issue in other states that have shorter statutes of limitations and that analyze the issue the way the Delaware courts have.
Given the foregoing, opinion givers sometimes include a qualification in an enforceability opinion as to any provision that could be construed as an unenforceable modification of the applicable statute of limitations.
10. Transfer-of-Property Restrictions
Sample Qualification:
We express no opinion with respect to the enforceability of any provision of the agreement that unreasonably restricts the ability of any person to transfer any property or that purports to render void or of no force or effect any transfers of property in breach of the terms of the agreement.
Comments
This qualification relates to agreements that contain broad, unusual, or unqualified restrictions on transfer that may rise to the level of unreasonable restraints on alienation. The qualification is not, therefore, usually needed in a typical commercial loan transaction. For example, opinion givers typically do not need to take this kind of qualification as to a typical negative pledge covenant, negative sale, or other disposition covenant contained in a credit agreement with typical exceptions (such as those frequently contained in standard forms of credit agreements). Sometimes, however, collateral documents or other ancillary loan documents may contain more sweeping or unusual restrictions on transfer.
When the covered agreement goes even further than prohibiting transfer by purporting to render the prohibited transfer void or of no force or effect, some opinion givers also choose to state expressly, as in the example set out above, that they express no opinion as to the enforceability of any provision of the agreement “that purports to render void or of no force or effect any transfers of property in breach of the terms of the agreement.”69
In general, a transfer restriction will be enforced unless it is found to be unreasonable. A typical test for determining the reasonableness of a restriction is by the court’s examining “whether the provision is sufficiently necessary to the particular corporate enterprise to justify overruling the usual policy [against restraints on the alienability of personal property].”70 Although questions of reasonableness are generally questions of fact, case law does provide guidance with respect to some kinds of transfers. For example, in a case where the corporation was a brokerage house member of the New York Stock Exchange, a provision in the corporation’s articles of incorporation requiring a shareholder intending to transfer his stock first to seek the approval of the New York Stock Exchange was found by a Texas court not to be “arbitrary, capricious and unreasonable.”71 The common law rule prohibiting unreasonable restraints on alienation has also been applied to rights of first refusal, although a right of first refusal, depending on its terms, may be found reasonable and thus a permissible restriction on transfer. For example, restrictions requiring selling shareholders to notify other shareholders (who have a right to purchase the shares) of the selling shareholders’ intent to sell, and the price at which the shares are offered, have been held reasonable when the time period during which the shares are to be offered to other shareholders is short.72
Alternatively, if an option to buy another’s stock or other property were to have no time limit, specify a purchase price highly disproportionate to the market price, and serve no reasonable commercial purpose, such an option could well be an unreasonable restraint on alienation and if so, would be unenforceable in many jurisdictions.73
It should also be noted that there is an extensive body of case law regarding restraints on alienation in the context of real property. Further, the Uniform Commercial Code contains provisions that invalidate certain anti-assignment provisions regarding specific types of personal property.74
11. Usury, Liquidated Damages, and Penalty Clauses
Sample Qualification:
We express no opinion with respect to provisions providing for forfeitures or liquidated damages, and we also express no opinion as to any other remedies to the extent such other remedies are deemed to constitute penalties. [A state-specific usury qualification would be included where applicable.]
Comments
As confirmed in many bar reports on third-party legal opinion practice, an enforceability opinion rendered in a commercial loan transaction covers matters relating to usury, as well as other laws governing charges for the use, forbearance, or detention of money, unless the opinion giver expressly disclaims an opinion as to such matters.75 A number of states have generous usury statutes that exempt commercial transactions over a certain size (and that satisfy certain other statutory requirements) from civil and criminal usury regulation.76 In these jurisdictions, usury qualifications are typically not required in remedies opinions on commercial extensions of credit meeting the applicable statutory requirements. Other states, such as California, Florida, and Texas, have complicated usury laws (and extensive case law interpreting those laws) that may require state-specific provisions in the credit documents, as well as assumptions, exceptions, or qualifications to a remedies opinion addressing their enforceability.77 It is beyond the scope of this article to try to characterize all of the various state-specific usury requirements and related opinion qualifications that are commonly given and received, which is why the authors have not included a sample qualification relating to usury in the sample language set out above.
However, in many states, including those with very generous usury statutes, other laws related to liquidated damages and similar types of damages resolution may require qualification of the remedies opinion if the agreement provides for charges of this nature. The enforceability of these types of clauses usually turns on their “reasonableness,” a matter as to which opinion givers generally are unwilling to opine. Opinion givers commonly qualify the opinion accordingly, unless the opinion giver concludes either that such a qualification is implicit and need not be expressly stated or that the economic remedy at issue is reasonable under the law of the jurisdiction whose law is covered by the opinion.78
In some states, acceleration of future amounts due (other than principal) without appropriate discount to present value, late charges, prepayment charges, make whole premiums, and default interest are specifically subject to a reasonableness standard—again, a matter as to which opinion givers commonly are unwilling to opine. In these states, the sample qualification set out above may be expanded to take account of any of these matters provided for in the covered agreement.79
C. QUALIFICATIONS RELATING TO FEDERAL LAW AND INTERNATIONAL MATTERS
We express no opinion with respect to the USA Patriot Act of 2001 or any laws relating to foreign assets control or any rules, regulations or orders relating to any of the foregoing.
Comments
Some credit agreements contain covenants relating to the Patriot Act, such as:
Each Lender and the Agent (for itself and not on behalf of any Lender) hereby notifies the Borrower that pursuant to the requirements of the Patriot Act, it is required to obtain, verify and record information that identifies the Borrower, which information includes the name and address of the Borrower and other information that will allow such Lender or the Agent, as applicable, to identify the Borrower in accordance with the Patriot Act. The Borrower shall, and shall cause each of its Subsidiaries to, provide such information and take such actions as are reasonably requested by the Agent or any Lender in order to assist the Agent or such Lender in maintaining compliance with the Patriot Act.
Some lawyers are concerned about the enforceability of broad covenants, such as the example set out above, relating to the Patriot Act. They are concerned that such broad covenants, like the last sentence contained in the sample covenant set out above, might be too indefinite to be enforced by a court. They are also concerned that a transaction might violate the Patriot Act if the transaction is funded with funds from any one of a number of specified unlawful activities when the borrower has a certain kind of knowledge about those funds. Other opinion givers do not believe it is necessary to take a Patriot Act qualification because opinion givers commonly assume, without expressly so stating, the absence of fraud or criminal activities, unless the opinion giver has knowledge or notice to the contrary.81
2. Comity
Sample Qualification:
Our opinions are subject to possible judicial action giving effect to governmental actions or foreign laws affecting creditors’ rights and remedies.
Comments
This qualification applies only in transactions in which one or more of the relevant parties is, or is controlled by, a non-U.S. person. This comity exception covers two types of legal qualifications: (1) In Allied Bank International v. Banco Credito Agricola de Cartago,82 the U.S. Court of Appeals for the Second Circuit indicated in dicta that in appropriate circumstances (not present in the Allied Bank case) “comity” to the governmental actions or laws of another country could justify a declination by a U.S. court to hear an otherwise appropriate U.S. claim against such foreign country or a national thereof; and (2) the President of the United States has powers under the Trading with the Enemy Act83 and the International Emergency Economic Powers Act84 in national emergencies to regulate or prohibit (a) transactions involving property in which a foreign country or a national thereof has an interest and (b) foreign exchange transactions and transfers of credit or payments involving a banking institution.
3. Sovereign Immunity Waivers
Sample Qualification:
To the extent that the borrower is now an agency or instrumentality of a foreign state that is entitled to immunity from jurisdiction of any court or from legal process with respect to itself or its property, any waiver by the borrower of such immunity is subject to the limitations imposed by the United States Foreign Sovereign Immunities Act of 1976. Further, we express no opinion as to the enforceability of any such waiver if the borrower is not now such an agency or instrumentality, but becomes one at some time in the future.
Comments
This qualification relates to two concerns relating to a waiver of sovereign immunities under a credit agreement or other document: (i) the limitations on such a waiver under the United States Foreign Sovereign Immunities Act of 1976, as amended ( “FSI Act”),85 and (ii) the uncertainty of a waiver of sovereign immunities by an entity that is not, at the time of execution and delivery of such agreement or document, an agency or instrumentality of a foreign state, but that does become such an agency or instrumentality thereafter.
Regarding the limitations on a waiver of sovereign immunities under the FSI Act, the Act initially grants to a “foreign state” (which term includes a political subdivision of a foreign state and an agency or instrumentality of a foreign state) a general immunity from “the jurisdiction of the courts of the United States and of the States.”86 The Act then provides that a foreign state will not have such immunity in any case, among others, in which the foreign state “has waived its immunity either explicitly or by implication.”87 However, the Act provides that a foreign state (other than an agency or instrumentality) will not be liable for punitive damages.88 In addition, the Act prescribes how service in such courts shall be made, and allows the parties to provide for service “in accordance with a special arrangement for service between the plaintiff and the foreign state.”89
The FSI Act also grants to a foreign state a general immunity “from attachment, arrest and execution.”90 The Act then provides for a foreign state to waive (i) its immunity from attachment in aid of execution or from execution, either explicitly or by implication, but only with respect to “property in the United States of a foreign state . . . used for a commercial activity in the United States” and (ii) its immunity from attachment prior to the entry of judgment explicitly and only with respect to “property of a foreign state . . . used for a commercial activity in the United States” and only if the purpose of the attachment is to secure satisfaction of a judgment and not to obtain jurisdiction.91
Finally, the FSI Act provides that certain property of a foreign state is absolutely immune from attachment and from execution: (i) property of a foreign central bank or monetary authority, unless such bank or authority, or its parent foreign government, has explicitly waived its immunity from attachment in aid of execution or from execution and (ii) property used, or intended to be used, in connection with a military authority and of a military character or under the control of a military authority or defense agency.92
Regarding the uncertainty of a waiver of sovereign immunities by an entity that is not, at the time of execution and delivery of the credit agreement or other document, an agency or instrumentality of a foreign state, it is not clear that, if, as and when such entity thereafter becomes such an agency or instrumentality, the entity’s earlier waiver, when such entity was not such an agency or instrumentality, will be given effect by a court.
4. Judgment Currency
Sample Qualification:
Although the agreement provides for obligations of the borrower denominated in [a] currenc[y] [ies] other than United States dollars, we express no opinion as to whether a court would award a judgment in a currency other than United States dollars or as to any rate of exchange that might be applied.
Comments
This qualification applies if the agreement creates or provides for obligations in a currency other than United States dollars (“foreign currency”). The traditional rule in the United States for courts to render judgments on an obligation in a foreign currency is the so-called “home-currency rule,” which requires that all awards be denominated in U.S. dollars.93 Under this rule the question becomes: On what date should the court convert a foreign currency obligation into U.S. dollars? Courts have commonly used one of three dates: (1) the date of the breach of the foreign currency obligation (the “Breach-Day Rule”), (2) the date of the court judgment on the foreign currency obligation (the “Judgment-Day Rule”), or (3) the date of the payment by the debtor of such court judgment (the “Payment-Day Rule”).94 Various courts use various of these rules, although U.S. federal courts have often used the Judgment-Day Rule.95
The State of New York, taking a somewhat different approach, amended its laws in 1987 to provide expressly, for the first time, that judgments on a foreign currency obligation are to be rendered in the currency of the obligation; however, the amendment goes on to require the conversion of any such foreign currency judgment into U.S. dollars using the Judgment-Day Rule.96 Thus, a New York lawyer might express a New York currency exception this way:
We point out, with reference to obligations stated to be payable in a currency other than U.S. dollars, that (i) a New York statute provides that a judgment rendered by a court of the State of New York in respect of an obligation denominated in any such other currency is to be rendered in such other currency but is then to be converted into U.S. dollars at the rate of exchange prevailing on the date of entry of the judgment and (ii) a judgment rendered by a federal court sitting in the State of New York in respect of an obligation denominated in any such other currency will be expressed in U.S. dollars, but we express no opinion as to the date of the rate of exchange such federal court will apply. Further with respect to both a New York State court or a federal court, we express no opinion as to any rate of exchange that might be applied.
Starting in 1989, numerous states have adopted the Uniform Foreign-Money Claims Act97 (“UFMCA”) in substantial part. The UFMCA requires a court judgment on a foreign currency obligation to be rendered in the foreign currency of the obligation, but then gives the debtor the option to make payment on the judgment in U.S. dollars using the Payment-Day Rule.98 Thus, an example of an opinion qualification under the UFMCA might be:
We point out, with reference to obligations stated to be payable in a currency other than U.S. Dollars, that (i) pursuant to the [State] Uniform Foreign-Money Claims Act (the “UFMCA”), a judgment on any claim in any foreign currency entered by a [State] court is to be stated in an amount of such foreign currency, except that assessed costs are to be entered in United States dollars, and such judgment is then payable, at the option of the debtor, in either the foreign currency of such claim or in the amount of United States dollars that will purchase that foreign currency on the “conversion date” at a “bank offered spot rate” (as each such term is defined in the UFMCA), and (ii) we express no opinion as to whether a federal court sitting in [the State] will award a judgment in a currency other than United States dollars or as to any rate of exchange that may apply.
There are other issues relating to a court judgment on a foreign currency obligation. What is the exact exchange rate? New York Judiciary Law section 27(b) does not say. The UFMCA says that, if the debtor elects to pay the foreign currency judgment in U.S. dollars, the exchange rate will be “the spot rate of exchange at which a bank will sell foreign money at a spot rate.”99 But what bank to choose? And at what time of day? A possible solution to such questions is given by the UFMCA, which permits the parties to vary the effect of the UFMCA “by agreement of the parties made before or after commencement of an action or distribution proceeding or the entry of judgment.”100 And, finally, for purposes of the U.S. federal courts, are the state currency choice rules substantive or procedural—or so important that currency choice rules warrant the development of controlling federal common law?101
5. Currency Indemnity
Sample Qualification:
We express no opinion with respect to the enforceability of any indemnity against loss in converting into a specified currency the proceeds or amount of a court judgment in another currency.
Comments
This qualification applies if the agreement contains a currency indemnity clause. A currency indemnity clause relates to the desire of a lender of a foreign currency to get repaid in the currency and in the aggregate amount that the lender lent. However, as we have seen in the foregoing part of this article concerning the judgment currency exception, if the borrower fails to repay a foreign currency loan and the lender brings an action against the borrower to collect the loan in a court in the United States, such court may render a judgment in favor of the lender in an amount in U.S. dollars that, when paid and converted into the foreign currency, does not repay in full the loan in the foreign currency. In an effort to protect themselves against this risk, lenders frequently include in their credit agreements a currency indemnity clause. In its typical form, this clause will provide that a borrower’s obligation under the credit agreement may be discharged by the payment of a currency other than the foreign currency only to the extent that the lender may, following receipt of such payment, purchase therewith an amount of the foreign currency equal to the full amount of the foreign currency loans. The credit agreement then commonly provides that, to the extent the amount so purchased falls short of the foreign currency amount originally due to the lender, the amount of the shortfall is due and payable by the borrower to the lender as a “separate and independent” obligation.
It is not clear, however, that a federal or state court in the United States would enforce such a “separate and independent” obligation. In the United States, the judicial doctrine of “merger” provides that a plaintiff ’s original claim under a contract will be extinguished at the time the plaintiff obtains a final judgment on the contract from a court, and the plaintiff ’s rights under the judgment are then substituted for the original contractual claim. The original claim is thus said to be merged in the judgment.102 To the extent that a currency indemnity clause purports to create a separate and independent claim under an agreement after a judgment has been rendered on the agreement, such an indemnity clause may raise an enforceability concern in light of the doctrine of “merger.”103
* * *
CONCLUSION
The authors hope the foregoing discussion will help both opinion givers and opinion recipients when considering third-party opinions to be rendered in the context of U.S.-based commercial loan transactions. While the experiences of the authors are likely to differ from those of some readers, the authors believe that this article reflects the widespread experience of many lawyers in the states in which they practice. Since there are other common qualifications often seen but not addressed in this article, and since opinion practice does change over time, we recognize there is still much more work to be done on this subject.
_____________
1. The authors of this article are Gail Merel (Reporter), of counsel at Andrews Kurth LLP in Houston and a member of the New York and Texas bars; A. Mark Adcock, a partner at Moore & Van Allen PLLC in Charlotte and a member of the North Carolina bar; Robert W. Barron, a partner at Berger Singerman LLP in Ft. Lauderdale and a member of the Florida bar; Willis R. Buck, Jr., a partner at Sidley Austin LLP in Chicago and a member of the Illinois bar; Jerome A. Grossman, senior counsel at Gresham, Savage, Nolan & Tilden, PC in San Diego and a member of the California bar; Louis G. Hering, a partner at Morris, Nichols, Arsht & Tunnell LLP in Wilmington and a member of the Delaware bar; Timothy G. Hoxie, a partner at Jones Day in San Francisco and a member of the California bar; Andrew M. Kaufman, of counsel at Kirkland & Ellis LLP in Chicago and a member of the Illinois and New York bars; Reade H. Ryan, Jr., of counsel at Shearman & Sterling LLP in New York City and a member of the New York bar; Philip B. Schwartz, a partner at Akerman LLP in Miami and a member of the Florida bar; and Stephen C. Tarry, a partner at Vinson & Elkins LLP in Houston and a member of the New York and Texas bars.
This article arose out of discussions that took place at meetings of the Working Group on Legal Opinions (“WGLO”), but this article reflects only the views of its authors and has not been submitted for approval to WGLO or to any bar association or other organization. Further, this article does not necessarily reflect the views of the law firms with which the authors are associated or modify the positions taken on subjects covered in this article in various bar association reports promulgated by committees on which any of the authors has served.
2. While the focus of this article is on exceptions and other qualifications commonly accepted in opinion letters in the context of U.S. commercial loan transactions, the authors believe the citations and other information provided will assist both opinion givers and recipients in other types of transactions as well.
4. The authors recognize that some opinion qualifications are understood to be implicit even if not expressly stated in the opinion letter. See, e.g., infra note 11. However, a discussion of which qualifications may be recognized as implicit, and the extent of that recognition, is beyond the scope of this article, which addresses certain qualifications commonly stated expressly in opinion letters.
5. For example, in the experience of the authors, inclusion in an agreement of language qualifying a particular provision with words such as “to the extent permitted by applicable law” sometimes suffices to satisfy an opinion giver that a qualification to the remedies opinion for that particular provision is unnecessary.
6. For purposes of this article, the authors have approached the use of opinion qualifications on an exception-by-exception basis, with each qualification being targeted to a particular type of provision. Some opinion givers include a generic qualification in their opinion letters in addition to or in lieu of targeted qualifications tailored to the specific provisions of a covered agreement. Two commonly used formulations of the generic qualification are the material breach qualification and the practical realization qualification. Other opinion givers use other types of generally stated qualifications, and some opinion givers include in their opinion letters extensive lists of qualifications that are not necessarily related to the provisions of the covered agreement (the so-called laundry list or kitchen sink approach). This article takes no position on the appropriateness or inappropriateness of any of these types of other qualifications or approaches.
7. In fact, a review of opinions delivered and accepted by experienced practitioners in the U.S. commercial loan context in the same jurisdiction is likely to show variation in the qualifications that are actually taken. As the footnotes in this article indicate, for example, some opinion givers in some jurisdictions usually take a qualification for a jury waiver clause while others do not. One will also find variation in how the qualifications are phrased, with some practitioners in some cases taking, for example, a narrower qualification than do others. Such differences suggest that the qualifications described in this article, though often taken for the cost-benefit and other reasons described above, remain variable and contextual.
8. Statement on the Role of Customary Practice in the Preparation and Understanding of Third-Party Legal Opinions, 63 BUS. LAW. 1277 (2008). As of its 2008 publication date, this statement was approved by twenty-eight bar groups from around the country, and it has since been approved by a number of other such groups.
9. ABA Bus. Law Section Legal Opinions Comm., Guidelines for the Preparation of Closing Opinions, 57 BUS. LAW. 875, 876, 878 (2002) (§§ 1.3, 1.4 & 3.1) [hereinafter Closing Opinion Guidelines].
10. The Business Law Section of the California State Bar concluded that various commonly used formulations of the bankruptcy exception should not be understood to have different meanings. STATE BAR OF CAL. BUS. LAW SECTION, REPORT ON THIRD-PARTY REMEDIES OPINIONS app. 10, at 5 (2004 & 2007 update) (Exceptions Subcommittee Report) [hereinafter 2007 CALIFORNIA REMEDIES REPORT EXCEPTIONS APPENDIX], available athttp://apps.americanbar.org/buslaw/tribar/materials/20120820000005.pdf. Accordingly, while the bankruptcy exception set out above is stated somewhat differently in the Sample California Third-Party Legal Opinion for Business Transactions, published by the Business Law Section of the California State Bar, this formulation should be an acceptable alternative form of bankruptcy exception for California opinion givers. STATE BAR OF CAL. BUS. LAW SECTION, SAMPLE CALIFORNIA THIRD-PARTY LEGAL OPINION FOR BUSINESS TRANSACTIONS 16 (2010 & rev. 2014) [hereinafter CALIFORNIA SAMPLE OPINION], available athttp://apps.americanbar.org/buslaw/tribar/ (in the California section under the heading “State and Other Bar Reports”).
The authors from Florida believe that the above formulation of the bankruptcy exception and the meaning of this qualification are consistent with the position on this qualification taken in the Report on Third-Party Legal Opinion Customary Practice in Florida, and such formulation should be an acceptable alternative form of bankruptcy exception for Florida opinion givers. LEGAL OPINION STANDARDS COMM., BUS. LAW SECTION, FLA. BAR & LEGAL OPINIONS COMM., REAL PROP., PROBATE & TRUST LAW SECTION, THIRD-PARTY LEGAL OPINION CUSTOMARY PRACTICE IN FLORIDA 98–100 (2011) [hereinafter FLORIDA REPORT], available athttp://www.flabizlaw.org/images/pdf/thirdpartylegalopinions120311.pdf.
11. See TriBar Opinion Comm., Third-Party “Closing” Opinions: A Report of The TriBar Opinion Committee, 53 BUS. LAW. 592, 623 (§ 3.3.1) (1998) [hereinafter 1998 TriBar Report], available athttp://apps.americanbar.org/buslaw/tribar/materials/20050303000003.pdf (“These qualifications are understood to be applicable to the remedies opinion even if they are not expressly stated.”); see also 2007 CALIFORNIA REMEDIES REPORT EXCEPTIONS APPENDIX, supra note 10, at 1 (“The bankruptcy exception and the equitable principles limitation . . . should be understood to be included in every remedies opinion, regardless of whether they are expressly stated.”); FLORIDA REPORT, supra note 10, at 99 (“The bankruptcy exception and the equitable principles limitation are implicit qualifications to every remedies opinion rendered by Florida counsel.”).
12. See 1998 TriBar Report, supra note 11, at 623 (§ 3.3.2). In the view of the authors, this exception also excludes from the scope of the opinion the effect of the orderly liquidation authority provisions of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, tit. II, §§ 201−217, 124 Stat. 1376, 1442−1520 (2010) (codified at 12 U.S.C. §§ 5381– 5394 (2012)).
14. See 1998 TriBar Report, supra note 11, at 625 (§ 3.3.4).
15. As with the bankruptcy exception, the California Opinions Committee has concluded that various common formulations of the equitable principles qualification adequately encompass what should commonly be understood to be included within that qualification. 2007 CALIFORNIA REMEDIES REPORT EXCEPTIONS APPENDIX, supra note 10, app. 10, at 9. Accordingly, while the equitable principles qualification set out above is stated somewhat differently in the California Sample Opinion, the formulation set out above should be an acceptable alternative form of qualification for California opinion givers. See CALIFORNIA SAMPLE OPINION, supra note 10, at 16. The authors from Florida believe that the above formulation of the equitable principles qualification and the meaning of this qualification are consistent with the position on this qualification taken in the Florida Report, and such formulation should be an acceptable alternative form of qualification. FLORIDA REPORT, supra note 10, at 100.
16. The 1998 TriBar Report provides that “as a matter of customary usage the remedies opinion is understood not to address the enforceability of . . . rules” of the applicable arbitral tribunal. See 1998 TriBar Report, supra note 11, at 631 (§ 3.6.2). For a discussion of the issues that arise in rendering enforceability opinions on arbitration clauses, see DONALD W. GLAZER ET AL., GLAZER AND FITZGIBBON ON LEGAL OPINIONS: DRAFTING, INTERPRETING, AND SUPPORTING CLOSING OPINIONS IN BUSINESS TRANSACTIONS 383– 86 (3d ed. 2008 & Supp. 2013). In those instances where opinion givers agree to cover the enforceability of arbitration provisions, they may find helpful the recent U.S. Supreme Court cases of American Express Co. v. Italian Colors Restaurant, 133 S. Ct. 2304 (2013) and AT&T Mobility v. Concepcion, 563 U.S. 321 (2011), each upholding arbitration agreements to which the Federal Arbitration Act applies.
17. See ABA Bus. Law Section Comm. on Legal Opinions, Legal Opinion Principles, 53 BUS. LAW. 831, 832 (1998) (§ II.D); Closing Opinion Guidelines, supra note 9, at 876 (§ 1.4).
18. Many opinion givers, when rendering opinions on choices of law that are clearly authorized by statute, will render such opinions without qualification and without including any express reference (such as the one set out in the text above) to the statute on which they are relying.
19. RESTATEMENT (SECOND) OF CONFLICT OF LAWS § 187 (1971) [hereinafter RESTATEMENT].
20. The bracketed language relates to the reasonable relationship standard established under Restatement § 187(2), quoted below in this note. Sometimes opinion givers, rather than assuming or specifying the contacts on which the opinion is based, simply assume the existence of a reasonable relationship of the parties or the transaction to the chosen jurisdiction.
The rule of the Restatement set out in § 187 is as follows:
§ 187. LAW OF THE STATE CHOSEN BY THE PARTIES
(1) The law of the state chosen by the parties to govern their contractual rights and duties will be applied if the particular issue is one which the parties could have resolved by an explicit provision in their agreement directed to that issue.
(2) The law of the state chosen by the parties to govern their contractual rights and duties will be applied, even if the particular issue is one which the parties could not have resolved by an explicit provision in their agreement directed to that issue, unless either
(a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties’ choice, or
(b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue and which, under the rule of § 188, would be the state of the applicable law in the absence of an effective choice of law by the parties.
(3) In the absence of a contrary indication of intention, the reference is to the local law of the state of the chosen law.
21. See CALIFORNIA SAMPLE OPINION, supra note 10, at 11 n.23 (uses the word “should” instead of “would” in its sample qualification). As explained in the 1998 TriBar Report, supra note 11, at 607 n.37, “would” and “should” “convey the same professional judgment as to the judicial resolution of the issues covered,” and, consequently, “would” and “should” are “equally appropriate as a matter of customary practice.” Accord Closing Opinion Guidelines, supra note 9, at 879 (§ 3.5); STATE BAR OF CAL. BUS. LAW SECTION, LEGAL OPINIONS IN BUSINESS TRANSACTIONS (EXCLUDING THE REMEDIES OPINION) 19 (2005 & rev. 2007) [hereinafter CALIFORNIA OPINION REPORT (EXCLUDING REMEDIES)] (“Recent reports take the position . . . that there is no difference in meaning between a ‘would hold’ and a ‘should hold’ opinion.”). However, a recent real estate finance opinion report promulgated by the legal opinions committees of the ABA Real Property, Trust and Estate Section, the American College of Real Estate Lawyers, and the American College of Mortgage Attorneys addresses this issue as follows:
Some opinion givers prefer the use of “should” when referring to likely actions of a court; some opinion recipients prefer the use of “would.” Practitioners differ on whether the two words have different meanings in the context of [a choice-of -law] opinion. . . . Moreover, there is authority for the position that such an opinion has the same meaning whether stated as “would” or “should.” . . . Regardless of the choice of words . . . opinions [sic] letters are expressions of professional judgment and not guarantees of particular results.
ABA Section of Real Prop., Trust & Estate Law Comm. on Legal Opinions in Real Estate Transactions et al., Real Estate Finance Opinion Report of 2012, 47 REAL PROP. PROB. & TR. J. 213, 247 n.33 (2012).
The Florida-recommended form of choice of law opinion uses the phrase “more likely than not . . . a Florida court . . . would conclude,” Florida Report, supra note 10, at 174. Further, the Florida Report recommends that such opinion provide that it is “not free from doubt (or words to similar effect)” and that the opinion has the same meaning whether the words “more likely than not” or “should” are used. Id.
22. When used in this article in connection with choice of law, choice of forum, and venue, “inbound” refers to the selection of a state’s law, forum, or venue under that same state’s rules governing such selection, while “outbound” refers to the selection of another state’s or country’s law, forum, or venue under the selection rules of the state governing the selection. For example, the selection of New York law as the governing law under New York’s choice of law rules is an inbound selection, while the choice of Illinois law as the governing law under New York’s choice of law rules is an outbound selection.
23. See, e.g., CAL. CIV. CODE § 1646.5 (West Supp. 2014) (applies whether or not the contract, agreement, undertaking, or transaction in question bears a reasonable relation to California, but does not apply to “any contract, agreement, or undertaking (a) for labor or personal services, (b) relating to any transaction primarily for personal, family, or household purposes, or (c) to the extent provided to the contrary in [CAL. COM. CODE § 1301(c) (West 2012)]”); DEL. CODE ANN. tit. 6, § 2708 (2013); 735 ILL. COMP. STAT. 105/5-5 (2012); N.Y. GEN. OBLIG. LAW § 5-1401 (McKinney 2010). A TriBar report provides that “[i]n states that have adopted the statutory approach, opinion preparers typically have no difficulty concluding that an exception is not required.” Report of the TriBar Opinion Committee: The Remedies Opinion—Deciding When to Include Exceptions and Assumptions, 59 BUS. LAW. 1483, 1496 (2004) [hereinafter 2004 TriBar Report], available athttp://apps.americanbar.org/buslaw/tribar/materials/20050303000002.pdf. It goes on to say that “[i]n states that follow the Restatement approach, the analysis is more complex.” Id. at 1497.
24. Note that the Texas statute—TEX. BUS. & COM. CODE ANN. §§ 271.001–.011 (West 2009 & Supp. 2014)—is somewhat unusual, in that it addresses both inbound and outbound choices of law and requires the same types of reasonable contacts to support both. The statute authorizes, for transactions involving at least $1,000,000 (generally including commercial transactions but expressly excluding certain issues relating to transactions involving real property), the selection of the laws of either Texas or another jurisdiction so long as the transaction bears a reasonable relation to the chosen jurisdiction. Id. §§ 271.001, .005. The statute includes a non-exhaustive list of specific contacts that constitute a “reasonable relationship” for purposes of applying the statute. Id. § 271.004. Accordingly, it is common in Texas for opinion givers to render both inbound choice-of-law opinions on choices of the Covered Law, as well as outbound choice-of-law opinions on choices of the laws of other jurisdictions, provided that, in each case, the transaction falls within one or more of the statutory safe harbors. Texas practitioners are rarely expected to render choice-of-law opinions based on the Restatement and Texas common law when this statute is either inapplicable or does not afford a clear safe harbor.
25. Delaware practitioners generally agree that compliance with the Delaware statute eliminates the requirement that the parties or the transaction have any contacts with the state. However, some Delaware practitioners are of the view that the Delaware statute does not necessarily preempt the fundamental policy aspect of the Restatement test, which is quoted at supra note 20. These practitioners, therefore, will sometimes qualify their opinions using the exception provided in the Restatement sample qualification set forth above in the text.
Florida has an inbound choice-of-law statute, FLA. STAT. § 685.101 (2014), which, subject to certain enumerated exceptions, allows the parties to select Florida law as the governing law in a contract, but only to the extent permitted by the United States Constitution and so long as the transaction in-volves at least $250,000. The statute provides certain exclusions, including exclusions for transactions that bear no substantial or reasonable relation to Florida and transactions where no party to the contract is a resident of Florida, is incorporated in Florida or maintains a place of business in Florida. As a result of these qualifications in the statute, the authors of this article from Florida believe that few third-party legal opinions are rendered by Florida lawyers in reliance on Florida’s inbound choice of law statute.
26. This appears to be the practice, for example, in New York. New York lawyers are generally reluctant to give an outbound choice-of-law opinion because New York courts have applied at least three different choice-of-law rules. Under the majority of New York cases, courts will honor parties’ selection of a non-New York law if the jurisdiction of the chosen law has a “reasonable relationship” to the transaction reflected in the agreement. See A.S. Rampell, Inc. v. Hyster Co., 144 N.E.2d 371, 381 (N.Y. 1957); Culbert v. Rols Capital Co., 585 N.Y.S.2d 67, 68 (App. Div. 1992); Vital Spark Found., Inc. v. N. Am. Globex Fund, L.P., No. 650415, 2013 WL 486517, at *10 (N.Y. Sup. Ct. Jan. 31, 2013); Reger v. Nat’l Ass’n of Bedding Mfrs. Grp. Ins. Trust Fund, 372 N.Y.S.2d 97, 114 (Sup. Ct. 1975). However, the New York Court of Appeals, in Auten v. Auten, 124 N.E.2d 99, 101–02 (N.Y. 1954), also applied the “grouping of contacts” or “center of gravity” test as a choice-of-law rule. Under Auten, the court will apply the substantive law of the jurisdiction “which has the most signif-icant contacts with the matter in dispute.” Id. at 102. Though the agreement in Auten appears not to have had a choice-of-law clause, the New York Court of Appeals in Haag v. Barnes, 175 N.E.2d 441, 443 (N.Y. 1961), applied Auten’s grouping of contacts test to a child-support agreement containing a choice-of-law clause. And courts in New York have also applied a third choice-of-law rule—the “governmental interest” test—in upholding a governing law clause selecting a non-New York law. Under the governmental interest test, the law of the jurisdiction having the most interest in the disputed issue will be applied to a contract. See Zanfardino v. E-Sys., Inc., 652 F. Supp. 637, 639 (S.D.N.Y. 1987) (applying to a contract containing a choice-of-law clause the ruling in Intercontinental Planning, Ltd. v. Daystrom, Inc., 248 N.E.2d 576, 582 (N.Y. 1969)); Indosuez Int’l Fin. B.V. v. Nat’l Reserve Bank, 774 N.E.2d 696, 700 (N.Y. 2002). In addition, whatever the choice-of-law rule applied, a New York court will limit the application of any such rule if such application results in a violation of a fundamental public policy of New York. See Guar. Mortg. Co. v. Z.I.D. Assocs., Inc., 506 F. Supp. 101, 107–08 (S.D.N.Y. 1980); Nakhleh v. Chem. Constr. Corp., 359 F. Supp. 357, 360 (S.D.N.Y. 1973). This uncertainty in the New York choice-of-law rules is the reason New York adopted section 5-1401 of the General Obligations Law of New York for inbound choice-of-law opinions, which New York lawyers will generally give, and is also the reason New York lawyers are generally reluctant to give any outbound choice-of-law opinions.
27. See Nedlloyd Lines B.V. v. Superior Court, 834 P.2d 1148, 1151–52 (Cal. 1992); Annan v. Wilmington Trust Co., 559 A.2d 1289, 1293 (Del. 1989) (holding that under Delaware law, choice-of-law provisions will be respected so long as the chosen law bears some material relationship to the transaction); Pharmathene, Inc. v. Siga Techs., Inc., C.A. No. 2627-VCP, 2008 WL 151855, at *6–8 (Del. Ch. Jan. 16, 2008) (applying § 187 of the Restatement (Second) of Conflicts of Laws); Abry Partners V, L.P. v. F & W Acquisition LLC, 891 A.2d 1036, 1049 (Del. Ch. 2006) (noting that satisfaction of requirements of section 2708 of Title 6 of the Delaware Code establishes a material relationship sufficient to satisfy § 187 of the Restatement (Second) of Conflicts of Laws); Morris B. Chapman & Assocs. v. Kitzman, 739 N.E.2d 1263, 1269 (Ill. 2000) (“Ordinarily, Illinois follows the Restatement (Second) of Conflict of Laws (1971) in making choice-of-law decisions.”); Torres v. McClain, 535 S.E.2d 623 (N.C. Ct. App. 2000). In North Carolina, which is a Restatement jurisdiction, there are also a number of statutory exceptions to the enforceability of the choice of a foreign law. These exceptions include matters relating to usury laws, provisions governed by the Uniform Computer Transactions Act, and N.C. Gen. Stat. § 22B-2 relating to contracts for the improvement of real property.
29. The Florida Supreme Court has not expressly adopted the Restatement. In Mazzoni Farms, Inc. v. E.I. DuPont de Nemours & Co., 761 So. 2d 306, 311 (Fla. 2000), the Florida Supreme Court stated that a choice of law provision in a contract will be upheld unless the application of the law of the chosen forum contravenes strong public policy. Prior to Mazzoni, Florida-reported decisions on choice of law had generally followed an analysis similar to the Restatement (but without adopting the second prong of the Restatement test requiring analysis as to whether another state has a materially greater interest in the matter) that required a showing of a normal relation or a reasonable relation between the parties or the transaction, on the one hand, and the state whose law has been selected to govern the agreement, on the other hand, in order to uphold the parties’ contractual choice of a governing law for the transaction documents. However, notwithstanding the broad language used by the Florida Supreme Court in Mazzoni, state and federal court cases interpreting Florida law on this issue subsequent to Mazzoni have created confusion regarding whether such a normal relation or reasonable relation test is still required before a Florida court will uphold the parties’ contractual selection of a governing law for an agreement. As a result, many Florida attorneys who render outbound choice of law opinions continue to take assumptions for their choice of law opinions with respect to such normal or reasonable relations as well as qualifications with respect to public policy. For further information, see FLORIDA REPORT, supra note 10, at 169.
30. See RESTATEMENT (SECOND) OF CONFLICT OF LAWS § 187(2)(a) (1971).
31. Due to the limited utility of many choice-of-law opinions, opinion recipients may—if they are concerned about the possible applicability of the Covered Law rather than the governing law chosen in the agreement in circumstances where a reasoned or Restatement choice-of-law opinion would be rendered—seek an “as if ” remedies opinion (either in conjunction with or in lieu of a choice-of-law opinion) to the effect that the agreement in question would be enforceable if the Covered Law, rather than the law chosen in the agreement, were applied.
32. See 1998 TriBar Report, supra note 11, at 633 n.89. Recently, the New York Court of Appeals unanimously applied New York substantive law, and refused to apply New York’s choice-of-law rules, where the parties chose “the laws of the State of New York” to govern their agreement. IRB-Brasil Resseguros, S.A. v. Inepar Invs., S.A., 982 N.E.2d 609, 610, 612 (2012), cert. denied, 133 S. Ct. 2396 (2013). The court held that “the plain language” of the New York choice-of-law statute, N.Y. GEN. OBLIG. LAW § 5-1401 (McKinney 2010), dictates that “New York substantive law applies when parties include an ordinary New York choice-of-law provision.” IRB-Brasil Resseguros, S.A., 982 N.E.2d at 612.
33. While some commercial loan recipients will accept, in lieu of a more targeted qualification such as the sample qualification set out in the text above, a public policy qualification with respect to indemnification and other exculpation provisions, such as the following, note that such a public policy qualifier does not apply to the remedies opinion more generally:
We express no opinion with respect to provisions purporting to indemnify, release, exculpate, hold harmless or exempt any person or entity from liability for its own [gross] negligence or willful misconduct or to the extent that such provisions are otherwise against public policy.
See infra note 35 for a further discussion of exceptions that are commonly taken in some jurisdictions on these types of risk-shifting agreements, including discussions of broader qualifications that are commonly taken and accepted in Florida, North Carolina, and Texas.
35. California courts continue to be guided by Rossmoor Sanitation, Inc. v. Pylon, Inc., 532 P.2d 97, 100 (Cal. 1975), in which the California Supreme Court noted that a contract may expressly “provide for indemnification against an indemnitee’s own negligence, but such an agreement must be clear and explicit and is strictly construed against the indemnitee.” Given that an enforceability opinion only addresses a clause as interpreted, California practitioners can opine on clauses indemnifying for ordinary negligence if the contract is clear. If it is not, a court may not interpret it as covering at least a party’s own “active” negligent acts. Given the judicial proclivity toward strict construction as well as the tendency to distinguish between “active” and “passive” negligence, it is not uncommon for opinion givers in California not to opine as to the enforceability of attempts to indemnify against ordinary negligence.
In Delaware, a contract provision must be “crystal clear and unequivocal” in requiring one party to assume liability for the negligence of another party in order to be enforceable. State v. Interstate Amiesite Corp., 297 A.2d 41, 44 (Del. 1972). Similarly, in Illinois, the language in a contract requiring one party to assume liability for the negligence of another party must be “clear and explicit.” Tatar v. Maxon Constr. Co., 294 N.E.2d 272, 273 (Ill. 1973); see also Westinghouse Elec. Elevator Co. v. La-Salle Monroe Bldg. Corp., 70 N.E.2d 604, 607 (Ill. 1946). Thus, depending on the language at issue, opinion givers in both Delaware and Illinois may qualify opinions on indemnification or exculpation provisions with respect to negligence as well as gross negligence.
Florida courts have enforced express carveouts of ordinary negligence if the contract clearly and expressly states that the indemnitees’ own wrongful acts are indemnified. See Fid. & Guar. Ins. Co. v. Ford Motor Co., 707 F. Supp. 2d 1300, 1313 (M.D. Fla. 2010). Thus, a provision that purports to “indemnify, protect and save forever harmless from and against any and all claims” was held to be legally insufficient to provide indemnity from an indemnitee’s own ordinary negligence. See Cox Cable Corp. v. Gulf Power Co., 591 So. 2d 627, 629 (Fla. 1992). The illustrative forms of opinion letters that accompany the FLORIDA REPORT, supra note 10, at Form A-16, Form B-15, Form C-14, and Form D-14, contain a qualification excluding from the scope of the remedies opinion any provision that “purports to excuse a party from liability for the party’s own acts.” The authors of this article from Florida believe that Florida lawyers commonly take this qualification.
New York courts have consistently affirmed the enforceability of indemnities and exculpatory clauses that protect a party against such party’s own ordinary negligence. See Abacus Fed. Sav. Bank v. ADT Security Servs., Inc., 967 N.E.2d 666, 669 (N.Y. 2012); Sommer v. Fed. Signal Corp., 593 N.E.2d 1365, 1370 (N.Y. 1992); Kalisch-Jarcho, Inc. v. City of New York, 448 N.E.2d 413, 416 (N.Y. 1983). While New York courts have continually upheld indemnities and exculpatory clauses against ordinary negligence, they have made clear that such indemnities and clauses will not protect a party from its own “gross negligence.” See Sommer, 593 N.E.2d at 1371; Kalisch-Jarcho, 448 N.E.2d at 416–17. However, under New York law, gross negligence is more than just heightened negligence. Rather, the New York concept of “gross negligence” is closer to willful misconduct (“smacks of intentional wrongdoing” and “betokens a reckless indifference to the rights of others”) and thus is different in kind, not just degree. Colnaghi, U.S.A., Ltd. v. Jewelers Prot. Servs., Ltd., 611 N.E.2d 282, 283–84 (N.Y. 1993); accord Sommer, 593 N.E.2d at 1371; Kalisch-Jarcho, 448 N.E.2d at 416–17.
As to North Carolina, see LEGAL OPINIONS COMM., BUS. LAW SECTION, N.C. BAR ASS’N, THIRD PARTY LEGAL OPINIONS IN BUSINESS TRANSACTIONS 57 (2d ed. 2004) (§ 10.2) [hereinafter NORTH CAROLINA REPORT], which includes as a common qualification to a remedies opinion an exception for “any provisions of the Agreement that purport to excuse a party for liability for its own acts.”
Texas is an example of a state with an express negligence rule that imposes restrictions on the ability of parties to enter into contractual indemnification and exculpation provisions. A statement on contractual indemnity and exculpation issued by a Texas bar committee contains a number of alternative formulations of indemnity and exculpation qualifications for legal opinions, depending upon the nature of the provisions covered by the opinion and the parties’ determination as to the necessity of an enforceability opinion on such provisions in light of the time and expense required to render such an opinion. See Tex. State Bar Bus. Law Section Legal Opinions Comm., Statement on Legal Opinions Regarding Indemnification and Exculpation Provisions Under Texas Law, 41 TEX. J. BUS. L. 271, 281– 86 (2006) [hereinafter Texas Indemnity Statement]. The Texas Indemnity Statement notes that parties to certain types of transactions frequently agree that the opinion recipient will accept a legal opinion that completely excludes indemnification and exculpation provisions from coverage under a Texas law enforceability opinion, in which case the Texas Indemnity Statement offers the following sample qualification:
We express no opinion with respect to the validity or enforceability of the following provisions to the extent that the same are contained in the Transaction Documents: provisions purporting to release, exculpate, hold harmless, or exempt any person or entity from, or to require indemnification of or by any person or entity for, liability for any matter.
Id. at 283.
36. See, e.g., NORTH CAROLINA REPORT, supra note 35, at 57 (§ 10.2), which includes as a common qualification to a remedies opinion an exception for provisions “that purport to effect waivers of constitutional, statutory or equitable rights or the effect of applicable laws.”
For reasons explained in the 2007 California Remedies Report Exceptions Appendix, supra note 10, at B-9 n.6, it is common for California opinion givers to state that certain exculpatory provisions, including waivers of rights to damages, may be limited by statute or public policy.
The illustrative forms of opinion letters that accompany the Florida Report, supra note 10, at Form A-16, Form B-16, Form C-14, and Form D-14, contain a qualification excluding from the scope of the remedies opinion any provision that “purports to effect waivers of . . . rights to damages,” and the authors of this article from Florida believe that Florida lawyers commonly take this qualification.
As to Texas opinion practice, the last paragraph at supra note 35 quotes a sample qualification from the Texas Indemnity Statement. This sample qualification is broad enough to exclude exculpation provisions and waivers that purport to exempt a party from liability for damages. See also Texas Indemnity Statement, supra note 35, at 296–98 (discussing Texas case law regarding contractual provisions purporting to exonerate a party from liability for damages for breach of contract).
37. Some forum selection clauses (such as a provision stating that all disputes between the parties shall be litigated in a specific court) do not contain an express statement pursuant to which the parties submit to the jurisdiction of the chosen forum. In the absence of such a submission-to-jurisdiction clause, courts still typically interpret a forum selection clause as a consent to personal jurisdiction in the designated forum. 2004 TriBar Report, supra note 23, at 1499 n.77. However, some state forum selection statutes require an express submission or other consent to the jurisdiction of that state’s courts. See infra note 46.
38. See, e.g., 2004 TriBar Report, supra note 23, at 1498; GLAZER ET AL., supra note 16, § 9.14.13, at 387–90. The United States Supreme Court has used the term “forum-selection clause” to refer to mandatory forum selection clauses. E.g., Atl. Marine Constr. Co. v. U.S. Dist. Court W. Dist. of Tex., 134 S. Ct. 568 (2013); Carnival Cruise Lines, Inc. v. Shute, 499 U.S. 585 (1991); M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972).
39. See, e.g., 16 JAMES WM. MOORE ET AL., MOORE’S FEDERAL PRACTICE—CIVIL § 108.53 (2013) (referring to permissive forum selection clauses as “non-exclusive consent-to-jurisdiction clauses” and mandatory forum selection clauses as “prorogation (exclusive forum selection) agreements”).
40. As noted at infra note 46, the illustrative forms of opinion letters that accompany the Florida Report contain a broad qualification excluding any provision in a transaction document that “concerns choice of forum, consent or submission to the personal or subject matter jurisdiction of courts.” FLORIDA REPORT, supra note 10, at Form A-16, Form B-16, Form C-14, and Form D-15. In addition, the North Carolina Report includes as a common qualification to a remedies opinion an exception for provisions “concerning choice of forum or consent to the jurisdiction of courts, venue of actions or means of service of process.” NORTH CAROLINA REPORT, supra note 35, at 57 (§ 10.2).
41. See 2004 TriBar Report, supra note 23, at 1499.
42. See, e.g., N.C. GEN. STAT. § 22B-3 (2013) (invalidating any provision in a contract entered into in North Carolina that requires the prosecution of any action arising from the contract to be instituted or heard in another state). Although there are statutory exceptions to this prohibition, lawyers in North Carolina, as in other states, typically do not render opinions on forum selection clauses (even as to those matters excepted from the prohibitions of the North Carolina statute).
43. 2004 TriBar Report, supra note 23, at 1499–1500 (agreeing that “when a forum selection clause is governed by the law of a state that [has not adopted the “modern” view] . . . , the opinion may require an express exception or assumption.” However, when a forum selection clause is governed by the law of a state that has adopted the “modern” view, the Report says that “opinion givers rendering an opinion on a mandatory forum selection clause (or a permissive forum clause with a waiver of forum non conveniens) generally do not regard the possibility that a court might decline to enforce the clause by reason of the Bremen exception [that is, non-enforcement if the clause would be ‘unfair or unreasonable’] to require an opinion qualification.” Id. at 1501. The U.S. Supreme Court, adopting the “modern view” in M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 15 (1972), held that a mandatory forum selection clause is enforceable as a constitutional matter, unless it can be shown by the resisting party that such enforcement would be “unreasonable and unjust, or that the clause was in-valid for such reasons as fraud or overreaching.”
For a discussion of cases that have adopted the “modern” view, see, for example, 2004 TriBar Report, supra note 23, at 1500 n.9; Joseph E. Smith, Civil Procedure—Forum Selection—N.C. Gen. Stat. § 22B-3 (1994), 72 N.C. L. REV. 1608 (1994); GLAZER ET AL., supra note 16, § 9.14.4, at 389 n.53.
44. See, e.g., CAL. CIV. PROC. CODE § 410.40 (West 2012); DEL. CODE ANN. tit. 6, § 2708 (2013); 735 ILL. COMP. STAT. 105/5-10 (2012); N.Y. GEN. OBLIG. LAW § 5-1402 (McKinney 2010). The 2004 TriBar Report confirms that, at the time of its publication in 2004, “opinion preparers in New York typically give opinions without an exception on the forum selection clauses (permissive or mandatory) selecting New York courts as the forum in agreements that qualify under the statute.” 2004 TriBar Report, supra note 23, at 1502.
45. Section 15.020 of the Texas Civil Practice and Remedies Code is a venue statute that applies by its terms to a “major transaction,” which is defined to mean “a transaction evidenced by a written agreement under which a person pays or receives, or is obligated to pay or entitled to receive, consideration with an aggregate stated value equal to or greater than $1 million,” provided that the term “does not include a transaction entered into primarily for personal, family, or household purposes, or to settle a personal injury or wrongful death claim, without regard to the aggregate value.” TEX. CIV. PRAC. & REM. CODE ANN. § 15.020(a) (West 2009 & Supp. 2014). Section 15.020(b) provides that “[a]n action arising from a major transaction shall be brought in a county if the party against whom the action is brought has agreed in writing that a suit arising from the transaction may be brought in that county.” Id. § 15.020(b). Section 15.020(c) provides that “an action arising from a major transaction may not be brought in a county if: (1) the party bringing the action has agreed in writing that an action arising from the transaction may not be brought in that county, and the action may be brought in another county of this state or in another jurisdiction; or (2) the party bringing the action has agreed in writing that an action arising from the transaction must be brought in another county of this state or in another jurisdiction, and the action may be brought in that other county, under [section 15.020] or otherwise, or in that other jurisdiction.” Id. § 15.020(c).
Section 15.020(d) provides that section 15.020 “does not apply to an action if (1) the agreement described by this section was unconscionable at the time it was made; (2) the agreement regarding venue is voidable under Chapter 272 [of the Texas Business and Commerce Code],” which provides that, as to contracts principally for the construction or repair of an improvement to real property lo-cated in Texas, a forum selection clause choosing the courts of a state other than Texas is voidable by the party obligated by the contract to perform the construction or repair; “or (3) venue is established under another Texas statute other than Title 2 of the Texas Civil Practice and Remedies Code.” Id. § 15.020(d).
Some Texas courts have adopted a narrow construction of section 15.020. See, e.g., In re Togs Energy, Inc., No. 05-09-01018-CV, 2009 WL 3260910, at *1 (Tex. App. Oct. 13, 2009) (mem.) (in order to satisfy the $1 million threshold, written agreement must contain the aggregate stated value of the consideration). However, Texas courts have also applied the statute to enforce forum selection clauses in contracts that are found to meet the statutory requirements. See, e.g., Spin Doctor Golf, Inc. v. Paymentech, L.P., 296 S.W.3d 354, 359 (Tex. App. 2009) (agreement contained a forum selection clause specifying Dallas county as the site of a lawsuit relating to the agreement; appellate court found that agreement constituted a “major transaction” for the purposes of section 15.020 and affirmed order of trial court transferring the case from Harris County to Dallas County); In re Royalco Oil & Gas Corp., 287 S.W.3d 398, 400–01 (Tex. App. 2009) (lease with a 99-year term and monthly rental payments of $20,000 satisfied “major transaction” requirement; appellate court affirmed order of trial court transferring case to Tarrant County, in which suits were contractually required to be brought pursuant to the lease).
46. Section 5-1402 of the New York General Obligations Law expressly permits parties to maintain an action in New York state courts if such action arises out of an agreement wholly or in part governed by New York law, which agreement (a) relates to an obligation arising out of a transaction covering in the aggregate not less than $1,000,000, and (b) contains a provision in which the non-resident expressly submits to the jurisdiction of New York state courts. N.Y. GEN. OBLIG. LAW § 5-1402 (McKinney 2010). The New York Civil Practice Law’s Rule 327, enacted together with section 5-1402, provides that New York state courts shall not stay or dismiss any action on the ground of inconvenient forum where section 5-1402 applies. N.Y. C.P.L.R. 327(b) (McKinney 2010). In New York, these provisions support both mutual and non-mutual choices of New York state courts. Based on section 5-1402 and N.Y. C.P.L.R. 327, a New York opinion qualification might be stated as follows:
We express no opinion with respect to [cite forum selection Section] of the Agreement to the extent such Section (i) contains a waiver of any objection based on inappropriate venue or forum non conveniens in a federal court of the United States, (ii) implies that a federal court of the United States has subject matter jurisdiction, or (iii) purports to grant any court exclusive jurisdiction.
While California, Delaware, and Illinois have adopted forum selection statutes similar to that of New York, these states have not adopted an equivalent to N.Y. C.P.L.R. 327, so opinion qualifications relating to the laws of those states may be further qualified. Further, while California case law has upheld both exclusive and nonexclusive forum selection clauses (see, e.g., Smith, Valentino & Smith, Inc. v. Superior Court, 551 P.2d 1206 (Cal. 1976) (en banc)), so a California opinion giver typically would be in a position to render an opinion on the enforceability of such clauses, venue selection clauses that select a venue in contravention of applicable California venue statutes are not enforceable under California law. In general, this means that under California law the parties may designate the state (forum) in which matters are to be litigated, but cannot designate a county (venue) except in accordance with California’s venue statutes. See Global Packaging, Inc. v. Superior Court, 127 Cal. Rptr. 3d 813, 820 (Ct. App. 2011) (“If [plaintiff] meant ‘forum,’ it should have said ‘forum,’ not ‘venue,’ and it should have specified a state (a forum), not a county (a venue).”); Alexander v. Superior Court, 8 Cal. Rptr. 3d 111 (Ct. App. 2003); see also Battaglia Enters., Inc. v. Superior Court of San Diego Cnty., 154 Cal. Rptr. 3d 907 (Ct. App. 2013). Moreover, under California law, merely designating a forum state does not constitute a submission to jurisdiction in that state; the submission to jurisdiction must be express. See Global Packaging, 127 Cal. Rptr. 3d at 820.
Section 2708 of Title 6 of the Delaware Code provides that any person may maintain an action in a court of competent jurisdiction in Delaware where the action arises out of a contract not subject to section 1-301(c) of Title 6 of the Delaware Code and not involving less than $100,000 and for which the parties have chosen Delaware law, if the parties, either as provided by law or in the manner specified in such contract, are (i) subject to the jurisdiction of the courts of, or arbitration in, Delaware and (ii) may be served with legal process. DEL. CODE ANN. tit. 6, § 2708 (2013). The similar Illinois statute provides that any person may maintain an action against a foreign corporation or nonresident in a court of competent jurisdiction in Illinois where the action arises out of a contract not involving less than $500,000 and for which the parties have chosen Illinois law as the governing law, subject to the further requirement that the foreign corporation or nonresident has agreed in the contract to submit to the jurisdiction of the Illinois courts. 735 ILL. COMP. STAT. 105/5-10 (2012).
In Florida, under Florida Statutes section 685.102, but subject to whatever limitations arise under the U.S. Constitution, an agreement in a contract that a matter will be litigated in Florida will be upheld if the selection of Florida as the governing law for the agreement has been made under Florida Statutes section 685.101. FLA. STAT. § 685.102 (2014). However, in McWane, Inc. v. Water Management Services, Inc., 967 So. 2d 1006 (Fla. Dist. Ct. App. 2007), the court refused to enforce a forum selection clause because enforcement would have been “unjust and unreasonable” in a products liability case involving interrelated claims, cross-claims, and multiple defendants from multiple states. The court noted that a party seeking to avoid the enforcement of a mandatory contractual forum selection provision as unreasonable or unjust must demonstrate that trial in the agreed-upon forum “will be so gravely difficult and inconvenient that he will for all practical purposes be deprived of his day in court. . . . Although mere inconvenience or additional expense will not suffice, a venue provision may be avoided when it appears that enforcement of the provision will lead to multiple lawsuits, a splitting of the causes of action, and the potential for conflicting results in different courts.” Id. at 1007. As a result, notwithstanding Florida Statutes section 685.102, Florida lawyers commonly exclude coverage of express forum selection clauses from the scope of their remedies opinions, and the illustrative forms of opinion letters that accompany the Florida Report contain a broad qualification excluding from the scope of the remedies opinion any provision in a transaction document that “concerns choice of forum, consent or submission to the personal or subject matter jurisdiction of courts.” See supra note 40.
47. See 735 ILL. COMP. STAT. 5/2-201−5/2-212 (2012); N.Y. C.P.L.R. 303–318 (McKinney 2010).
48. CAL. CIV. PROC. CODE §§ 413.10–415.95 (West 2004 & Supp. 2014).
50. In California, the state supreme court, in the case of Grafton Partners L.P. v. Superior Court, 116 P.3d 479 (Cal. 2005), held that provisions waiving a party’s right to a jury trial are not enforceable. The California Sample Opinion provides the following sample exception, which does not differ materially from the sample formulation set out above: “We express no opinion regarding the enforceability of [Section __] of the [Loan Agreement], which purports to waive the parties’ rights to a jury trial.” CALIFORNIA SAMPLE OPINION, supra note 10, at 17.
In North Carolina, section 22B-10 of the North Carolina General Statutes expressly provides that any provision in a contract waiving the right to a jury trial is unenforceable. N.C. GEN. STAT. § 22B-10 (2013). An opinion exception on a provision governed by North Carolina law purporting to waive the right to jury trial might read as follows: “Any provision waiving a right to jury trial is unenforceable as against public policy pursuant to North Carolina General Statutes § 22B-10.”
51. Under Illinois law, for example, judicial decisions make reference to a broad array of factors such as whether the jury trial waiver was conspicuous and knowing, whether it was the subject of negotiation, whether the waiver was reviewed by counsel, and the relative bargaining power and business acumen of the parties. Despite the broader scope of these conditions, the Illinois courts have nevertheless consistently upheld contractual jury trial waivers absent a statute to the contrary. (Examples of statutory prohibitions may be found in the Illinois Home Repair and Remodeling Act, 815 ILL. COMP. STAT. 513/15.1 (2012), which requires specific disclosure and express acceptance of a jury trial waiver in a contract for home repair or remodeling, and in a provision of the Illinois Code of Civil Procedure, 735 ILL. COMP. STAT. 5/9-108 (2012), which provides that when a landlord files a forcible action for possession of residential property, either party may demand a trial by jury, and that any lease provision purporting to waive this right is unenforceable.) The Illinois Supreme Court has not yet addressed the topic, leading the Seventh Circuit to conclude in a recent case that there was no clear basis in Illinois law for scrutinizing a jury trial waiver, even in a form agreement. See IFC Credit Corp. v. United Bus. & Indus. Fed. Credit Union, 512 F.3d 989, 992 (7th Cir. 2008) (reviewing a district court decision that invalidated a bench trial agreement “because it was not the subject of negotiation (that is, it appears on a form), does not stand out (it is in the same type as other clauses), and was not reviewed by the Credit Union’s lawyer before the contract was signed (the Credit Union’s executives negotiated the deal without the participation of counsel)”). The Seventh Circuit reversed, stating, among other things, that it had been unable to identify a clear basis in Illinois law for imposing the requirements enumerated by the lower court. Against this somewhat unsettled background, some Illinois opinion givers do not routinely include exceptions for jury waivers in the absence of special statutory requirements, while others, acknowledging the array of conditions referenced in the cases, routinely do.
See also 2004 TriBar Report, supra note 23, at 1494 (stating that “often, when states impose conditions on enforcing a jury waiver, those conditions will not necessitate an exception”). The 2004 TriBar Report concludes that in states that require a jury trial waiver to be “conspicuous,” such waiver “ordinarily will be made conspicuous [and therefore needs no exception].” Id. That same report also concludes that when jurisdictions require a jury trial waiver to be “knowing or intentional,” the opinion preparers “ordinarily will satisfy themselves that their client is aware of the waiver [and therefore do not take an exception].” Id. But see infra notes 54 & 55 (discussing the reasons that practitioners in Delaware, Florida, and Texas often take a different view).
52. See, e.g., Uribe v. Merchants Bank of New York, 642 N.Y.S.2d 23 (App. Div. 1996); Gunn v. Palmieri, 589 N.Y.S.2d 577 (App. Div. 1992); Barclays Bank of New York, N.A. v. Heady Elec. Co., 571 N.Y.S.2d 650, 652–53 (App. Div. 1991).
53. Note, however, that under New York law, jury waivers in leases of real property are ineffective as to claims for personal injury or property damage. N.Y. REAL PROP. LAW § 259-c (McKinney 2006). Thus, many New York lawyers specifically limit jury waivers in leases of real property to exclude personal injury or property damage claims and so avoid an opinion exception.
54. Under Florida law, a jury trial waiver, to be enforceable, must be clear on its face, knowing and with no evidence of unconscionability, matters which Florida opinion givers are frequently unwilling to address other than by a complete exclusion of the jury trial waiver from the enforceability opinion. Most Florida cases that have addressed the jury trial waiver issue have examined a mutual jury trial waiver without noting whether mutuality is a factor in their decisions. In Oglesbee v. IndyMac Financial Services, Inc., 675 F. Supp. 2d 1155, 1158 (S.D. Fla. 2009), the court upheld a non-mutual jury waiver by a borrower. Both the Oglesbee court and the court in Lascoutx v. Wells Fargo Bank, No. 11-21619-CIV, 2011 WL 5825655, at *6–7 (S.D. Fla. Nov. 16, 2011), considered five factors when determining whether a waiver was “knowing and voluntary”: “(1) the conspicuousness of the provision in the contract; (2) the level of sophistication and experience of the parties entering into the contract; (3) the opportunity to negotiate terms of the contract; (4) the relative bargaining power of each party; and (5) whether the waiving party was represented by counsel.” As noted by the Lascoutx court, “[a] court can consider these factors, but they are not determinative.” Id. at *8. In GE Commercial Finance Business Property Corporation v. Heard, 621 F. Supp. 2d 1305, 1310 (M.D. Ga. 2009), the court held that while a waiver of jury trial is enforceable under Florida law when there is no evidence of unconscionability, the court must also determine whether the federal right to a jury trial was properly waived in a federal diversity case by a knowing and voluntary waiver. In addition, a Florida court may, in its discretion, utilize an advisory jury even if the parties have effectively waived their right to a common law jury trial. See Gelco Corp. v. Campanile Motor Serv., Inc., 677 So. 2d 952, 953 (Fla. Dist. Ct. App. 1996).
The Texas Supreme Court has upheld knowing and voluntary jury trial waivers and has further held that, absent fraud or imposition as to the waiver provision itself, a conspicuous jury trial waiver is prima facie evidence that the waiver is knowing and voluntary, thereby shifting the burden of proof to the party challenging the waiver’s validity. See In re Bank of Am., N.A., 278 S.W.3d 342, 344–46 (Tex. 2009) (per curiam); In re Gen. Elec. Capital Corp., 203 S.W.3d 314, 316 (Tex. 2006) (per curiam); In re Prudential Ins. Co. of Am., 148 S.W.3d 124, 129–35 (Tex. 2004). However, because many lawyers in Texas do not generally opine as to matters of “conspicuousness” or as to states of mind such as whether an action is “knowing” or “voluntary,” opinion givers in Texas frequently express no opinion with respect to waivers of the right to trial by jury.
55. Under Delaware law, for example, to be enforceable a jury trial waiver must meet a number of tests. The Delaware Superior Court has held that a party can waive the right to a jury trial where the waiver provision is clear and unambiguous. See CIT Commc’ns Fin. Corp. v. Level 3 Commc’ns, LLC, C.A. No. 06C-01-236JRS, 2008 WL 2586694, at *5 (Del. Super. Ct. June 6, 2008) (finding that lease provision “clearly and unambiguously” waived right to jury trial); see also Cantor Fitzgerald, Inc. v. Cantor Fitzgerald, L.P., Civ. A. No. 00C-05-151WCC, 2001 WL 589028, at *2 (Del. Super. Ct. May 24, 2001). In addition, the CIT court set forth four elements, some involving considerations outside the terms of the contract, that a court will consider when determining whether a contract effectively provides for a waiver of a jury trial: “(1) the negotiability of the contract terms; (2) any disparity in bargaining power between the parties; (3) the business acumen of the party opposing the waiver; and (4) the conspicuousness of the jury waiver provision.” CIT Commc’ns Fin. Corp., 2008 WL 2586694, at *5. The Delaware Supreme Court has stated that the right to jury trial “is not absolute but subject to waiver if the parties so intend.” Graham v. State Farm Mut. Auto. Ins. Co., 565 A.2d 908, 912 (Del. 1989). In Graham, the court held that an arbitration clause in an insurance contract can serve as a “fully informed” waiver of the right to jury trial even where the arbitration provision is part of a contract of adhesion and the non-drafting party is not specifically advised of the inclusion of such provision. Id. Lawyers in Delaware commonly express no opinion on the enforceability of jury trial waivers, though sometimes an opinion under Delaware law is rendered noting that the jury trial waiver must meet certain requirements, such as being clear, unambiguous, and conspicuous, and, in addition, sometimes assuming as well that the parties are sophisticated and that the waiver provision is material and freely bargained for.
56. 2007 CALIFORNIA REMEDIES REPORT EXCEPTIONS APPENDIX, supra note 10, at B-33 n.27 (in considering provisions pursuant to which a debtor agreed to allow a lender or the lender’s affiliates or participants to set off amounts owed to them against amounts owed to the debtor, noting that no case had been found “indicating that contractual provisions granting rights of setoff in the commercial context would not be enforced, except to avoid inequity, a basis that falls within the scope of the equitable principles limitation”). As to Illinois, see infra note 57.
57. Under Delaware law, for example, “a bank, undoubtedly, has the right to apply a balance on general deposit to a matured note or other debt held by it against a depositor.” Reed v. Cent. Nat’l Bank of Wilmington, 184 A. 772, 773 (Del. Super. Ct. 1936). In addition, in several cases the Delaware courts have recognized the general validity of a contractual right to setoff even though, in certain cases, the court found that the contractual conditions to setoff had not been met. See Republic Envtl. Sys. v. RESI Acquisition (Del.) Corp., No. 99C-02-194WTQ, 1999 WL 464521, at *5 (Del. Super. Ct. May 28, 1999) (recognizing the validity of a promissory note’s setoff provision, but finding the facts at issue to be outside the specific terms of such provision); Biasotto v. Spreen, C.A. No. 96C-04-030WTQ, 1997 WL 527956, at *13 (Del. Super. Ct. July 30, 1997) (declining to enforce a setoff provision in a promissory note because the conditions necessary to trigger the setoff right had not occurred); Lynch v. Cnty. Bank, C.A. No. 92C-08-024, 1993 WL 390217, at *3 (Del. Super. Ct. Aug. 9, 1993) (upholding a bank’s right to setoff amounts due under a loan with funds in the debtor’s bank account where the loan documents provided for such a right); Kimmel v. Wilmington Trust Co., 287 A.2d 760, 762–63 (Del. Ch. 1972) (enforcing setoff provisions granting a bank the right to set off against any commissions due to a trustee the amount of any unpaid obligations to the bank, whether or not due). Based on the foregoing authority, some opinion givers will not take an exception for a setoff provision between a borrower and its lender. However, in the event that the provision in question is broader in scope than the few that have been upheld by the courts, which will often be the case, Delaware opinion givers will often either take a general exception such as the sample qualification set out in the text above or specifically refer to the problematic provisions.
The general rule in Illinois is that a bank may look to deposits in its hands for the repayment of an indebtedness owed to it by the applicable depositor where the debt is a matured obligation. First Nat’l Bank of Blue Island v. Estate of Philp, 436 N.E.2d 15, 16 (Ill. App. Ct. 1982). In addition, there is substantial case law indicating that a contractual setoff provision is enforceable even in cases where the requirements of the general rule are not met. See, e.g., Selby v. DuQuoin State Bank, 584 N.E.2d 1055, 1058 (Ill. App. Ct. 1991) (a bank had the right to set off funds in a joint checking account against the amount due on a decedent’s loan even though the surviving joint depositor did not execute the note and security agreements, where there was a setoff provision in the signature card agreement); Gillett v. Williamsville State Bank, 34 N.E.2d 552, 558 (Ill. App. Ct. 1941) (absent an express agreement, bank cannot apply the deposits to an unmatured indebtedness of the depositor). Against that background, some Illinois opinion givers routinely take an exception to the extent that the loan agreement provision contemplates setoff that is not fully mutual or may be applied to debt that is not fully matured, while others, on the strength of the case law enforcing contractual setoff provisions, do not.
There is clear authority in Texas for the exercise of a common law right of setoff against funds held in a depositor’s bank deposit accounts for debts owed to that depository bank where there is a mutuality of obligations between the depository bank and the depositing borrower, the obligations set off are fully matured, and the funds are held in general deposit accounts, as distinguished from trust or other special or restricted accounts. See, e.g., Bandy v. First State Bank, 835 S.W.2d 609, 617–22 (Tex. 1992). There is, however, limited authority in Texas as to a contractual right of setoff, and many opinion givers in Texas, in the absence of clear authority, take a broad qualification such as the sample qualification set out in the text above.
58. NORTH CAROLINA REPORT, supra note 35, at 58 (§ 10.2) (including as a common exception to a remedies opinion an exception for “provisions that purport to create rights of setoff otherwise than in accordance with applicable law”); FLORIDA REPORT, supra note 10, at Form A-17, Form B-16, Form C-14, and Form D-15 (containing a substantially similar common exception to the remedies opinion). There is no case law in Florida that deals with the issue of a contractual setoff that allows setoff rights beyond applicable common law. Further, in a case decided under Florida law, the U.S. Court of Appeals for the Fifth Circuit determined that there is no requirement to notify a borrower before a bank can enforce a common law setoff right. McKee v. Hood, 312 F.2d 394, 397 (5th Cir. 1963).
59. Cases in New York hold that a bank’s right of setoff may not be exercised, unless otherwise agreed, until the day after maturity of the applicable obligations of the borrower. Marine Midland Bank v. Graybar Elec. Co., 363 N.E.2d 1139, 1143 (N.Y. 1977). However, N.Y. Banking Law § 9-g (McKinney 2010) provides that no bank shall assert, claim or exercise any right to setoff against any deposit account held by such bank unless, prior to or on the same business day of such setoff, notice of such setoff together with the reasons for such setoff are mailed to the depositor. Although section 9-g says that the “failure to provide the notice required by this section shall not be deemed to affect the validity of the right of setoff,” it is generally thought to be unclear as to what this exculpatory provision means.
60. For applicable case law in Delaware, see, for example, Studiengesellschaft Kohle, GmbH v. Hercules, Inc., 748 F. Supp. 247, 249, 251 (D. Del. 1990); Dep’t of Labor v. Red Rose Roofing, Inc., C.A. No. 98C-02-019SCD, 2000 WL 970678, at *1 (Del. Super. Ct. Mar. 13, 2000). In New York, statutes and case law restrict the enforceability of such waivers. N.Y. GEN. OBLIG. LAW § 17-103 (McKinney 2010); John J. Kassner & Co. v. City of New York, 389 N.E.2d 99, 102–03 (N.Y. 1979). The New York statutes also impose similar restrictions on waivers affecting the time limited for actions to foreclose on a mortgage. N.Y. GEN. OBLIG. LAW § 17-105 (McKinney 2010).
The Texas courts have held that, as a defense to a civil action, the statute of limitations is a personal privilege and may be waived by agreement either before or after expiration of the prescribed time limit, provided that any agreement made before the statutory bar has fallen must be specific and for a reasonable time. The Texas courts have also held that a general agreement in advance to waive or not to plead the statute of limitations on a particular obligation is void as against public policy. See, e.g., Gardner v. Cummings, No. 14-04-01074-CV, 2006 WL 2403299, at *3 (Tex. App. Aug. 22, 2006); Duncan v. Lisenby, 912 S.W.2d 857, 858–59 (Tex. App. 1995); Am. Alloy Steel, Inc. v. Armco, Inc., 777 S.W.2d 173, 177 (Tex. App. 1989).
Note that, under New York law, a qualification for statute-of-limitations waivers should not be needed in the case of a guaranty’s “obligation absolute” clause that provides that the guaranty will be absolute and unconditional irrespective of, among other things, any statute of limitations applicable to the guaranteed obligations. Such a “waiver” is a waiver of the statute of limitations applicable to the underlying guaranteed obligations; it is not a waiver of the statute of limitations applicable to the guaranty itself (which cannot be waived unless the statutory or other conditions for such a waiver are satisfied). New York lawyers may, however, take an exception for the guaranty of an amendment that is so substantial as to constitute a new obligation. However, it does not appear that practitioners in California, Delaware, Florida, Illinois, or Texas typically opine on these types of provisions purporting to make a guarantor’s obligations absolute and unconditional irrespective of the occurrence of various enumerated matters.
61. For example, Cal. Civ. Proc. Code § 360.5 (West 2006) limits the effect of a waiver of an applicable statute of limitations to an extension of the period for an additional four years. However, Cal. Civ. Proc. Code § 337.1 (West 2006) provides that any provision contained in a deed of trust to the effect that the debtor waives the right to plead a statute of limitations as a defense to any demand secured by the deed of trust is void.
62. See 2007 CALIFORNIA REMEDIES REPORT EXCEPTIONS APPENDIX, supra note 10, at B-35 n.30 (“We advise you that the waiver of the applicable statute of limitations set forth in Section ___ of [the Agreement] will be subject to the limitations of [the relevant statutory limitation].”).
There is no Florida case law that addresses the enforceability of a statute of limitations waiver. However, Fla. Stat. § 95.03 (2014) provides: “Any provision in a contract fixing the period of time within which an action arising out of the contract may be begun at a time less than that provided by the applicable statute of limitations is void.” As a result, in the view of the authors of this article who practice in Florida, most Florida lawyers exclude coverage of waivers of statute of limitations provisions from the scope of their remedies opinions, and the illustrative forms of opinion letters that accompany the Florida Report, supra note 10, at Form A-16, Form B-16, Form C-14, and Form D-14, contain a qualification excluding from the scope of the remedies opinion any provision that purports to effect any waiver of any statute of limitations.
68. See Certainteed Corp. v. Celotex Corp., Civ. A. No. 471, 2005 WL 217032, at *1 (Del. Ch. Jan. 24, 2005) (distinguishing between direct claims for breach of representations and warranties between the contracting parties, which accrue at closing, and claims for reimbursement for third-party claims, which may not accrue until payment is made to the third party).
69. See, e.g., U.C.C. § 9-401(b) (2013) (providing that “[a]n agreement between the debtor and the secured party which prohibits a transfer of the debtor’s rights in collateral or makes the transfer a default does not prevent the transfer from taking effect”).
70. Dixie Pipe Sales, Inc. v. Perry, 834 S.W.2d 491, 493 (Tex. App. 1992).
72. See Wildenstein & Co. v. Wallis, 595 N.E.2d 828, 833–35 (N.Y. 1992) (art dealer’s right of first refusal to purchase and an exclusive right to consign paintings was reasonable); Metro. Transp. Auth. v. Bruken Realty Corp., 492 N.E.2d 379, 385 (N.Y. 1986) (preemptive right that served a beneficial purpose and was reasonable in terms of duration and price was enforceable); see also Dixie Pipe Sales, 834 S.W.2d at 494 (a right of first refusal that advanced the legitimate objectives of both the corporation and its individual shareholders, where only a few shareholders of the corporation were active in the business and were also members of the same family, was reasonable).
73. See, e.g., Lam v. Li, 635 N.Y.S.2d 26, 27 (App. Div. 1995).
74. See U.C.C. §§ 9-406 to -408 (2013). Among other things, subject to certain limitations, these provisions render ineffective contractual provisions that prohibit or restrict the assignment or transfer of, or the creation, attachment, or perfection of a security interest in, accounts, chattel paper, promissory notes, lease agreements, health-care-insurance receivables, and general intangibles (including payment intangibles) to the extent that such restrictions are set forth in an agreement with an account debtor (which is defined in section 9-102 to mean a person obligated on an account, chattel paper, or general intangible) or a person otherwise obligated on such assets. A negative pledge covenant in a credit agreement restricting a borrower’s ability to dispose of or grant liens on its assets would not typically be invalidated under sections 9-406 through 9-408, since those restrictions are not set forth in an agreement with an account debtor or a person otherwise obligated on such assets (as the lenders would usually not qualify as such). While sections 9-406 through 9-408 may bear on opinions relating to collateral grants made in favor of the lenders, qualifications taken in commercial loan transactions with respect to the creation or perfection of security interests are beyond the scope of this article.
75. See, e.g., 1998 TriBar Report, supra note 11, at 628 (§ 3.5.2(a)(iii)); see also infra note 77 (listing other bar association reports).
76. See, e.g., DEL. CODE ANN. tit. 6, § 2301(c) (2013) (providing that there is no limit on the rate of interest which may be legally charged for the loan or use of money where the amount of money loaned or used exceeds $100,000 and where repayment thereof is not secured by a mortgage against the principal residence of any borrower); N.Y. GEN. OBLIG. LAW § 5-501(6) (McKinney 2010) (providing an exemption from civil usury limits (16 percent per annum) for any obligation over $250,000, and an exemption from criminal usury limits (25 percent per annum) for any obligation over $2,500,000); N.C. GEN. STAT. § 24-9 (2013) (providing that a lender may charge interest at any rate and fees and other charges in any amount that the borrower agrees to pay in an exempt loan transaction (where an “exempt loan” means a loan in which (i) the amount of the loan is $300,000 or more, (ii) the borrower is a person other than a natural person, or (iii) the loan is obtained by a natural person for a purpose other than a personal, family, or household purpose)). In addition, section 2306 of title 6 of the Delaware Code provides that no corporation, limited partnership, statutory trust, business trust or limited liability company, and no association or joint stock company having any of the powers and privileges of corporations not possessed by any individuals or partnerships, shall interpose the defense of usury in any action. DEL. CODE ANN. tit. 6, § 2306 (2013).
In Illinois, the Interest Act, 815 ILL. COMP. STAT. 205/1–205/11 (2012), addresses civil usury. In addition, the Criminal Code of 2012 includes a criminal usury provision. 720 ILL. COMP. STAT. 5/17-59 (2012). Neither statute includes an exemption based on transaction size, but they do exempt, among other things, “any loan made to a corporation,” 815 ILL. COMP. STAT. 205/4(1)(a); 720 ILL. COMP. STAT. 5/17-59(d) and, subject to certain qualifications, they exempt “any business loan to a business association or copartnership or to a person owning and operating a business as a sole pro-prietor or to any persons owning and operating a business as joint venturers, joint tenants or tenants in common, or to any limited partnership, or to any trustee owning and operating a business or whose beneficiaries own and operate a business.” 815 ILL. COMP. STAT. 205/4(1)(a); 720 ILL. COMP. STAT. 5/17-59(d). In Bowman v. Neely, 37 N.E. 840, 841 (Ill. 1894), the Illinois Supreme Court held that to enforce an agreement to add interest accruing in the future to principal would violate Illinois public policy. While Bowman has never been overruled, subsequent case law indicates a shift in public policy as exemplified in Joliet Federal Saving & Loan Association v. Bloomington Loan Co., 265 N.E.2d 400, 403 (Ill. App. Ct. 1970), where the court approved a note provision adding interest to principal in the event a monthly payment was missed. Moreover, the Illinois General Assembly approved interest on interest in a section of the Illinois Savings and Loan Act of 1985, 205 ILL. COMP. STAT. 105/5-1 to 105/5-16 (2012), addressing loans and investments that an Illinois savings association may make. The statute reads:
Usury law inapplicable. No interest, premium, or interest on such interest or premium, or charge which may accrue to an association under the provisions of this Act shall be deemed to be usurious; and the same may be collected in the same manner as other debts in accordance with the laws of this State.
205 ILL. COMP. STAT. 105/5-10.
Accordingly, the Illinois Supreme Court might well decline to follow Bowman in a newly arising case. Nevertheless, on the strength of Bowman, some Illinois lawyers continue to include a qualification for provisions for compound interest or interest on interest.
77. It is common for California opinion givers to assume the existence of those facts necessary to satisfy the requirements for one of the constitutional or statutory exemptions from California usury law. See, e.g., CALIFORNIA SAMPLE OPINION, supra note 10, at 6–7 n.16 (discussing the inclusion of assumptions relevant to the enforceability opinion, as it relates to usury law). Where no exemption is available, the practice among California opinion givers is to include a qualification to the effect that “no opinion is expressed with respect to compliance with usury laws or the effect of non-compliance” on the parties to the loan transaction, since, absent any qualification, “an opinion that a loan is enforceable includes an opinion that it is not usurious.” Id. at 7 n.16 (citing CALIFORNIA OPINION REPORT (EXCLUDING REMEDIES), supra note 21, at 20) (cautioning that, where the opinion preparers conclude, in their professional judgment, that the loan is usurious, they should consider whether it would be appropriate to give any enforceability opinion at all).
On opinions addressing, respectively, Florida and Texas usury law issues, see FLORIDA REPORT, supra note 10, at 163; Supplement No. 1 to the Report of the Legal Opinions Committee Regarding Legal Opinions in Business Transactions, BULL. BUS. L. SEC. ST. B. TEX. (Tex. State Bar Bus. Law Section Legal Opinions Comm., Austin, Tex.) Dec. 1994, at 1.
78. See 2004 TriBar Report, supra note 23, at 1492–93 (stating that when some opinion preparers conclude that the reasonableness of an economic remedy cannot be determined as a practical matter, they routinely include an express exception or assumption in their opinion, whereas other opinion preparers, in like circumstances, regard their inability to make a determination of reasonableness to be so well understood that they follow the practice—unless they have serious doubts about the reasonableness of a particular remedy—of not taking an exception). The TriBar Opinion Committee further concludes that the preferred course is for opinion preparers to deal with the issue of reasonableness explicitly in the opinion. Id. at 1493. Contra 2007 CALIFORNIA REMEDIES REPORT EXCEPTIONS APPENDIX, supra note 10, at A-3 (stating that “such provisions are subject to a test of reasonableness, which is beyond the scope of a legal opinion. An exception with respect to the reasonableness of economic remedies is implied by customary practice and need not be expressly stated.”). The 2007 California Remedies Report Exceptions Appendix goes on to state:
Nevertheless, if an opinion giver has determined that a particular economic remedy would be unenforceable, an appropriate express exception should be stated; opinion givers do not customarily rely on an unstated exception for purposes of a provision that is clearly unreasonable. An opinion giver should expect to address whether a default rate of interest (e.g., 95% per year), or a provision for the acceleration of future interest without appropriate discount to present value, would be clearly unenforceable, as well as whether any specific requirements for enforceability other than reasonableness—for example, that the provision be separately initialed, or that it be printed in a specified font size (and some of which apply even to commercial transactions)—have been satisfied.
Id.
79. See 2004 TriBar Report, supra note 23, at 1491–93 & n.49.
80. USA PATRIOT Act of 2001, Pub. L. No. 107-56, 115 Stat. 357 (codified as amended in scattered sections of the U.S.C.) [hereinafter Patriot Act].
81. In lieu of taking a Patriot Act exception to the remedies opinion, some opinion givers take this qualification more broadly as part of their list of excluded laws not covered by the opinion letter in its entirety. Furthermore, some opinion givers take a qualification for the Patriot Act, without making express reference to the Act, by taking a broader exclusion for “any laws, rules or regulations relating to terrorism or money laundering.”
95. See Jennifer Freeman, Judgments in Foreign Currency—A Little Known Change in New York Law, 23 INT’L LAW. 737, 741 (1989); see also Agfa-Gevaert, A.G. v. A.B. Dick Co., 879 F.2d 1518, 1524 (7th Cir. 1989).
97. UNIF. FOREIGN-MONEY CLAIMS ACT §§ 1–19, 13(II) U.L.A. 17 (2002) [hereinafter UFMCA]. As of 2014, California, Colorado, Connecticut, Delaware, District of Columbia, Hawaii, Idaho, Illinois, Minnesota, Montana, Nevada, New Jersey, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, Oregon, Rhode Island, U.S. Virgin Islands, Utah, Virginia, Washington, and Wisconsin had all enacted such Act in substantial part. 13(II) U.L.A. 2014 Cum. Ann. Pocket Part 13.
102. See RESTATEMENT (SECOND) OF JUDGMENTS § 18 cmt. a (1982).
103. See id. § 24(1). Opinion givers opining as to the law of a state that has adopted section 5(c) of the UFMCA, such as California, Delaware, Illinois, and North Carolina, might consider adding, at the end of the sample qualification set out in the text in boldface type above, an exception such as the following:
except to the extent authorized by [Section 5(c)] of the Uniform Foreign-Money Claims Act, as enacted in the State of ______.
Section 5(c) of the UFMCA as adopted in California and Illinois provides: “If, because of unexcused delay in payment of a judgment or award, the amount received by the creditor does not equal the amount of the foreign money specified in the agreement, the court or arbitrator shall amend the judgment or award accordingly.” CAL. CIV. PROC. CODE § 676.5(c) (West 2009); 735 ILL. COMP. STAT. 5/12-635(c) (2012). Comment 3 to that section 5(c) of the UFMCA expressly states that the purpose of the provision is to prevent application of the merger doctrine where the cause of a discrepancy between the amount received and the agreed-upon amount is the payor’s unexcused delay in paying the judgment.
The Opinions Committee (the “Committee”) of the Business Law Section of the State Bar of California (the “California State Bar Business Law Section”) has prepared and issued this sample opinion (the “Venture Opinion”)1 in consultation with the Corporations Committee (the “Corporations Committee”) of the California State Bar Business Law Section, and with the approval of the Executive Committee of the California State Bar Business Law Section. The editors and contributors to the Venture Opinion are the following:
In 2009, the Opinions Committee of the Business Law Section of the State Bar of California published a commentary on customary practice with respect to third-party legal opinions given in venture capital financing transactions (the “2009 Venture Capital Report”).2 This sample opinion (the “Venture Opinion”), along with the accompanying footnotes, augments the 2009 Venture Capital Report by providing an illustration of what an opinion letter given in a venture capital financing transaction might look like.
The Venture Opinion builds upon several prior exemplars: the Committee’s Sample California Third-Party Legal Opinion for Business Transactions (the “Transactional Opinion”),3 the “Boston Form” based upon the ABA Legal Opinion Principles,4 and the form legal opinion of the National Venture Capital Association.5 Unlike the Venture Opinion, both the Transactional Opinion and the BostonForm use an unsecured loan as their transactional model. In addition to building on these prior forms, the Venture Opinion is based on various other opinion reports of the California State Bar Business Law Section6 and other bar associations, such as the Committee on Legal Opinions of the American Bar Association’s Section of Business Law7 and the TriBar Opinion Committee.8 The Venture Opinion provides an illustration of an opinion letter, based on the principles articulated in the 2009 Venture Capital Report, that is directly relevant to venture financings 9of the type frequently consummated in California and elsewhere, including examples of opinions on capitalization, stock issuances, and “no registration.”
The Committee chose as the transaction model for the Venture Opinion a private offering, not involving general solicitation or general advertising, of Series B Preferred Stock by a Delaware corporation10 under transaction documents governed by California law.11 The Venture Opinion is annotated and contains alternative language for use when the company is incorporated in California. Because the Venture Opinion uses a Delaware corporation as the issuer, opinion preparers should consider in each case whether they have the competence to give, when requested, opinions under the Delaware General Corporation Law.12 Finally, the opinion recipients are identified in the Venture Opinion as the purchasers of the company’s Series B Preferred Stock under the stock purchase agreement. A Series B Preferred Stock financing highlights, among other things, the serial nature of most Venture Financings.
As noted in the Transactional Opinion, no single form of legal opinion can be viewed as the “sole” or even in most cases the “best” or “preferred” form for use in Venture Financings or any other business transaction. The Venture Opinion, therefore, is illustrative and should not be treated as prescriptive.
The Venture Opinion should be interpreted in accordance with the customary practice of California lawyers in giving opinions (and advising those who receive opinions) as articulated in the various opinion reports of the California State Bar Business Law Section and other professional associations, such as the American Bar Association’s Section of Business Law and the TriBar Opinion Committee.
A clean version of the Venture Opinion, without footnotes, follows the annotated form and is attached as Exhibit A.
SAMPLE CALIFORNIA THIRD-PARTY LEGAL OPINION FOR VENTURE CAPITAL FINANCING TRANSACTIONS13
To the Purchasers on the date hereof15 of [Company Name] Series B Preferred Stock Listed on Exhibit A to the Series B Preferred Stock [and Warrant] Purchase Agreement
Ladies and Gentlemen:
We have acted as counsel for [Company Name], a Delaware corporation (the “Company”),16 in connection with the sale and issuance on the date hereof by the Company to you of _____ shares of the Company’s Series B Preferred Stock (the “Shares”) [and the sale of warrants to purchase _____ shares of the Company’s [Type of Securities] (the “Warrants”), each] pursuant to the Series B Preferred Stock [and Warrant] Purchase Agreement (the “Purchase Agreement”), dated as of __________, 20___ among the Company and the persons listed on Exhibit A attached thereto (the “Purchasers”). This opinion letter is delivered to you pursuant to Section _____ of the Purchase Agreement.17 Each capitalized term that is defined in the Purchase Agreement and that is used but not defined in this opinion letter has the meaning given to it in the Purchase Agreement.
the Investors’ Rights Agreement, dated as of ______, 20___ (the “Investors’ Rights Agreement”);
(iii)
the Right of First Refusal and Co-Sale Agreement, dated as of _______, 20__ (the “Co-Sale Agreement”);
(iv)
the Voting Agreement, dated as of __________, 20___ (the “Voting Agreement”);
(v)
the [form of] Warrant[s] [to be] issued to the Purchasers pursuant to the Purchase Agreement;
(vi)
the Schedule of Exceptions to the Purchase Agreement (the “Schedule of Exceptions”);
(vii)
the Certificate of Incorporation of the Company, as amended to date, certified by the Delaware Secretary of State as of ____________, 20__ and certified to us by an officer of the Company as being complete and in full force and effect as of the date of this opinion letter (the “Restated Charter”);20
(viii)
the Bylaws of the Company, certified to us by an officer of the Company as being complete and in full force and effect as of the date of this opinion letter;
(ix)
records certified to us by an officer of the Company as constituting the records of proceedings and actions of the board of directors [and the stockholders]21 of the Company relevant to the opinions set forth below;22
(x)
a Certificate of Status—Foreign Corporation with respect to the Company, issued by the California Secretary of State on __________, 20___;23
(xi)
a Good Standing Certificate with respect to the Company, issued by the Delaware24 Secretary of State on __________, 20___;25
(xii)
a certificate of the [Chief Executive Officer, Chief Financial Officer, or other appropriate officer]26 of the Company identifying certain agreements and instruments to which the Company is a party or by which the Company’s properties or assets are bound (the “Certificate Relating to Agreements”); 27
(xiii)
a copy of each of the agreements and instruments identified in the Certificate Relating to Agreements, certified to us as being a true and complete copy of the original (“Scheduled Agreements”); 28
(xiv)
a certificate of the [Chief Executive Officer, Chief Financial Officer, or other appropriate officer]29 of the Company as to certain factual matters relevant to the opinions expressed below;30 [and]
(xv)
the Capitalization Records (as defined in Section E (“Certain Qualifications”) below). [; and]
[(xvi)
the Certificate of Transfer Agent (as defined in Section E (“Certain Qualifications”) below).]
Each of the documents identified in items (i) through [(iv) OR (v)] above is sometimes referred to below as a “Transaction Document.”31
The shares of Common Stock issuable upon conversion of the Shares are referred to herein as the “Conversion Shares32 [,” the shares of Series B Preferred Stock issuable upon exercise of the Warrants are referred to below as the “Warrant Shares,” and the shares of Common Stock issuable upon conversion of the Warrant Shares are referred to below as the “Warrant Conversion Shares].”
We have also examined such other documents and made such further legal and factual examination and investigation as we deem necessary for purposes of giving the following opinions.33
We have assumed, for purposes of the opinions set forth below, that:
(a)
The information provided by the Company to the Purchasers in connection with the offer and sale of the Shares is accurate and complete;35
(b)
The Company’s representations to us [that the Company and its agents have made no offer to sell the Shares by means of any general solicitation or in connection with the publication of any advertisement relating to such an offer and] that no offer or sale of the Shares has been made or will be made in any state outside of [California] where such offer or sale would be contrary to applicable law are accurate and complete;36
(c)
The representations and warranties made by the Company and all prior purchasers of the Company’s securities given in connection with the sale of such securities are accurate and complete;37
(d)
The Company is not disqualified from relying on the exemption from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), provided by Rule 506 thereunder by reason of the provisions of paragraphs (d) or (e) of Rule 506;38 [; and]
(e)
At the time of conversion of the Shares into Common Stock [and/or Warrant Shares into Common Stock] a sufficient number of shares of Common Stock will be authorized and available for issuance under the Company’s certificate of incorporation as then in effect to satisfy (i) the conversion of all Shares (and all other then outstanding shares of the Company’s Preferred Stock) into Common Stock at the then effective respective conversion rates of such shares and (ii) the exercise, conversion and exchange rights of all other then outstanding securities of the Company that are then, directly or indirectly, issuable or exchangeable for, or convertible into, Common Stock at their then effective rates of issuance, exchange or conversion.39 [; and]
[(f)
At the time of exercise of the Warrants, a sufficient number of Warrant Shares will be authorized and available for issuance under the Company’s certificate of incorporation as then in effect to satisfy the Company’s obligations under the Warrants to issue all of such Warrant Shares.]40
C. OPINIONS
Based on the foregoing, and subject to the qualifications set forth in Section E (“Certain Qualifications”) below, [and except as specifically set forth in the Schedule of Exceptions,]41 we are of the opinion that:
1. The Company is a corporation validly existing42 and in good standing under the laws of the State of Delaware.43 The Company is qualified to transact intrastate business44 and is in good standing under the laws of the State of California.
2. The Company has the corporate power45 to enter into and perform46 its obligations under each of the Transaction Documents.47
3. The Transaction Documents have been duly authorized by all necessary corporate action on the part of the Company48 and have been duly executed and delivered by the Company.49
4. The Company’s authorized capitalization consists of (a) _____ shares of Common Stock, of which _____ shares are issued and outstanding, and (b) _____ shares of Preferred Stock, of which (i) _____ shares have been designated as Series A Preferred Stock, all of which are issued and outstanding, and (ii) _____ shares have been designated as Series B Preferred Stock, none of which have been issued.50 The issued and outstanding shares of Common Stock and Preferred Stock of the Company have been duly authorized51 and validly issued52 and are fully paid53 and nonassessable.54
5. The Shares have been duly authorized55 for issuance and, when issued and paid for in accordance with the provisions of the Purchase Agreement, will be validly issued, fully paid and nonassessable56 The Conversion Shares have been duly authorized for issuance and, when and if issued upon conversion of the Shares in accordance with the Restated Charter,57 will be validly issued, fully paid and nonassessable. [The Warrant Shares have been duly authorized for issuance and, when and if issued upon exercise of the Warrants in accordance with the provisions of the Warrants, will be validly issued, fully paid and nonassessable. The Warrant Conversion Shares have been duly authorized for issuance and, when and if issued upon conversion of the Warrant Shares in accordance with the Restated Charter,58 will be validly issued, fully paid and nonassessable.]
6. Each of the Purchase Agreement, Investors’ Rights Agreement, [and] Co-Sale Agreement [and Warrant]59 is a valid and binding obligation of the Company enforceable60 against the Company in accordance with its terms.61
7. All consents, approvals, authorizations or orders of, and filings, registrations and qualifications on the part of the Company with, any United States federal or California state regulatory authority or governmental body pursuant to any Covered Law (as defined in Section E (“Certain Qualifications”) below)62 required to execute and deliver the Transaction Documents63 and for the sale and issuance of the Shares [and Warrants] under the Purchase Agreement as of the closing have been obtained or made. 64
8. The execution and delivery by the Company of the Transaction Documents, and65 the sale and issuance of the Shares [and Warrants] under the Purchase Agreement as of the closing, do not66:
(a) violate the Restated Charter or the Bylaws;
(b) result in a breach of or constitute a default by the Company under any Scheduled Agreement, but excluding (i) financial covenants and similar provisions therein requiring financial calculations or determinations to ascertain compliance or (ii) provisions relating to the occurrence of a “material adverse event” or “material adverse change” or words or concepts to similar effect; 67
(c) violate any judgment, order or decree applicable to the Company of any court or arbitrator identified in Section _____ of the Schedule of Exceptions;68 or
(d) violate any Covered Law (as defined in Section E (“Certain Qualifications”) below) to which the Company is subject.69
9. Based on, and assuming the accuracy of, the representations of each of the Purchasers in the Purchase Agreement, the offer and sale of the Shares70 [and the Warrants] and, assuming [the Warrants were exercised by the Purchasers in accordance with their terms on the date of this opinion letter and] the Shares [and the Warrant Shares] were converted on the date of this opinion letter in accordance with the conversion provisions of the Restated Charter, the issuance of [the Warrant Shares and] the Conversion Shares [and Warrant Conversion Shares]71 do not require registration under Section 5 of the Securities Act [or qualification under the California Corporate Securities Law of 1968, as amended].72
D. CONFIRMATION
We are not representing the Company in any action or proceeding that is pending, or overtly threatened in writing by a potential claimant, that seeks to enjoin the transaction or challenge the validity of the Transaction Documents or the performance by the Company of its obligations thereunder.73
E. CERTAIN QUALIFICATIONS
Our opinions are limited to the federal law of the United States, the law of the State of California,74 and the Delaware75 General Corporation Law76 but in each case only to laws that in our experience are typically applicable to transactions of the type exemplified by the Transaction Documents. We express no opinion with respect to compliance with any law, rule or regulation that as a matter of customary practice is understood to be covered only when an opinion refers to it expressly. Without limiting the generality of the foregoing [and except as specifically stated herein], we express no opinion on local or municipal law, antitrust, unfair competition, environmental, land use, antifraud, tax, pension, labor, employee benefit, health care, privacy, margin, insolvency, fraudulent transfer, antiterrorism, money laundering, racketeering, criminal and civil forfeiture, foreign corrupt practices, foreign asset or trading controls, or investment company laws.77 We express no opinion on any securities laws except as expressly stated in Section C (“Opinions”), paragraph 9.78 The law covered by this opinion letter is referred to herein as the “Covered Law.”
Our opinions are subject to the following additional qualifications:
(1) Our opinions are subject to (a) bankruptcy, insolvency, reorganization, arrangement, moratorium and other similar laws of general applicability relating to or affecting creditors’ rights generally; and (b) general principles of equity, including, without limitation, concepts of materiality, reasonableness, good faith and fair dealing, regardless of whether considered in a proceeding in equity or at law.79
(2) Where a statement is qualified by “to our knowledge” or any similar phrase, that knowledge is limited to the actual knowledge of lawyers currently in this firm who have been involved in representing the Company in connection with the Transaction Documents. Except as otherwise expressly indicated, we have not undertaken any independent investigation to determine the accuracy of any such statement, and no inference as to our knowledge of any matters bearing on the accuracy of any such statement should be drawn from the fact of our representation of the Company. 80
(3) We advise you that, on statutory or public policy grounds, waivers or limitations of the following may not be enforced: (i) broadly or vaguely stated rights, (ii) the benefits of statutory, regulatory or constitutional rights, (iii) unknown future defenses, and (iv) rights to one or more types of damages.
(4) [The enforcement of Section _____ of [the __________ Agreement], relating to the payment of attorneys’ fees and costs, is subject to the effect of Section 1717 of the California Civil Code.]81
(5) [We express no opinion regarding the enforceability of [Section _____] of the [__________ Agreement], which purports to fix the venue of proceedings related to the [__________ Agreement].]82
(6) [We express no opinion regarding the enforceability of [Section _____] of the [__________ Agreement], which purports to waive the parties’ rights to a jury trial.]83
(7) [We express no opinion regarding the enforceability of [Section _____] of the [__________ Agreement], which purports to submit disputes to arbitration.]84
(8) The opinions above relating to the fully paid status of all of the issued shares of capital stock of the Company are based, without independent verification, on the representation in the Officers’ Certificate to the effect that the Company has received the consideration in the amount and form approved by the Company’s Board of Directors prior to the issuance of each outstanding share of capital stock of the Company.85
(9) With respect to the equity capitalization opinion set forth in Section C (“Opinions”), paragraph 4,86 please note that we do not maintain any of the Company’s stock records. Such records are maintained by [a third-party stock transfer agent (“Agent”)] [the Company] and we do not have any control over the procedures used by [Agent] [the Company] for issuing and transferring shares of the Company’s capital stock. Accordingly, in giving the equity capitalization opinion, we have relied without further investigation on (a) the Restated Charter, (b) the Bylaws, (c) minute books relating to meetings and written actions of the incorporator(s), Board of Directors, and stockholders of the Company [in our possession] [delivered to us by the Company for the purposes of giving this opinion], (d) our review of the stock records of the Company maintained by [Agent] [the Company], consisting of [description], (e) statements in a certificate the Company has delivered to us relating to the equity capitalization of the Company, and (f) the attached Certificate of Transfer Agent issued by [Agent] [the Company] as of [date] (collectively, the “Capitalization Records”). We have not undertaken to verify the accuracy and completeness of that information other than by reviewing the Capitalization Records. Accordingly, our opinion on the number and character of issued and outstanding securities means that, based upon the examination referred to above, the Capitalization Records are consistent with the information as to the number and character of outstanding securities that is set forth in Section C (“Opinions”), paragraph 4.87
(10) We express no opinion as to the enforceability of any indemnification or contribution provisions in the Transaction Documents (or other provisions having an effect similar to any of these types of provisions) to the extent that the enforceability of such provisions is limited [by United States federal or state laws concerning the issuance or sale of securities or] by public policy or statutory provisions or that such indemnification or similar provisions purport to indemnify a party against, or release a party from liability for, its own fraudulent or illegal actions or [gross] negligence. 8887. The Committee believes that the current trend is against giving “Outstanding Options Opinions” and “No Outstanding Preemptive Rights Opinions” and, therefore, neither has been included in the Venture Opinion. See supra note 54. Nevertheless, to the extent those opinions are given, the further qualifications articulated in the 2009 Venture Capital Report are appropriate:
(11) [We express no opinion as to whether the members of the Company’s Board of Directors or officers have complied with their fiduciary duties in connection with their approval of the Transaction Documents or the effect, if any, of any Covered Law regarding (a) the fiduciary duties of majority stockholders, or (b) the rights of minority stockholders with respect to the transactions contemplated by the Transaction Documents or the corporate or other approvals of those transactions.]89
(12) We express no opinion with respect to, or as to the effect of, any provisions imposing obligations to vote the Company’s capital stock in a certain manner or to comply with any drag-along provisions, including without limitation those provisions set forth in the Voting Agreement.90
This opinion letter may be relied on solely by the Purchasers for use in connection with their purchase and sale of the Shares [and Warrants] pursuant to the Purchase Agreement. This opinion letter may not be relied on by any other party or for any other purpose without our prior written consent.91
Very truly yours, [Law Firm]
EXHIBIT A SAMPLE CALIFORNIA THIRD-PARTY LEGAL OPINION FOR VENTURE CAPITAL FINANCING TRANSACTIONS (UNANNOTATED)
[Date]
To the Purchasers on the date hereof of
[Company Name] Series B Preferred
Stock Listed on Exhibit A to the Series
B Preferred Stock [and Warrant] Purchase Agreement
Ladies and Gentlemen:
We have acted as counsel for [Company Name], a Delaware corporation (the “Company”), in connection with the sale and issuance on the date hereof by the Company to you of _____ shares of the Company’s Series B Preferred Stock (the “Shares”) [and the sale of warrants to purchase _____ shares of the Company’s [Type of Securities] (the “Warrants”), each] pursuant to the Series B Preferred Stock [and Warrant] Purchase Agreement (the “Purchase Agreement”), dated as of __________, 20___ among the Company and the persons listed on Exhibit A attached thereto (the “Purchasers”). This opinion letter is delivered to you pursuant to Section _____ of the Purchase Agreement. Each capitalized term that is defined in the Purchase Agreement and that is used but not defined in this opinion letter has the meaning given to it in the Purchase Agreement.
A. DOCUMENTS EXAMINED
We have examined the following documents:
(i)
the Purchase Agreement;
(ii)
the Investors’ Rights Agreement, dated as of ______ , 20__ (the “Investors’ Rights Agreement”);
(iii)
the Right of First Refusal and Co-Sale Agreement, dated as of __________, 20__ (the “Co-Sale Agreement”);
(iv)
the Voting Agreement, dated as of __________, 20__ (the “Voting Agreement”);
(v)
the [form of] Warrant[s] [to be] issued to the Purchasers pursuant to the Purchase Agreement;
(vi)
the Schedule of Exceptions to the Purchase Agreement (the “Schedule of Exceptions”);
(vii)
the Certificate of Incorporation of the Company, as amended to date, certified by the Delaware Secretary of State as of ____________, 20__ and certified to us by an officer of the Company as being complete and in full force and effect as of the date of this opinion letter (the “Restated Charter”);
(viii)
the Bylaws of the Company, certified to us by an officer of the Company as being complete and in full force and effect as of the date of this opinion letter;
(ix)
records certified to us by an officer of the Company as constituting the records of proceedings and actions of the board of directors [and the stockholders] of the Company relevant to the opinions set forth below;
(x)
a Certificate of Status—Foreign Corporation with respect to the Company, issued by the California Secretary of State on __________, 20__;
(xi)
a Good Standing Certificate with respect to the Company, issued by the Delaware Secretary of State on __________, 20___;
(xii)
a certificate of the [Chief Executive Officer, Chief Financial Officer, or other appropriate officer] of the Company identifying certain agreements and instruments to which the Company is a party or by which the Company’s properties or assets are bound (the “Certificate Relating to Agreements”);
(xiii)
a copy of each of the agreements and instruments identified in the Certificate Relating to Agreements, certified to us as being a true and complete copy of the original (“Scheduled Agreements”);
(xiv)
a certificate of the [Chief Executive Officer, Chief Financial Officer, or other appropriate officer] of the Company as to certain factual matters relevant to the opinions expressed below; [and]
(xv)
the Capitalization Records (as defined in Section E (“Certain Qualifications”) below). [; and]
[(xvi)
the Certificate of Transfer Agent (as defined in Section E (“Certain Qualifications”) below).]
Each of the documents identified in items (i) through [(iv) OR (v)] above is sometimes referred to below as a “Transaction Document.”
The shares of Common Stock issuable upon conversion of the Shares are referred to herein as the “Conversion Shares [,” the shares of Series B Preferred Stock issuable upon exercise of the Warrants are referred to below as the “Warrant Shares,” and the shares of Common Stock issuable upon conversion of the Warrant Shares are referred to below as the “Warrant Conversion Shares].”
We have also examined such other documents and made such further legal and factual examination and investigation as we deem necessary for purposes of giving the following opinions.
B. CERTAIN ASSUMPTIONS
We have assumed, for purposes of the opinions set forth below, that:
(a)
The information provided by the Company to the Purchasers in connection with the offer and sale of the Shares is accurate and complete;
(b)
The Company’s representations to us [that the Company and its agents have made no offer to sell the Shares by means of any general solicitation or in connection with the publication of any advertisement relating to such an offer and] that no offer or sale of the Shares has been made or will be made in any state outside of [California] where such offer or sale would be contrary to applicable law are accurate and complete;
(c)
The representations and warranties made by the Company and all prior purchasers of the Company’s securities given in connection with the sale of such securities are accurate and complete;
(d)
The Company is not disqualified from relying on the exemption from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), provided by Rule 506 thereunder by reason of the provisions of paragraphs (d) or (e) of Rule 506; [; and]
(e)
At the time of conversion of the Shares into Common Stock [and/or Warrant Shares into Common Stock] a sufficient number of shares of Common Stock will be authorized and available for issuance under the Company’s certificate of incorporation as then in effect to satisfy (i) the conversion of all Shares (and all other then outstanding shares of the Company’s Preferred Stock) into Common Stock at the then effective respective conversion rates of such shares and (ii) the exercise, conversion and exchange rights of all other then outstanding securities of the Company that are then, directly or indirectly, issuable or exchangeable for, or convertible into, Common Stock at their then effective rates of issuance, exchange or conversion. [; and]
[(f)
At the time of exercise of the Warrants, a sufficient number of Warrant Shares will be authorized and available for issuance under the Company’s certificate of incorporation as then in effect to satisfy the Company’s obligations under the Warrants to issue all of such Warrant Shares.]
C. OPINIONS
Based on the foregoing, and subject to the qualifications set forth in Section E (“Certain Qualifications”) below, [and except as specifically set forth in the Schedule of Exceptions,] we are of the opinion that:
1. The Company is a corporation validly existing and in good standing under the laws of the State of Delaware. The Company is qualified to transact intrastate business and is in good standing under the laws of the State of California.
2. The Company has the corporate power to enter into and perform its obligations under each of the Transaction Documents.
3. The Transaction Documents have been duly authorized by all necessary corporate action on the part of the Company and have been duly executed and delivered by the Company.
4. The Company’s authorized capitalization consists of (a) _____ shares of Common Stock, of which _____ shares are issued and outstanding, and (b) _____ shares of Preferred Stock, of which (i) _____ shares have been designated as Series A Preferred Stock, all of which are issued and outstanding, and (ii) _____ shares have been designated as Series B Preferred Stock, none of which have been issued. The issued and outstanding shares of Common Stock and Preferred Stock of the Company have been duly authorized and validly issued and are fully paid and nonassessable.
5. The Shares have been duly authorized for issuance and, when issued and paid for in accordance with the provisions of the Purchase Agreement, will be validly issued, fully paid and nonassessable. The Conversion Shares have been duly authorized for issuance and, when and if issued upon conversion of the Shares in accordance with the Restated Charter, will be validly issued, fully paid and nonassessable. [The Warrant Shares have been duly authorized for issuance and, when and if issued upon exercise of the Warrants in accordance with the provisions of the Warrants, will be validly issued, fully paid and nonassessable. The Warrant Conversion Shares have been duly authorized for issuance and, when and if issued upon conversion of the Warrant Shares in accordance with the Restated Charter, will be validly issued, fully paid and nonassessable.]
6. Each of the Purchase Agreement, Investors’ Rights Agreement, [and] Co-Sale Agreement [and Warrant] is a valid and binding obligation of the Company enforceable against the Company in accordance with its terms.
7. All consents, approvals, authorizations or orders of, and filings, registrations and qualifications on the part of the Company with, any United States federal or California state regulatory authority or governmental body pursuant to any Covered Law (as defined in Section E (“Certain Qualifications”) below) required to execute and deliver the Transaction Documents and for the sale and issuance of the Shares [and Warrants] under the Purchase Agreement as of the closing have been obtained or made.
8. The execution and delivery by the Company of the Transaction Documents, and the sale and issuance of the Shares [and Warrants] under the Purchase Agreement as of the closing, do not:
(a) violate the Restated Charter or the Bylaws;
(b) result in a breach of or constitute a default by the Company under any Scheduled Agreement, but excluding (i) financial covenants and similar provisions therein requiring financial calculations or determinations to ascertain compliance or (ii) provisions relating to the occurrence of a “material adverse event” or “material adverse change” or words or concepts to similar effect;
(c) violate any judgment, order or decree applicable to the Company of any court or arbitrator identified in Section _____ of the Schedule of Exceptions; or
(d) violate any Covered Law (as defined in Section E (“Certain Qualifications”) below) to which the Company is subject.
9. Based on, and assuming the accuracy of, the representations of each of the Purchasers in the Purchase Agreement, the offer and sale of the Shares [and the Warrants] and, assuming [the Warrants were exercised by the Purchasers in accordance with their terms on the date of this opinion letter and] the Shares [and the Warrant Shares] were converted on the date of this opinion letter in accordance with the conversion provisions of the Restated Charter, the issuance of [the Warrant Shares and] the Conversion Shares [and Warrant Conversion Shares] do not require registration under Section 5 of the Securities Act [or qualification under the California Corporate Securities Law of 1968, as amended].
D. CONFIRMATION
We are not representing the Company in any action or proceeding that is pending, or overtly threatened in writing by a potential claimant, that seeks to enjoin the transaction or challenge the validity of the Transaction Documents or the performance by the Company of its obligations thereunder.
E. CERTAIN QUALIFICATIONS
Our opinions are limited to the federal law of the United States, the law of the State of California, and the Delaware General Corporation Law but in each case only to laws that in our experience are typically applicable to transactions of the type exemplified by the Transaction Documents. We express no opinion with respect to compliance with any law, rule or regulation that as a matter of customary practice is understood to be covered only when an opinion refers to it expressly. Without limiting the generality of the foregoing [and except as specifically stated herein,] we express no opinion on local or municipal law, antitrust, unfair competition, environmental, land use, antifraud, tax, pension, labor, employee benefit, health care, margin, privacy, insolvency, fraudulent transfer, antiterrorism, money laundering, racketeering, criminal and civil forfeiture, foreign corrupt practices, foreign asset or trading controls, or investment company laws. We express no opinion on any securities laws except as expressly stated in Section C (“Opinions”), paragraph 9. The law covered by this opinion letter is referred to herein as the “Covered Law.”
Our opinions are subject to the following additional qualifications:
(1) Our opinions are subject to (a) bankruptcy, insolvency, reorganization, arrangement, moratorium and other similar laws of general applicability relating to or affecting creditors’ rights generally; and (b) general principles of equity, including, without limitation, concepts of materiality, reasonableness, good faith and fair dealing, regardless of whether considered in a proceeding in equity or at law.
(2) Where a statement is qualified by “to our knowledge” or any similar phrase, that knowledge is limited to the actual knowledge of lawyers currently in this firm who have been involved in representing the Company in connection with the Transaction Documents. Except as otherwise expressly indicated, we have not undertaken any independent investigation to determine the accuracy of any such statement, and no inference as to our knowledge of any matters bearing on the accuracy of any such statement should be drawn from the fact of our representation of the Company.
(3) We advise you that, on statutory or public policy grounds, waivers or limitations of the following may not be enforced: (i) broadly or vaguely stated rights, (ii) the benefits of statutory, regulatory or constitutional rights, (iii) unknown future defenses, and (iv) rights to one or more types of damages.
(4) [The enforcement of Section _____ of [the __________ Agreement], relating to the payment of attorneys’ fees and costs, is subject to the effect of Section 1717 of the California Civil Code.]
(5) [We express no opinion regarding the enforceability of [Section _____] of the [__________ Agreement], which purports to fix the venue of proceedings related to the [__________ Agreement].]
(6) [We express no opinion regarding the enforceability of [Section _____] of the [__________ Agreement], which purports to waive the parties’ rights to a jury trial.]
(7) [We express no opinion regarding the enforceability of [Section _____] of the [__________ Agreement], which purports to submit disputes to arbitration.]
(8) The opinions above relating to the fully paid status of all of the issued shares of capital stock of the Company are based, without independent verification, on the representation in the Officers’ Certificate to the effect that the Company has received the consideration in the amount and form approved by the Company’s Board of Directors prior to the issuance of each outstanding share of capital stock of the Company.
(9) With respect to the equity capitalization opinion set forth in Section C (“Opinions”), paragraph 4, please note that we do not maintain any of the Company’s stock records. Such records are maintained by [a third-party stock transfer agent (“Agent”)] [the Company] and we do not have any control over the procedures used by [Agent] [the Company] for issuing and transferring shares of the Company’s capital stock. Accordingly, in giving the equity capitalization opinion, we have relied without further investigation on (a) the Restated Charter, (b) the Bylaws, (c) minute books relating to meetings and written actions of the incorporator(s), Board of Directors, and stockholders of the Company [in our possession] [delivered to us by the Company for the purposes of giving this opinion], (d) our review of the stock records of the Company maintained by [Agent] [the Company], consisting of [description], (e) statements in a certificate the Company has delivered to us relating to the equity capitalization of the Company, and (f) the attached Certificate of Transfer Agent issued by [Agent] [the Company] as of [date] (collectively, the “Capitalization Records”). We have not undertaken to verify the accuracy and completeness of that information other than by reviewing the Capitalization Records. Accordingly, our opinion on the number and character of issued and outstanding securities means that, based upon the examination referred to above, the Capitalization Records are consistent with the information as to the number and character of outstanding securities that is set forth in Section C (“Opinions”), paragraph 4.
(10) We express no opinion as to the enforceability of any indemnification or contribution provisions in the Transaction Documents (or other provisions having an effect similar to any of these types of provisions) to the extent that the enforceability of such provisions is limited [by United States federal or state laws concerning the issuance or sale of securities or] by public policy or statutory provisions or that such indemnification or similar provisions purport to indemnify a party against, or release a party from liability for, its own fraudulent or illegal actions or [gross] negligence.
(11) [We express no opinion as to whether the members of the Company’s Board of Directors or officers have complied with their fiduciary duties in connection with their approval of the Transaction Documents or the effect, if any, of any Covered Law regarding (a) the fiduciary duties of majority stockholders, or (b) the rights of minority stockholders with respect to the transactions contemplated by the Transaction Documents or the corporate or other approvals of those transactions.]
(12) We express no opinion with respect to, or as to the effect of, any provisions imposing obligations to vote the Company’s capital stock in a certain manner or to comply with any drag-along provisions, including without limitation those provisions set forth in the Voting Agreement.
This opinion letter may be relied on solely by the Purchasers for use in connection with their purchase and sale of the Shares [and Warrants] pursuant to the Purchase Agreement. This opinion letter may not be relied on by any other party or for any other purpose without our prior written consent.
Very truly yours, [Law Firm]
_____________
1. The statements and views in the Venture Opinion and accompanying footnotes are those of the collective membership of the Committee and not necessarily those of the State Bar of California. The Venture Opinion is made available with the understanding that neither the State Bar of California nor the Committee is engaged in rendering legal or other professional services in publishing it. If legal advice or other expert assistance is required, the services of a competent, professional person should be sought.
2. Opinions Comm. of the Bus. Law Section of the State Bar of Cal., Report on Selected Legal OpinionIssues in Venture Capital Financing Transactions, 65 BUS. LAW. 161 (2009) [hereinafter 2009 VentureCapital Report].
3. OPINIONS COMM. OF THE BUS. LAW SECTION OF THE STATE BAR OF CAL., SAMPLE CALIFORNIA THIRD-PARTY LEGAL OPINION FOR BUSINESS TRANSACTIONS (rev. Aug. 2014) [hereinafter TRANSACTIONAL OPINION], avail-able at apps.americanbar.org/buslaw/tribar (under the “State and Other Bar Reports” subsection).
4. Donald W. Glazer & Stanley Keller, A Streamlined Form of Closing Opinion Based on the ABA LegalOpinion Principles, 61 BUS. LAW. 389 (2005) [hereinafter Boston Form].
5. MODEL LEGAL OPINION OF THE NATIONAL VENTURE CAPITAL ASSOCIATION (rev. June 2013) [hereinafter NVCA FORM], available athttp://goo.gl/VIjFz (under the “Model Legal Documents” tab). The original NVCA Form predates the publication of both the 2009 Venture Capital Report and the Transactional Opinion.
6. See, e.g., CORPS. COMM. OF THE BUS. LAW SECTION OF THE STATE BAR OF CAL., LEGAL OPINIONS IN BUSI-NESS TRANSACTIONS (EXCLUDING THE REMEDIES OPINION) (May 2005) (2007 printing) [hereinafter 2007 Business Transactions Report]; BUS. LAW SECTION, STATE BAR OF CAL., REPORT ON THIRD-PARTY REMEDIES OPINIONS: 2007 UPDATE (2007) [hereinafter 2007 REMEDIES REPORT]; P’SHPS & LTD. LIAB. COS. COMM. OF THE BUS. LAW SECTION OF THE STATE BAR OF CAL., REPORT ON LEGAL OPINIONS CONCERNING CALIFORNIA LIMITED LIABILITY COMPANIES (Feb. 2000) [hereinafter CALIFORNIA LLC REPORT].
7. See, e.g., ABA Comm. on Legal Opinions, Legal Opinion Principles, 53 BUS. LAW. 831 (1998) [hereinafter Principles]; ABA Comm. on Legal Opinions, Guidelines for the Preparation of Closing Opin-ions, 57 BUS. LAW. 875 (2002) [hereinafter Guidelines]; Subcomm. on Sec. Law Opinions, Comm. on Fed. Regulation of Sec., ABA Section of Bus. Law, No Registration Opinions, 63 BUS. LAW. 187 (2007) [hereinafter No Registration Report]; Task Force on Sec. Law Opinions, Comm. on Fed. Regulation of Sec., ABA Section of Bus. Law, Special Report: Negative Assurance in Securities Offerings (2008 Revision), 64 BUS. LAW. 395 (2009) [hereinafter Negative Assurance Report].
8. See, e.g., TriBar Opinion Comm., Report: Third-Party “Closing” Opinions, 53 BUS. LAW. 591 (1998) [hereinafter 1998 TriBar Report]; TriBar Opinion Comm., The Remedies Opinion—DecidingWhen to Include Exceptions and Assumptions, 59 BUS. LAW. 1483 (2004) [hereinafter TriBar RemediesOpinion Report]; TriBar Opinion Comm., Report on Duly Authorized Opinions on Preferred Stock, 63 BUS. LAW. 921 (May 2008) [hereinafter 2008 TriBar Preferred Stock Report].
9. Following the convention of the 2009 Venture Capital Report, as used in the Venture Opinion and the accompanying footnotes, the term “Venture Financing” refers to an equity investment in a privately held company by professional investors, and is not restricted to the financing of technology companies as the term “Venture” might imply. 2009 Venture Capital Report, supra note 2, at 163; seealso infra note 11 (the Venture Financing addressed in the Venture Opinion is a private offering not involving general solicitation or general advertising).
Although at one time venture-backed companies often incorporated in California and then reincorporated in Delaware immediately before an initial public offering, today venture-backed companies usually incorporate in Delaware at the outset.
2009 Venture Capital Report, supra note 2, at 166.
11. The Venture Opinion does not address issues raised by newly adopted Rule 506(c) under Regulation D, 78 Fed. Reg. 44771 (July 25, 2013) (effective September 23, 2013). Rule 506(c) permits general solicitation and general advertising in offerings meeting specified requirements. The Committee cannot predict whether venture firms will rely on Rule 506(c) for Venture Financings in the future to avoid registration under the Securities Act of 1933, as amended [hereinafter Securities Act]. The Committee notes that traditionally venture capital firms have preferred to include only professional investors known to them in the offerings they lead. See also infra notes 36 (which further discusses Rule 506(c)) & 70 (last sentence refers to a proposed update to the No Registration Report, supra note 7, to address the changes in Regulation D).
In addition, the Venture Opinion does not address “crowdfunding” as authorized under Title III of the Jumpstart Our Business Startups Act of 2012, Pub. L. No. 112-106, 126 Stat. 306 [hereinafter JOBS Act] creating new section 4(a)(6) of the Securities Act and addressed in recently proposed regulations of the U.S. Securities and Exchange Commission, 78 Fed. Reg. 66427 (proposed Oct. 23, 2013). Due to the $1,000,000 limitation on proceeds raised in a crowdfunding offering and limitations on the amount per investor that may be included in such an offering, Venture Financings are not likely to be conducted using the “crowdfunding” exemption from registration.
12. The fact that venture (and other) transactions commonly involve Delaware corporations presents an issue for non-Delaware lawyers asked to give legal opinions in these transactions. The 2007 Business Transactions Report states:
[A] lawyer should not be asked to render opinions on matters that are outside his or her area of professional competence. Where an opinion is appropriate but beyond the competence of the opinion giver, then the opinion giver should associate competent counsel to render the opinion.
2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 20 (footnote omitted); see infra note 51. The practice of non-Delaware lawyers has long been to give opinions on routine matters such as the corporate status of Delaware corporations and the due authorization by Delaware corporations of agreements when they regularly represent Delaware corporations and follow developments in Delaware corporation law. The practice of non-Delaware lawyers has been not to give opinions on more difficult questions of Delaware corporation law or on Delaware contract law (although some California lawyers, like lawyers elsewhere, also give routine opinions on Delaware limited liability companies even though those opinions require some consideration of Delaware contract law). See, e.g., 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 91–92; TriBar Opinion Comm., Third-Party “Closing” Opinions:Limited Liability Companies, 61 BUS. LAW. 679, 681–83 (2006) (discussing coverage by non-Delaware lawyers of Delaware contract law for purposes of providing closing opinions on Delaware limited liability companies).
No easy line can be drawn between “routine” and “more difficult” questions of Delaware corporation law. Opinion preparers must decide whether they are competent to give requested opinions. The Committee believes that the matters addressed in the Venture Opinion are matters on which California lawyers who regularly advise Delaware corporations and who follow developments in Delaware corporation law are typically competent to cover. If, however, the opinion preparers recognize that an opinion they have been asked to give involves an issue with respect to which they do not feel competent, they should consider obtaining an opinion letter from Delaware counsel, addressed directly to the opinion recipient, that covers that issue and in their own opinion letter either expressly rely on Delaware counsel’s opinion or include an express exception or assumption regarding that issue. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 35–38 (discussing foreign law and the retention of local counsel); see also infra note 51. A preliminary call to competent Delaware counsel to discuss the requested opinion may help the opinion preparers decide whether to retain Delaware counsel to address the issue in question.
13. Consistent with the Transactional Opinion, the Venture Opinion is often referred to as an “opinion letter” even though, in addition to legal opinions, it contains a factual confirmation (which is presented in Section D (“Confirmation”)). As with the Transactional Opinion, the Venture Opinion does not specifically state that it is to be interpreted in accordance with the customary practice of lawyers giving opinions in California; however, regardless of whether such a statement is included in the opinion letter, the opinion letter should be interpreted in light of such customary practice. Some opinion preparers, nonetheless, include a reference to customary practice in their opinion letters to make clear how the opinion letter is to be interpreted. One increasingly accepted method of referring to customary practice is to refer to the Principles, supra note 7. This could be done by including, either at the beginning or at the end of the opinion letter, a statement such as:
This opinion letter shall be interpreted in accordance with the Legal Opinion Principles published by the Committee on Legal Opinions of the American Bar Association’s Section of Business Law, 53 Bus. Law 831 (1998)[, a copy of which is attached].
See TRANSACTIONAL OPINION, supra note 3, at 1 n.1; ABA MERGERS & ACQUISITIONS COMM., VOLUME II, MODEL STOCK PURCHASE AGREEMENT WITH COMMENTARY: EXHIBITS, ANCILLARY DOCUMENTS, AND APPENDICES 61 (2010) (recommends including reference to the Principles). As is suggested by the bracketed language, if the Principles are incorporated, some firms attach a copy of the Principles to the opinion letter.
14. By its nature, a third-party legal opinion letter speaks only as of its date. Accordingly, it does not cover subsequent changes in law or fact. See Principles, supra note 7, at 833.
15. Inclusion of the words “on the date hereof ” is intended to make clear that the opinion letter is only for the benefit of Purchasers at the closing occurring on that date. Typically, in a Venture Financing, if a stock purchase agreement contemplates additional closings, it will require delivery of a new opinion letter at each closing.
16. Although at one time venture-backed companies were often incorporated in California and then reincorporated in Delaware immediately before an initial public offering, today venture-backed companies located in California usually incorporate in Delaware at the outset. See 2009 Venture Cap-ital Report, supra note 2, at 166.
17. It is common to state the context in which the opinion letter is being delivered. The Venture Opinion refers to the provision (which is typically included in a stock purchase agreement) that makes delivery of an opinion letter a condition to closing. See TRANSACTIONAL OPINION, supra note 3, at 2 n.5.
18. Like the Transactional Opinion, the Venture Opinion follows the order set out in the 2007 Business Transactions Report: (1) introductory matters, for example, the date, the identity of the opinion recipient, the role of the opinion giver giving the opinion letter, and the purpose for which the opinion letter is given; (2) a general or specific recitation of the documents and other factual and legal matters reviewed by the opinion preparers, including in some instances a statement of reliance on various factual assumptions; (3) the legal conclusions expressed in the opinion letter, and any qualifications to the legal conclusions; (4) matters peculiar to the particular opinion letter, for example, references to opinion letters of local counsel in other jurisdictions and specific limitations on the use of the opinion letter; and (5) the signature of the opinion giver. See TRANSACTIONAL OPINION, supra note 3, at 3 n.6 (citing the 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 21).
For the reasons set forth in the Transactional Opinion, the Venture Opinion departs from the foregoing framework in one significant respect: it separates factual confirmations—whether or not traditionally expressed with the legal conclusions—from the legal conclusions by placing them in a separate section, Section D (“Confirmation”), immediately following the numbered opinion paragraphs. See TRANSACTIONAL OPINION, supra note 3, at 3 n.6.
19. Practice varies on whether to list documents that the opinion preparers have reviewed. See TRANSACTIONAL OPINION, supra note 3, at 3 n.7, and for an extended discussion regarding the description of an opinion giver’s factual examination, see 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 24–32.
20. The Delaware term “Certificate of Incorporation” is used throughout the Venture Opinion because the assumed transaction is the Venture Financing of a Delaware corporation. The appropriate California term—“Articles of Incorporation”—should be used if the Company is incorporated in California and all references herein changed accordingly. For a sample Certificate of Incorporation for a Delaware corporation, see CERTIFICATE OF INCORPORATION OF THE NATIONAL VENTURE CAPITAL ASSOCIATION (Aug. 2013), available athttp://goo.gl/VIjFz (under the “Model Legal Documents” tab).
Alternative language for use if the Company is incorporated in California follows:
the Articles of Incorporation of the Company, as amended to date, certified by the California Secretary of State as of ______, 20___ and certified to us by an officer of the Company as being complete and in full force and effect as of the date of this opinion letter (the “Restated Charter”);
21. The Delaware term “stockholder” is used throughout the Venture Opinion because the assumed transaction involves a Delaware corporation. The appropriate California term—“shareholder”—should be used if the Company is incorporated in California and all references in the Venture Opinion changed accordingly.
22. Although some opinion preparers may review the corporate minute books, others may rely on a secretary’s certificate confirming adoption of the relevant resolutions. See TRANSACTIONAL OPINION, supra note 3, at 4 n.8.
23. If the Company is incorporated in California, this provision is not applicable.
24. Alternative language for use if the Company is incorporated in California follows:
a Certificate of Status—Domestic Coporation with respect to the Company, issued by the California Secretary of State on _____, 20___;
When the Company is a California corporation, some opinion preparers also obtain a good standing letter from the Franchise Tax Board to confirm that no suspension of the corporation’s charter for non-payment of taxes is imminent. The Committee believes that, absent some particular concern about tax delinquencies, a Franchise Tax Board letter need not be obtained to give a good standing opinion on a California corporation. The Secretary of State’s good standing certificate reflects whether as a result of a tax delinquency the corporation’s charter has been suspended or forfeited. See TRANSACTIONAL OPINION, supra note 3, at 4 n.9 (citing the 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 42).
25. For a general description of the certificates of public officials customarily relied on, see 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 26–28. As the 2007 Business Transactions Report concludes, at least in routine cases, customary practice requires neither that every certificate be dated the date of the opinion letter nor that the opinion letter state that the opinions it contains are based solely on the certificates listed, without telephonic or other update.
26. The Transactional Opinion refers to the delivery of this certificate by the Company’s “Chief Financial Officer, General Counsel, or other appropriate officer.” See TRANSACTIONAL OPINION, supra note 3, at 5 n.12. The Committee notes that most early stage companies engaging in Venture Financings do not have a General Counsel and that opinion preparers ordinarily rely on a certificate of the Chief Executive Officer or Chief Financial Officer. Nothing would preclude the General Counsel of a company with the relevant knowledge from delivering a certificate of the type described in connection with a Venture Financing.
27. When the Purchase Agreement includes a schedule of certain agreements of the Company, the opinion preparers instead often refer to the agreements and instruments identified on the relevant schedule. See TRANSACTIONAL OPINION, supra note 3, at 5 n.12; see also NVCA FORM, supra note 5, at 2 n.7 (“Consideration should be given to which contracts should be covered in light of the cost constraints of many venture financings.”).
28. The Venture Opinion uses the term “Scheduled Agreements” to describe the list of contracts that are addressed in the opinion letter, rather than the term “Material Agreements”—the term used in the Transactional Opinion—to avoid any suggestion that the list of contracts corresponds to those that might be viewed as objectively “material” under some standard, such as that included in Item 601(b)(10) of Regulation S-K promulgated by the U.S. Securities and Exchange Commission. Regardless of whether the term “Material” is used, the Committee believes that, by referring to a list of agreements, opinion givers are not implicitly giving an opinion that the agreements on the list comprise all “material” agreements to which the Company is a party (regardless of how “material” might be defined).
30. This certificate addresses factual matters relevant to the Company and the opinion giver. These may include such matters as the absence of dissolution proceedings and the absence (or identification) of pending litigation. Some opinion preparers do not refer to this certificate and instead rely on the general statement about the making of “further legal and factual examination” to cover any such matters. See TRANSACTIONAL OPINION, supra note 3, at 5 n.13. Finally, some opinion preparers draft this certificate (as well as other similar opinion-related certificates) to be signed by an officer on behalf of the Company. Other opinion preparers draft the certificate to be signed by an officer in his or her own name. The Committee believes that these approaches are all appropriate.
31. Opinion preparers should take care that the Company’s Certificate of Incorporation is not included in the definition of Transaction Documents. See NVCA FORM, supra note 5, at 1 n.2 (“Inclusion of the certificate of incorporation would be both illogical (e.g., in the case of the due execution and delivery opinion) and troublesome (e.g., in the case of the enforceability opinion).”); see also 2009Venture Capital Report, supra note 2, at 170–72 (an extended discussion of the business issues that underlie historical—and inappropriate—requests for an opinion to the effect that the provisions of the Certificate of Incorporation “work”).
32. See NVCA FORM, supra note 5, at 3 n.12 (“Because shares may be issued in the future under antidilution clauses or otherwise, as a matter of customary practice [an opinion regarding the duly authorized, validly issued, fully paid and nonassessable status of conversion shares] is understood to mean that sufficient authorized shares are available on the date of the opinion letter, not that sufficient authorized shares necessarily will be available on the conversion date. To make the limited nature of the opinion clear, some opinion preparers include an express assumption regarding the availability of sufficient authorized shares in the future.”). The Venture Opinion addresses this issue expressly in the assumptions below (see Section B (“Assumptions”), paragraphs (e) and (f)). It does not address the issue in the opinions themselves or in the definition of terms but these approaches are also acceptable.
33. Some opinion givers include a statement to the effect that they have not conducted a search of the docket of any court or other tribunal. According to the 1998 TriBar Report, no such disclaimer is necessary (and no such search is required in connection with a “no litigation” confirmation). See TRANSACTIONAL OPINION, supra note 3, at 6 n.14 (citing the 1998 TriBar Report, supra note 8, at 664; 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 64 n.195); see also Section D (“Confirmation”) (concerning the “no litigation” confirmation). Also, some opinion givers omit the last paragraph, thus intending to imply that the list of documents reviewed constitutes the exclusive scope of their document review. Merely deleting the last paragraph, however, is not generally understood to be sufficient to limit the responsibility of the opinion preparers to review other pertinent documents. When such a limitation is intended, additional language should be added that makes clear that the opinions being given are based solely on a review of the listed documents. 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 25–26 (“If no specific limitation is included, a list of documents is not generally understood to constitute a limitation on the general responsibility of the opinion giver to follow customary diligence in rendering the opinion.”).
34. The 1998 TriBar Report takes the view that assumptions of general applicability need not be stated. For example (and without limitation), the following assumptions, relating to facts that “are common to transactions generally and are customarily assumed as a matter of course,” are understood to be applicable whether or not stated as long as they are not known to be false or reliance on them in the particular circumstance is not unreasonable: (a) that individuals have legal capacity, (b) that copies of documents furnished to the opinion preparers conform to the originals, (c) that the original documents furnished to the opinion preparers are authentic, (d) that the signatures on executed documents are genuine, and (e) that the agreement that is the subject of the enforceability opinion is binding on the other parties to it. See TRANSACTIONAL OPINION, supra note 3, at 6 n.15 (citing the 1998 TriBar Report, supra note 8, at 615).
Similarly, as a matter of customary practice, opinion givers may assume, without so stating, that those who have approved an agreement have satisfied their fiduciary obligations and have disclosed any interest in the transaction, see TRANSACTIONAL OPINION, supra note 3, at 6 n.15 (citing 1998 TriBarReport, supra note 8, at 629); see also infra note 89, and that contracts covered by the “no breach” opinion that by their terms are governed by the law of a jurisdiction whose law is not being covered in the opinion letter are being interpreted in accordance with their plain meaning, see TRANSACTIONAL OPINION, supra note 3, at 6 n.15 (citing 1998 TriBar Report, supra note 8, at 660). Nevertheless, many California opinion givers expressly state some or all of these assumptions, see TRANSACTIONAL OPINION, supra note 3, at 6 n.15 (citing 1998 TriBar Report, supra note 8, at 610). For a discussion of the practice of some opinion givers of stating expressly that no fiduciary opinion is being given, see infra note 89. See also TriBar Remedies Opinion Report, supra note 8, at 1484 (for a discussion of the appropriateness of the use of unstated assumptions).
The Committee notes that the recent decision in Fortress Credit Corp. v. Dechert, 934 N.Y.S.2d 119 (App. Div. 2011), may lead some opinion givers to state expressly some or all of the assumptions of general applicability. This stems from the fact that the court in that case noted, as one of the bases for dismissing the action, that the opinion letter in question included an assumption regarding the genuineness of the documents reviewed. Although the result in the case no doubt was correct, the Committee believes that, in the absence of facts suggesting that the opinion preparers knew that the documents were not genuine, the case should ultimately have been decided the same way whether or not an express assumption had been included in the opinion letter. However, for many of the same reasons that some opinion givers are inclined to include an express reference to the Principles in their opinion letters (see, e.g., supra note 13), some opinion givers state some or all of the general assumptions. The Committee believes that, whether or not assumptions of general application are stated, an opinion letter should be read as if they were stated—and the opinion preparers should not be respon-sible for affirmatively investigating their accuracy. The Committee notes that a “laundry list” approach to assumptions (and to qualifications/exceptions)—that is, utilizing a standard list of assumptions, qualifications, or exceptions that may include assumptions, qualifications, or exceptions that do not apply to the actual terms of the agreement(s) being considered—can impair the value of an opinion letter as a communications tool. See TriBar Remedies Opinion Report, supra note 8, at 1486.
In addition to assumptions of general application, opinion givers sometimes include express assumptions about matters that are not generally applicable to all opinions but are necessary for the particular opinions being given. Inclusion of these assumptions is required if they are to be relied on, and their inclusion shifts to the recipient the burden of confirming the matters assumed or taking the risk that they are not accurate. See 1998 TriBar Report, supra note 8, at 616.
35. If the Venture Financing includes any unaccredited investors and relies on Regulation D as the exemption from registration under the Securities Act, this assumption may be necessary to support the Regulation D exemption, although it relates much more directly to Rule 10b-5, as to which no opinion or “negative assurance” is typically given in Venture Financings. See 2009 Venture Capital Re-port, supra note 2, at 188. In Venture Financings that rely on the statutory private placement exemption provided by section 4(a)(2) of the Securities Act and not on Regulation D, or that rely on Regulation D but do not include any unaccredited investors, this assumption is not needed to address a specific disclosure requirement of Regulation D. However, a court may consider the accuracy and completeness of information provided to the Purchasers as a factor in deciding whether a section 4(a)(2) exemption is available.
The opinion preparers representing the Company in a Venture Financing may assist in the preparation of disclosure documents (such as a private placement memorandum) used in connection with the transaction, but the core of the contents of the documents and their completeness and accuracy are the responsibility of the Company, its board of directors, and its officers, who are in a much better position than the opinion preparers to know the relevant facts about the Company. This assumption makes clear that the Venture Opinion does not cover the accuracy or adequacy of the disclosure provided by the Company to the Purchasers.
36. Prior to its amendment in 2013, Rule 506 under the Securities Act was not available for offerings utilizing general solicitation or general advertising. However, pursuant to section 201(a) of the Jobs Act, the U.S. Securities and Exchange Commission revised Rule 506 to provide, among other things, that the prohibition against general solicitation and general advertising in Rule 502(c) would not apply to offers or sales of securities made in compliance with new Rule 506(c). 78 Fed. Reg. 44771 (July 25, 2013). One of the requirements of Rule 506(c) is that the issuer take reasonable steps to verify that each purchaser is an accredited investor. As indicated in supra note 11, the Venture Opinion does not address Rule 506(c) offerings. See infra note 70.
37. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 82 (“To be certain that the exemption from federal registration or California qualification is available in a particular transaction, the opinion giver must determine that the transaction is not part of other offers or sales of securities that, taken together, would not qualify for the exemption. These requirements often involve mixed questions of law and fact. The opinion giver will typically rely upon officers’ certificates and may review the Company’s minute book and stock book in an effort to substantiate the factual basis for the determination of whether there are other transactions that may have to be ‘integrated’ with the current offering.” (footnotes omitted)).
See the introductory clause to opinion 9 that seeks to cover the facts described in the 2007 Business Transactions Report and that tracks the form of the “no registration opinion” suggested in the NVCA FORM. See NVCA FORM, supra note 5 (opinion 8).
38. Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, required the U.S. Securities and Exchange Commission to adopt new requirements for offerings made in reliance on the Rule 506 exemption, including Venture Financings. Rule 506, as revised, now requires: (i) that no persons related to the offering (as identified in Rule 506(d)(1)) be “bad actors” (as defined in Rule 506(d)) and (ii) that written disclosure of prior bad actor events (as identified in Rule 506(e)) be provided to each purchaser a reasonable time prior to sale. The Committee believes that opinion givers may appropriately rely on an express assumption regarding the absence of “bad actors.” The Committee does not take a position on whether the absence of “bad actors” may be addressed by expressly assuming the accuracy of the representations set forth in certificates or other documents. See generally No Registration Report, supra note 7, at 191–92 (sample opinion, while predating the bad actor rules, relies on reference to representations in agreements to establish facts).
41. Opinion literature has long recognized that the benefit an opinion provides a recipient must be balanced against the costs of preparing the opinion. See, e.g., 2007 REMEDIES REPORT, supra note 6, app. 4, at 4–9. Most early stage venture-backed companies have limited resources that place a practical limit on the diligence the opinion preparers can perform without exceeding the Company’s budget for legal fees in the transaction. In these transactions, the Schedule of Exceptions to the representations and warranties in the Purchase Agreement—a document that, in a traditional Venture Financing, is not likely to be lengthy—often discloses matters such as potentially defective securities issuances, failures to have made required filings, and failures to have followed procedural requirements in approving organizational documents or contracts. These disclosures may be made out of a belief that they evidence a real problem; they may also be made simply because the Company is unwilling or unable to invest the time or incur the expense of determining whether a real problem exists. In either case, an opinion recipient’s counsel should discuss with its client the potential legal consequences of the matters disclosed in the Schedule of Exceptions so that the client can make an informed decision as to whether to assume the risk and proceed with the Venture Financing.
The subject matter of certain representations and warranties for which exceptions are taken may also be the subject of requested opinions (as in opinions on the validity of stock issuances, breaches of existing agreements, or the obtaining of consents or approvals) or confirmations (such as the absence of litigation). As a result, exceptions similar to those taken in the Schedule of Exceptions may be relevant to the opinions given. While the opinion preparers may choose to restate in the opinion letter itself some or all of the exceptions in the Schedule of Exceptions to the extent the opinion preparers find them relevant (and to set them out either as exceptions, qualifications, or assumptions, as appropriate), opinion preparers in Venture Financings often include an exception or qualification in the opinion letter substantially similar to that included in the bracketed text when the Schedule of Exceptions includes matters that might otherwise be addressed by express exceptions, qualifications, or assumptions. Considerations such as cost, or the desire to avoid highlighting in an opinion letter matters that could provide a “road map” for a plaintiff or governmental agency to pursue legal action against the Company based on the disclosed problem, are reasons for this practice in the Venture Financing context, though not all opinion givers follow this practice and not all recipients accept opinion letters containing the bracketed language. The Committee believes that this practice can be appropriate in the context of Venture Financings when the exceptions or qualifications are clearly identified in the Schedule of Exceptions, and when their effect as possible limitations on the relevant opinions is or should be apparent. The fact that items constituting exceptions or qualifications are set forth outside the opinion letter in a document to which the letter refers and to which the recipient and its counsel have access should not of itself require restatement of those exceptions or qualifications in the opinion letter when their potential relevance to the topics addressed in the opinion letter should be understood by both opinion giver and recipient.
Regardless of how exceptions, qualifications, and assumptions are stated, the opinion preparers should not give an opinion that, while technically correct, they recognize will mislead the opinion recipient with regard to its subject matter. See, e.g., 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 10 (fraudulent and misleading opinions); id. at 20 (“[A] lawyer should not render an opinion based on factual assumptions if the lawyer knows that the assumptions are false or that reliance on those facts is unreasonable.”). For example, if the opinion preparers discover that a board meeting at which the directors approved the issuance of shares was not in fact a valid meeting despite minutes to the contrary, a disclosure of the “possible invalidity of the board meeting” in the Schedule of Exceptions may not be sufficient to permit giving a “validly issued” opinion regarding the issuance of those shares. By contrast, where the facts at issue are not clear (such as where there is inadequate record keeping, but the opinion preparers believe the actual facts would support the giving of a particular opinion), noting the state of the record in the Schedule of Exceptions is appropriate and would appropriately qualify the opinion given.
Some opinion preparers broaden the bracketed text by including a reference to the Purchase Agreement itself in addition to the reference to the Schedule of Exceptions. This practice may have the unfortunate consequence of making it difficult for the opinion recipient to determine what facts or other disclosures the opinion giver is relying upon for purposes of giving opinions (e.g., factual statements that may be set forth in exceptions to affirmative or negative covenants or other provisions, exhibits, or schedules in the Purchase Agreement). Even if the opinion giver were to limit the broader reference to include only representations in the Purchase Agreement, the opinion recipient may find it difficult to determine if the opinion giver is inappropriately attempting to rely on more in the Purchase Agreement than just the factual representations in the Purchase Agreement. See, e.g., DONALD W. GLAZER, SCOTT FITZGIBBON & STEVEN O. WEISE, GLAZER AND FITZGIBBON ON LEGAL OPINIONS § 4.2.1, at 121 (3d ed. 2008) [hereinafter GLAZER & FITZGIBBON] (“Opinion preparers also sometimes base opinions on representations of the company in the agreement. Representations, however, often are framed not as statements of fact, which may be relied on to support an opinion, but as conclusions of law, which may not.”).
Finally, the Committee notes that the bracketed text may be less appropriate (as the cost/benefit analysis may be less compelling) for opinion letters delivered in transactions for later stage venture-backed companies when the amount being raised justifies more diligence and a larger budget for legal fees.
42. Practice has moved toward giving the “validly existing” opinion and away from the “duly incorporated” opinion. See NVCA FORM, supra note 5, at 1 n.1; 1998 TriBar Report, supra note 8, at 642–43.
43. Alternative language for use if the Company is incorporated in California follows:
The Company is a corporation validly existing and in good standing under the laws of the State of California.
If the Company is incorporated in California, the second sentence of this opinion (regarding qualification to transact business in California) is not necessary. For the distinction between the “validly existing” opinion and the “duly incorporated” opinion in California, see TRANSACTIONAL OPINION, supra note 3, at 8 n.17 (citing the 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 40). For the distinction between the “validly existing” opinion and the “duly incorporated” opinion in Delaware, see 1998TriBar Report, supra note 8, at 641–47.
44. This language tracks the California Corporations Code. CAL. CORP. CODE § 2105(a) (West 1990 & Supp. 2012).
45. Consistent with the Transactional Opinion, this opinion does not include: (1) an opinion that “the Company has the corporate power and authority to … ,” and (2) reference to the power of the Company to “own and operate its assets.” See TRANSACTIONAL OPINION, supra note 3, at 8–9 n.18 (“Historically, the corporate power opinion included a reference to ‘authority’ in addition to ‘power.’ Because of concerns that a reference to ‘authority’ could lead to a more expansive interpretation of the ‘corporate power’ opinion, current practice appears to be moving away from including ‘authority.’ However, the ‘corporate power’ opinion is generally understood to have the same meaning whether or not ‘authority’ is included and, to the extent that the word ‘authority’ is included, it is generally understood to be limited to ‘corporate authority’ even without the modifier ‘corporate’ immediately preceding the word ‘authority.’ In addition, the corporate power opinion has historically included an express opinion that the subject corporation has the corporate power to own and operate its assets. Current practice seems to be evolving away from this form of opinion in favor of limiting the ‘corporate power’ opinion to the Company’s power to carry on its business as it is currently conducted.” (citing the 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 44)).
The Committee notes that venture capital investors may have an interest in whether the business that is to be conducted by the Company is ultra vires. For example, venture capital investors often provide seed funding to a newly formed (or relatively new) corporation with a proposed business plan but little or no established operations. Thus, in Venture Financings, “[o]pinion recipients sometimes ask that this opinion be broadened, for example, to cover the Company’s corporate power to conduct its business.” NVCA FORM, supra note 5, at 1 n.3. In this regard, if the corporate power opinion is written to include the Company’s power to carry on its business and is not limited to the Company’s business as currently conducted, the Committee believes that the opinion giver should consider including other qualifying conditions in the opinion. If the business of the Company is described in a document that has been delivered to the investors, the opinion should make explicit reference to that document. For example, “The Company has the corporate power to conduct its business as proposed to be conducted in its Business Plan dated ______, 20_____,” or “The Company has the corporate power to conduct its business as described in Section ____ of the Purchase Agreement.” Alternatively, the opinion may be based on an officer’s certificate or disclosure document describing the Company’s business as currently and proposed to be conducted. In either case, the opinion requires a review of the Company’s Certificate of Incorporation (or Articles of Incorporation if the Company is incorporated in California) to confirm the absence of any limitations on corporate power. See TRANS-ACTIONAL OPINION, supra note 3, at 8–9 n.18 (citing the 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 44).
46. The opinion on corporate power to “perform” covers both the obligations in the Transaction Documents that the Company is required to meet at closing and the obligations that the Company is required to perform in the future. See 1998 TriBar Report, supra note 8, at 657−58 & n.139 (general discussion of obligations to be performed in the future). Opinion preparers must determine whether the corporation law of the state in which the Company was incorporated or the Company’s Restated Charter or Bylaws prohibit the Company from performing its obligations under the Transaction Documents both at and after the closing. For example, is the Company agreeing to conduct a banking business that would not be permitted under its articles of incorporation? See, e.g., CAL. CORP. CODE § 202 (West 1990 & Supp. 2012).
47. Some opinion givers include a supplemental reference to the sale and issuance of the securities that are the subject of the Venture Financing:
The Company has the corporate power to enter into and perform its obligations under the Transaction Documents, including without limitation, the sale and issuance of the Shares [and theWarrants], and the issuance of the Conversion Shares[, Warrant Shares and the Warrant ConversionShares]. (emphasis added).
The Committee believes that the supplemental reference to “the sale and issuance of the Shares …” is redundant (a view that is consistent with the NVCA FORM). See NVCA FORM, supra note 5.
In analyzing whether the Company has the corporate power to “perform its obligations,” opinion givers sometimes have concerns regarding circumstances that may arise in the future: for example, the law could change or the certificate of incorporation could be amended to prohibit future stock issuances or sufficient authorized but unissued shares might not be available when Conversion Shares, Warrant Shares, and Warrant Conversion Shares are to be issued. Nevertheless, the opinion preparers are entitled to rely on customary practice that the opinion letter speaks only as of its date and thus may ignore possible changes in the law or subsequent amendments to the certificate of incorporation. See GLAZER & FITZGIBBON, supra note 41, § 2.2.1, at 572. In addition, the opinion preparers may rely on the assumptions that in the Venture Opinion are stated expressly (Section B (“Assumptions”), paragraphs (e) and (f)) for the sufficiency of available common and preferred shares when Conversion Shares, Warrant Shares, and Warrant Conversion Shares are issued.
48. This opinion follows the formulation recommended in the 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 45–48. Regardless of whether the word “performance” is included in the opinion, it covers the corporate authorizations the Company is required to obtain under the corporation law of the state where it is incorporated to execute, deliver, and perform its obligations under the Transaction Documents. 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 45.
This opinion is understood, as a matter of customary practice, to mean that the Company has taken the corporate action required to authorize its officers to bind the Company contractually to perform its obligations under the Transaction Documents. As a matter of customary practice, the opinion is understood not to provide assurance that the Company has taken the corporate action required to authorize performance after the closing of obligations in the Transaction Documents, such as an obligation to issue shares in the future at a price based on a future market price, when that action can be taken only at some future date.
Finally, by covering “corporate action on the part of the Company,” the opinion by its terms makes clear that, in general, it is not covering authorizations or approvals that do not constitute corporate action but that are required by a law other than the applicable corporation law (i.e., usually the law of the state in which the Company is incorporated). For example, the opinion does not cover board approval of the future filing of a registration statement under a registration rights agreement even though board approval of the filing (or at least signing of the registration statement by a majority of directors) is required by the Securities Act. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 45 (“The phrase ‘duly authorized by all necessary corporate action on the part of the Company’ may be preferable to ‘duly authorized’ alone, as the latter might be construed to imply authorization under law other than the GCL or by a governmental regulatory body . . . , although the Committee does not believe that any such inference is justified or appropriate.”). However, if the Company is a Delaware corporation and it may be subject to the requirements of section 2115 of the California Corporations Code (which provides for the application of specified provisions of California corporation law to certain internal affairs of foreign corporations that have a sufficient nexus to California to justify their application), CAL. CORP. CODE § 2115 (West 1990 & Supp. 2012), the Committee believes that a due authorization opinion in an opinion letter that covers California law and does not expressly limit the opinion’s coverage to the Delaware corporation law also addresses any authorization requirements imposed by section 2115 on a “quasi-California” Delaware corporation. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 47–48 (“If [section 2115 applies], the opinion giver [of a duly authorized opinion] will need to be aware of the provisions of the Corporations Code specified in Section 2115 as possibly being applicable to the “quasi-foreign” corporation.”); CERTIFICATE OF INCOR-PORATION OF THE NATIONAL VENTURE CAPITAL ASSOCIATION iii–iv (rev. Aug. 2013), available athttp://goo.gl/VIjFz (under the “Model Legal Documents” tab) (for a legal analysis of the interaction between Delaware corporation law and section 2115); infra note 75 (for further discussion of the interaction of Delaware corporation law and section 2115). That said, under customary practice the opinion giver may assume, without so stating, that the requirements for application of section 2115 have not been met unless the opinion giver believes that assumption is not reliable given the apparent locus of the Company’s business or identity of its stockholders.
49. The last clause of this opinion means that the relevant agreements have been executed and delivered by duly authorized officers or agents:
The “duly executed” opinion involves a review of the minutes or reliance upon an officers’ certificate to establish that the officers executing the documents on behalf of the Company have been validly elected, that they are or were officers of the Company at the time of execution, and that they were in fact authorized to execute the documents on behalf of the Company. While the “duly executed” opinion also addresses the genuineness of the signatures of the signing officers, such genuineness is expressly or implicitly assumed.
Giving an opinion that a document has been “duly delivered” generally means that the opinion giver is present at the delivery of the signed agreement or otherwise satisfied as to the implementation of procedures for actual delivery.
2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 46. As a matter of customary usage, therefore, “execution” means the signing of relevant documents by an authorized person, and “delivery” means the transmission of those documents to the appropriate parties at consummation of the transaction, thus completing these elements of contract formation. Under this customary usage, “execution” alone—without “delivery”—would not result in the formation of a contract. The Committee is cognizant of section 1933 of the California Code of Civil Procedure, CAL. CIV. PROC. CODE § 1933 (West 2007) (“The execution of an instrument is the subscribing and delivering it, with or without affixing a seal.”), but believes, as a matter of customary usage, that “executed,” standing alone in an opinion, merely means that appropriate persons have signed the agreement on behalf of the Company. See TRANSACTIONAL OPINION, supra note 3, at 9 n.19 (citing 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 45–48).
Closings today often are effected by an electronic exchange of signature pages. When the opinion preparers do not witness the physical execution of the signature pages, they are permitted, as a matter of customary practice, to assume, without so stating, that all signatures are genuine. See GLAZER & FITZGIBBON, supra note 41, § 4.3.3, at 152 (a partial listing of implied assumptions that need not be expressly stated under customary practice); see also supra note 34. In addition, customary practice permits the opinion preparers to assume, without so stating, that an electronic exchange of signature pages, coupled with express or implied authorization to attach them to the relevant documents, is an appropriate procedure to constitute actual delivery. Some opinion preparers are not comfortable relying on customary practice, however, and instead obtain an officer’s certificate regarding execution and delivery of the relevant documents and describe their reliance in the opinion letter as follows:
In rendering the opinion set forth in Section C (“Opinions”), paragraph 3 concerning the Company’s execution and delivery of the Transaction Documents, we have not necessarily observed their execution by the Company but have relied exclusively upon representations regarding the Company’s execution and delivery of the Transaction Documents made to us in a certificate and our review of copies, facsimiles or .pdf files of executed signature pages delivered to us by rep-resentatives of the Company or their agents.
The Committee believes that either approach is acceptable.
50. See 1998 TriBar Report, supra note 8, at 651–52 (general discussion of the authorized capital opinion under Delaware law); 2008 TriBar Preferred Stock Report, supra note 8 (under Delaware law); 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 65–66 (extended discussion of the authorized capital opinion as it relates to California corporations); C. Stephen Bigler & John Mark Zeberkiewicz, Restoring Equity: Delaware’s Legislative Cure for Defects in Stock Issuances and Other Corporate Acts, 69 BUS. LAW. 393 (2014).
51. See 1998 TriBar Report, supra note 8, at 648–49 (extended general discussion of the duly authorized opinion); 2008 TriBar Preferred Stock Report, supra note 8 (amplification regarding duly authorized opinions on preferred stock). Note that the duly authorized opinion confirms that the Company has the power under the corporation law of the state where the Company is incorporated and the Company’s charter documents to create stock with the rights, powers, and preferences of the shares in question. 2008 TriBar Preferred Stock Report, supra note 8, at 923–24; 2009 Venture CapitalReport, supra note 2, at 171; see also 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 66–69 (extended discussion of the duly authorized opinion as it relates to California corporations). For issues presented under Delaware law that California lawyers may not have the competence to advise on, see supra note 12. See generally 2008 TriBar Preferred Stock Report, supra note 8, at 923 n.12 (“The applicable state corporation statute may be the statute of the state in which the opinion preparers practice or it may be the statute of another state, such as Delaware. Non-Delaware lawyers are usually willing to give the duly authorized opinion on preferred stock issued by Delaware corporations when difficult issues are not presented.”); C. Stephen Bigler & Jennifer Veet Barrett, Words that Matter: Consid-erations in Drafting Preferred Stock Provisions, BUS. L. TODAY (Jan. 2014), http://goo.gl/BkT58Z; C. Stephen Bigler & Jennifer Veet Barrett, Drafting a Mandatory Put Provision for Preferred Stock AfterThoughtWorks, BUS. L. TODAY (Jan. 2012), http://goo.gl/7UTU93; MODEL LEGAL DOCUMENTS OF THE NA-TIONAL VENTURE CAPITAL ASSOCIATION (2014), available athttp://goo.gl/VIjFz (under the “Model Legal Documents” tab) (complete set of venture capital documents under Delaware law updated as of the date of publication of this Venture Opinion).
52. See 1998 TriBar Report, supra note 8, at 648–49 (extended general discussion of the validly issued opinion); 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 69–71 (extended discussion of the validly issued opinion as it relates to California corporations); see also NVCA FORM, supra note 5, at 3 n.10 (“Because the opinion on the valid issuance of the outstanding shares will require a review of each issuance of shares, in many situations it will not be cost justified. For a description of the work customarily required to be performed to give this opinion, see [2008 TriBar Preferred StockReport, supra note 8].”).
53. In Venture Financings in which a third-party opinion letter is given, investors routinely request an opinion that the outstanding securities of the Company are fully paid and nonassessable. As a matter of customary diligence, opinion preparers usually confirm that the Company has received the consideration required by the corporate action authorizing the issuance by obtaining an officer’s certificate. See 1998 TriBar Report, supra note 8, at 650–51 (extended discussion of the fully paid and nonassessable opinion); 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 72–74 (extended discussion of the fully paid and nonassessable opinion as it relates to California corporations); see also Section E (“Certain Qualifications”), paragraph (8) below for reference to reliance in the opinion letter on such an officer’s certificate.
54. In the past, opinion letters in Venture Financings sometimes have covered three additional items:(a) the reservation of shares for future issuance (a “Reservation of Shares Opinion”), (b) the number of outstanding stock options and the number of shares reserved for grant or issuance under stock option plans (an “Outstanding Options Opinion”), and (c) the absence of certain preemptive rights (a “No Outstanding Preemptive Rights Opinion”). These opinions (whether taking the form of an opinion or a confirmation) have not been included in the Venture Opinion for the reasons that follow:
Reservation of Shares
In Venture Financings, opinion givers in the past have stated that the Company has taken the action necessary to reserve the number of shares required to be issued under the Purchase Agreement, upon conversion of convertible securities and upon the exercise of options or warrants. Consistent with the conclusions of the 2007 Business Transactions Report, the Committee believes that such “reservation of shares” opinions should not be requested:
[Because the California GCL does not] provide any legal effect to the “reservation” of shares … [t]he opinion is almost entirely factual (i.e., establishing the existence of resolutions “reserving” shares for future issuance). Because reservations have no legal effect under the GCL, lawyers generally resist giving this opinion as it is potentially misleading and opinion recipients ordinarily are satisfied by a representation by the Company or by an officer’s certificate on this point. An alternative is for the opinion to address only the question of whether the board of directors of the Company has duly adopted a resolution “reserving” such shares and whether that resolution remains in force.
2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 74. Similar concerns about misleading opinions arise under Delaware law. See NVCA FORM, supra note 5, at 3 n.12 (second paragraph addresses concerns under Delaware law).
Although the Committee believes that the reservation of shares should be addressed only in the Company’s representations and warranties in the Purchase Agreement, if an opinion giver decides to provide an opinion on this point, then it might give an opinion that the board of directors has adopted a resolution reserving a specified number of shares for issuance. See NVCA FORM, supra note 5, at 3 n.12. For example, in Section A (“Documents Examined”) above, the following language could be included:
Resolutions adopted by the Board of Directors of the Company and copies of which are attached hereto as Exhibit A reserving (a) the Shares to be issued pursuant to the Purchase Agreement, (b) [the Warrant Shares to be issued upon exercise of the Warrants, (c)] the Conversion Shares [and Warrant Conversion Shares] to be issued upon conversion of the Shares [and Warrant Shares, respectively], and (d) shares of Common Stock of the Company for issuance under the Company’s [Stock Plan Name] (the “Resolutions”).
Similarly, in Section C (“Opinions”), the following language could be included:
The Board of Directors of the Company has adopted the Resolutions.
Outstanding Options
Likewise, even though sometimes given in the past, an opinion regarding the number of shares issuable upon exercise of outstanding options and reserved for future issuance under option plans or pools ordinarily should not be requested. For an extended discussion, see 2009 Venture CapitalReport, supra note 2, at 172–73. Compare NVCA FORM, supra note 5, at 3 n.10 (under Delaware law) (“Opinion recipients sometimes ask an opinion giver to state that, to the opinion giver’s knowledge, the Company has no outstanding options, warrants or other rights to acquire Company stock other than as disclosed in the Transaction Documents. Many law firms are unwilling to give this opinion because it constitutes negative assurance on a factual matter they rarely are in a position to confirm. When, however, the opinion is given, the opinion letter should describe what the opinion preparers have done to support it.”).
No Outstanding Preemptive Rights
In Venture Financings, opinion givers in the past have often given an opinion regarding the absence of certain preemptive rights. The 2009 Venture Capital Report discouraged this practice, a view the Committee confirms. For an extended discussion, see 2009 Venture Capital Report, supra note 2, at 175–77. In contrast, with respect to Delaware corporations, a limited opinion on preemptive rights may be possible if requested. See NVCA FORM, supra note 5, at 3 n.13 and accompanying text (under Delaware law).
55. The Committee believes that an opinion recipient should not request either (1) a separate opinion to the effect that “the rights, preferences and privileges [of the stock being purchased in the transaction] are as set forth in the Restated Charter,” or (2) a quasiremedies opinion that provisions in the Restated Charter will be “enforceable.” See 2009 Venture Capital Report, supra note 2, at 170–72; 2008 TriBar Preferred Stock Report, supra note 8, at 924.
56. In Venture Financings in which a third-party opinion letter is given, investors routinely request an opinion that the securities they are purchasing are fully paid and nonassessable. See 1998 TriBarReport, supra note 8, at 650 & n.136; 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 72–74. Because many Venture Financings have historically involved a real-time exchange of checks or wire transfers, stock certificates, signature pages of the Transaction Documents, and other closing documents (such as the third-party opinion of Company counsel), a practice of expressly assuming in the opinion letter that the Shares have been paid for in accordance with the terms of the Purchase Agreement has evolved. In giving the opinion set forth in this sentence, the opinion preparers still must determine that the consideration for the Shares called for by the Purchase Agreement is consistent with that set forth in the resolutions of the board authorizing the stock issuance and the corporation law of the state in which the Company was incorporated.
57. See supra note 32. Also, note that, if the Restated Charter includes a “pay-to-play” provision applicable to future financings, operation of the “pay-to-play” mandatory conversion feature raises questions as to the validity of the issuance of the Conversion Shares. See infra note 90.
59. This opinion does not cover all documents defined as the Transaction Documents. The Voting Agreement is intentionally omitted. The Committee believes that an opinion of Company counsel regarding the enforceability of a voting agreement against the Company is of little or no value to the recipient and should not be requested. See 2009 Venture Capital Report, supra note 2, at 182–85. Moreover, the enforceability of some provisions typically contained in a voting agreement, particularly so-called “drag-along” provisions, is not free from doubt even as against the stockholders to whom they apply (and whose obligations are not ordinarily covered by an opinion of Company counsel in a Venture Financing). Id. at 185. Other agreements ancillary to the sale of the securities in a Venture Financing (commercial agreements, intellectual property licenses, and “management rights letters”) are also not generally an appropriate subject of a third-party opinion. For an extended discussion, see 2009 Venture Capital Report, supra note 2, at 187–88. See also Section E (“Certain Qualifications”), paragraph 12.
60. The 2007 Remedies Report addresses the meaning and scope of this opinion. According to that report, the remedies opinion is customarily understood to mean that “(i) a contract has been formed, (ii) a remedy will be available in the event of a breach of the undertakings in the contract (or the undertakings will otherwise be given effect), and (iii) remedies in the contract will be given effect, unless, in the case of (ii) or (iii), expressly or implicitly excluded.” 2007 REMEDIES REPORT, supra note 6, at 3. In establishing whether a contract has been formed, the opinion preparers will need to confirm or assume the predicates of formation, many of which, as a matter of customary practice, they are permitted to assume without so stating (for example, the capacity of individuals) and others of which are covered in other opinions that typically accompany a remedies opinion, such as (in the case of parties who are entities) the opinions addressing power and due authorization. See TRANSACTIONAL OPINION, supra note 3, at 11–12 n.23. As to what a remedies opinion does not mean, see supra note 55 (remedies opinion on the certificate of incorporation (Delaware) or the articles of incorporation (California) is not appropriate).
The 2007 Remedies Report goes on to note:
[T]his report … concludes that the long-standing supposed continental divide over the meaning and scope of the remedies opinion—the “New York view” that it covers “each and every” provision of a contract versus the “California view” that it covers only the “essential provisions”— should no longer be of concern in opinion practice. Instead, the focus should be on customary practice. Customary practice comprises customary diligence (particularly the legal diligence customarily undertaken in giving a remedies opinion), customary competence, and customary usage (the customarily understood meaning of terms used in third-party legal opinions).
2007 REMEDIES REPORT, supra note 6, at 1.
Giving a legal opinion in general—and giving an enforceability opinion in particular—requires that the opinion preparers conduct factual and legal due diligence. A good discussion of customary factual diligence cited by the 2007 Remedies Report can be found in Article II of the 1998 TriBar Report. 1998TriBar Report, supra note 8, at 608–19. Customary legal diligence, addressed in Appendix 8 of the 2007 Remedies Report, begins with a review by competent opinion preparers of the agreement or agreements covered by the opinion. 2007 REMEDIES REPORT, supra note 6, app. 8. If a question arises about the enforceability of a particular provision, the opinion preparers must determine whether the opinion covers the issue. If it does, they must determine whether the issue can be resolved. If the issue cannot be resolved, they should include an appropriate exception in the opinion. See 2007 REM-EDIES REPORT, supra note 6, app. 8, at 7–8.
61. Absent express qualifications or assumptions, a remedies opinion covers the enforceability of the choice-of-law clause in each agreement covered by the opinion. See TriBar Remedies Opinion Re-port, supra note 8, at 1495 (“The remedies opinion addresses the enforceability of the provision in most agreements that chooses the law of a particular jurisdiction as the governing law.”). When California law is chosen (i.e., an “inbound” choice of law), that choice is effective under California’s choice-of-law rules in most commercial transactions involving at least $250,000. CAL. CIV. CODE § 1646.5 (West 2004). However, consistent with the trend toward Delaware incorporation is a trend toward the selection of Delaware law as the law governing the stock purchase agreement and other transactional documents in a Venture Financing. An opinion giver faced with a request for a remedies opinion on agreements that choose another state’s law as their governing law must decide how to respond. Although the Committee notes that some opinion givers are of the view that no remedies opinion should be given when the documents in question select the law of a state other than California as the governing law, the Committee believes that, in general, practice “now greatly favors permitting the primary opinion giver to give an opinion to the effect that, if the law of the State of California were held to apply to the agreement, notwithstanding the choice of law of another jurisdiction, the agreement would be enforceable.” 2007 REMEDIES REPORT, supra note 6, app. 10, at B-1 (endnote 1); see also 2007 REMEDIES REPORT, supra note 6, app. 4, at 12 (also supporting the use of this so-called “as if ” approach). If such an opinion is given (assuming, for illustrative purposes, that the relevant Transaction Documents are governed by Delaware law), the lead-in to the enforceability opinion would be modified to read substantially as follows:
If a court were to apply the law of California to the interpretation and enforcement of the [transaction documents], rather than the law of Delaware as provided therein, each of the [transaction documents] would be . . . .
In addition, although not required in such an event, many lawyers modify the statement about the law covered by this opinion (which appears at the beginning of Section E (“Certain Qualifications”) of the Venture Opinion) by adding to it the following:
We note that the [transaction documents] provide that they are to be governed by the law of the State of Delaware. Except with respect to those portions of the [transaction documents] that are governed by the Delaware General Corporation Law, our opinion in Section C (“Opinions”), paragraph 6 above regarding the validity, binding effect and enforceability of the [transaction documents] is given as though each of the [transaction documents] were governed by Internal California Law. As used herein, “Internal California Law” means the internal laws of the State of California applicable to a contract made by California residents in the State of California that selects California law as the governing law of such contract, without regard to any laws or equitable principles regarding choice of law, conflict of laws or public policies that might make any other law(s) applicable.
See alsoNVCA FORM,supranote 5, at 1 n.5. The Committee notes that the foregoing language differsslightly from the language recommended in the2009 Venture Capital Reportbut no difference inmeaning is intended. Rather, the additional sentence at the end is intended merely to provide furtherclarification of the meaning of an “as if ” remedies opinion.See 2009 Venture Capital Report,supranote 2, at 167.
The “as if ” remedies opinion does not cover the enforceability of the choice-of-law clause because it assumes that the choice-of-law clause is not enforced. See TriBar Remedies Opinion Report, supranote 8, at 1497 n.70 (“[The “as if ” remedies] opinion has the same meaning as any other remedies opinion except that it does not address the enforceability of the chosen law provision.”). Although not requested, some opinion givers state expressly that an “as if ” remedies opinion does not address the enforceability under California law of the choice-of-law clause in the agreements being covered.
If under California law sufficient contacts or bases exist to support the parties’ choice of law, and the opinion giver is giving a specific opinion on the choice-of-law clause, a form for such an opinion (where a law other than that of California is chosen) follows:
In a proceeding in a court of the State of California for the enforcement of the [transaction documents], and based on [describe contacts or bases for choosing law of chosen state], the court should give effect to Section ____ [choice-of-law provision] of the [transaction document], except to the extent (i) that any provision of the [transaction document] is determined by the court to be contrary to a fundamental policy of the state whose law would apply in the absence of that Section, and (ii) that state has a materially greater interest in the determination of the particular issue than does the state whose law is chosen.
See2007 BUSINESSTRANSACTIONSREPORT,supranote 6, at 88–91; 2007 REMEDIESREPORT,supranote 6,app. 10, at B-1 to B-6;see alsoTriBar Opinion Comm.,Supplemental Report: Opinions on Chosen-Law Provisions Under the Restatement of Conflict of Laws, 68 BUS. LAW. 1161 (2013). This opinion could begiven as a supplement to the “as if ” remedies opinion. It also could be given as a standalone opinion,without any remedies opinion, if the opinion recipient does not request a remedies opinion.See2007REMEDIESREPORT,supranote 6, at 90–91.
62. In the case of a “consents and approvals” opinion, the opinion preparers may rely on the qualifications in Section E (“Certain Qualifications”), which, among other things, exclude from the coverage of the opinion securities laws and many other laws (Section E (“Certain Qualifications”), first paragraph, last two sentences).
63. Opinion 7 generally follows the formulation of the “consents and approvals” opinion appearing in the 2007 Business Transactions Report but without the securities law exclusions, which are unnecessary in light of Section E (“Certain Qualifications”), first paragraph, last two sentences, of the Venture Opinion. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 61; see also supra note 62 (discussing exclusion of coverage of securities laws) & infra note 65 (discussing requests for “performance” opinions). If the opinion giver decides to give an opinion on consents and approvals required for the Company’s performance of future obligations, the opinion preparers should consider whether or not the Company’s future obligations under the Transaction Documents are sufficiently clear that they can identify all of the consents and approvals the Company needs to perform those obligations. See infra note 65 (which is equally applicable to this opinion 7).
64. The Committee has intentionally not included an exception for notice filings required by Regulation D under the Securities Act. Except for the “no registration” opinion (see opinion 9), the Venture Opinion does not cover securities laws. See infra note 78. The Venture Opinion expressly excludes coverage of securities laws (except for opinion 9), but that express exclusion would be implied even if not expressly stated. Compare NVCA FORM, supra note 5, at 2 n.8 (“Securities law approvals and filings are understood as a matter of customary practice not to be covered by this opinion unless referred to specifically. Some lawyers, however, choose to make this explicit by including [the articulated exception regarding the notice filings pursuant to Regulation D of the Securities Act and the California Corporate Securities Law of 1968, as amended], or a statement indicating that the only opinion covering securities laws is [the no registration opinion]. Such an exclusion does not mean that other laws customarily understood to be excluded are covered.”).
The Committee notes that, although not necessary, some firms regularly include an express exclusion for federal and state securities laws at the end of the “no approvals and consent” opinion such as the following:
except that we express no opinion as to federal or state securities laws.
The Committee believes that this approach is acceptable and that the inclusion of such an express exclusion does not mean that other opinions that do not include the exclusion are intended to cover such laws.
65. The formulation of this opinion (and opinion 7) often refers to “performance of the Company’s obligations,” “the consummation of the transactions,” or “sale and issuance of the Shares [and Warrants]” under the Purchase Agreement. Although some bar association reports have taken the view that these formulations “may” be different (suggesting, of course, that they also may not be), the Committee believes that in most contexts they are different, and that “performance” adds a future element to the opinion when the Company has obligations to be performed after the closing, while “consummation” or “sale and issuance of the Shares [and Warrants]” covers only matters through the closing of the transaction. See GLAZER & FITZGIBBON, supra note 41, § 15.5, at 572; 1998 TriBar Report, supra note 8, at 662–63; supra note 63 (discusses similar issue regarding “consents and approvals” opinion 7). As it relates to opinion 8(d), coverage of “performance,” although common, requires the opinion preparers to consider compliance with many laws (i.e., those Covered Laws (as defined in Section E (“Certain Qualifications”) below) of either (or both) California and Delaware) because the Transaction Documents often require the Company to perform numerous obligations after the closing. In contrast to the “due authorization” opinion, which “only” requires a review of the Company’s constituent documents, minute books, and similar corporate records and the applicable corporation law (i.e., Delaware or California or both), opinion 8 (and opinion 7) covers many more potentially applicable laws. As discussed elsewhere (see, e.g., supra notes 41 & 48), to reduce the opinion preparers’ factual and legal diligence in a Venture Financing when legal budgets are limited and time is critical, opinion givers often use a narrower formulation that does not add a future element to the opinion. The formulation of the “no violation” opinion in the Venture Opinion focuses on the execution and delivery of the Transaction Documents and the performance of the obligations the Company is required to perform at the closing: the sale and issuance of the Shares at the closing and, where applicable, the sale of the Warrants at the closing (or, the functional equivalent: “the consummation of the transactions”) under the Purchase Agreement. If the opinion giver agrees to give a “no violation” opinion on the Company’s performance in the future of specific obligations, it normally should address the Company’s performance of those obligations in a separate opinion (as is done with respect to securities laws in Section C (“Opinions”), paragraph 9). See 2007 BUSINESS TRANSAC-TIONS REPORT, supra note 6, at 61–62.
Finally, if the opinion giver agrees to give an opinion on the “performance” of all of the Company’s obligations under the Transaction Documents, the opinion will cover not only “performance” by the Company of its obligations under the Transaction Documents as of the closing but also the performance of its obligations after the closing, for example, post-closing issuances of Shares and Warrants in installments pursuant to the Transaction Documents. The analysis required to support an opinion covering the performance of future obligations can be difficult. See generally GLAZER & FITZGIBBON, supra note 41, §§ 13.2.3, 16.3.7, at 548–52, 602–07; 1998 TriBar Report, supra note 8, at 657–58 (general discussion of coverage of obligations to be performed in the future); see also 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 48–56 (discussing the diligence required to deliver a “no violation” opinion that covers the performance of future obligations under the Transaction Documents). As the foregoing reports and treatise generally state, certain assumptions and limitations on coverage of the opinion are understood as a matter of customary practice to apply, whether or not expressly stated in the opinion. See GLAZER & FITZGIBBON, supra note 41, § 13.2.3, at 548–52 (opinion only covers facts at the time of delivery but, if an agreement obligates the Company to take actions in specified circumstances, an exception is necessary if those actions are prohibited; further, the opinion only covers required actions, not voluntary ones).
66. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 48–57 (an explanation of the opinions listed in opinion 8 of the Venture Opinion).
67. For a discussion of the agreements covered by this opinion, see supra notes 26 and 27 and Section A (“Documents Examined”), paragraphs (xii) and (xiii). Consistent with the Transactional Opinion, this opinion should cover an agreed list of reviewed agreements and not a vaguely defined universe (e.g., “all agreements known to us”), which is less precise and, therefore, more susceptible to later disputes. See TRANSACTIONAL OPINION, supra note 3, at 13 n.26. Further, as suggested by the 2007 Business Transactions Report, the Venture Opinion expressly excludes financial covenants and similar provisions. See 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 51–52 n.161 (extended discussion of lawyers’ evaluation of financial covenants in the context of third-party noncontravention opinions).
68. As noted in the Transactional Opinion, the Committee believes that the trend in practice is toward use of the above formulation of this opinion, although the following formulation is not un-common. If used, this alternative formulation should be accompanied by a statement as to what constitutes “knowledge”:
violate any judgment, order or decree of any court or arbitrator applicable to the Company and known to us;
See TRANSACTIONAL OPINION, supra note 3, at 14 n.27; see also Section B (“Certain Qualifications”), paragraph 2.
The NVCA FORM, supra note 5, at 2 provides two alternative formulations of this opinion, both of which are consistent with the above formulation:
violate any court order, judgment or decree, if any, listed in Schedule _____ to this opinion letter
violate any court order, judgment or decree, if any, listed in Schedule _____ to the Purchase Agreement
69. See generally TRANSACTIONAL OPINION, supra note 3, at 14 n.28. This opinion is limited to the law of the jurisdiction(s) whose law is expressly covered by the opinion letter. As a matter of customary usage, it is understood not to cover local laws and certain regulatory laws (such as securities laws). 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 55–57; 2007 REMEDIES REPORT, supra note 6, app. 10, at 13. In addition, customary usage limits the coverage of the opinion to laws a lawyer would reasonably recognize to apply to transactions of the type covered by the opinion and excludes from the coverage of the opinion laws, such as securities and tax laws, that even when applicable are understood to be covered only when referred to expressly. 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 56 n.168; Principles, supra note 7. Consequently, although language stating that only laws “typically applicable” to transactions of the type addressed by the opinion letter is unnecessary, some lawyers include language to that effect in their opinion letters. To resolve any doubt as to the law covered by the opinion, the Venture Opinion uses the term “Covered Law” and defines it to incorporate the foregoing understandings. Finally, the “no violation” opinion should be understood to mean that neither the execution and delivery by the Company of the Transaction Documents nor sale and issuance of the Shares [and Warrants] under the Purchase Agreement will result in a fine, penalty, or other similar sanction against the Company under Covered Law. See 2007 BUSINESS TRANS-ACTIONS REPORT, supra note 6, at 55. The opinion does not cover the enforceability of the Transaction Documents. Rather, that is a matter covered by the remedies opinion in opinion 6.
70. For an extended discussion of the meaning and scope of opinions regarding the availability of an exemption from the registration requirements of the Securities Act, and qualification requirements under state law (a “No Registration Opinion”), see 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 78–83. In this regard, the No Registration Report is also instructive:
[A no registration opinion] is based on the assumption that [1] the Purchase Agreement contains representations by the issuer relating to the offering of the securities, including the absence of “general solicitation” and “general advertising” and prior sales of similar securities that could be integrated with the offering covered by the opinion; … [2] that the Purchase Agreement includes agreements by the issuer to limit future offers of the same or similar securities and, in certain cases, to provide information to holders of the securities; … [and] [3] that the purchasers are agreeing not to resell the securities except pursuant to an effective registration statement under the Securities Act or an exemption, such as Rule 144.
[Further,] [t]he opinion giver … must be satisfied as to the eligibility of the purchasers to acquire the securities pursuant to the exemption from registration being relied on. For example, an offering being made in reliance on Rule 506 of Regulation D may be structured so as to require all of the purchasers to be “accredited investors.” The opinion giver may rely on representations in the Purchase Agreement, a placement agent’s certificate, investor questionnaires or other procedures in confirming the eligibility of the purchasers. Ordinarily, the text of the opinion letter itself will not refer to any of the above matters.
No Registration Report, supra note 7, at 187–88. Note that the No Registration Report was published prior to the adoption of Rule 506(c), which now permits “general solicitation” and “general advertising” in offerings made in compliance with that Rule. See supra note 36. The Securities Law Opinions Subcommittee of the ABA Business Law Section’s Committee on Federal Regulation of Securities is currently considering an update to the No Registration Report to address the changes in Regulation D.
71. In many Venture Financings, No Registration Opinions are requested and given with respect to the issuance of Common Stock (or other securities) upon conversion of a convertible security or the exercise of Warrants (as has been done above in opinion 9). A No Registration Opinion can be problematic to the extent it covers Warrant Shares, Conversion Shares, or Warrant Conversion Shares because further consideration may or may not be payable for the underlying shares when they are issued. Because the transaction to which the Venture Opinion is directed involves the issuance of Warrants, the Venture Opinion adopts the approach described in a note to the NVCA Form, i.e., that an opinion on Shares issuable upon exercise of warrants (as well as options and other rights) may be given based on an express assumption that the warrants, options, or other rights were exercised and the underlying shares issued at the closing of the transaction. See NVCA FORM, supra note 5, at 4 n.16 (“When warrants, options or other rights to acquire Company stock are exercisable upon the payment of cash, the no registration opinion can raise difficult issues because the exemption under Section 3(a)(9) of the Securities Act would not be available (other than possibly if the warrants, options or other rights are exercised on a net exercise basis) and the availability of another exemption, such as under Section 4(2) of the Securities Act, would depend on the facts at the time of exercise. Accordingly, many firms will not give a no registration opinion on the issuance of shares upon the future exercise of warrants, options or other rights. Some firms, however, will give the opinion based on an express assumption that the warrants, options or other rights were exercised and the underlying shares issued at the closing [of the Venture Financing that is the subject of the opinion].”).
Although not including an opinion on the issuance of shares upon the exercise of warrants, the NVCA Form does include an opinion on the issuance of shares upon the conversion of a convertible security. That opinion, modified to adopt the definitions and style of the Venture Opinion, is as follows:
Based on, and assuming the accuracy of, the representations of each of the Purchasers in the Purchase Agreement, the offer and sale of the Shares does not, and the issuance of the Conversion Shares upon conversion of the Shares in accordance with the conversion provisions of the Restated Charter will not (assuming no commission or other remuneration is paid or given directly or indirectly for soliciting the conversion), require registration under Section 5 of the Securities Act [or qualification under the California Corporate Securities Law of 1968, as amended].
See NVCA FORM, supra note 5, at 3–4; see also No Registration Report, supra note 7, at 188 (“In cases where the securities being sold are convertible into Common Stock … some lawyers refer in the opinion letter to the conditions of the Section 3(a)(9) exemption from registration, for example by expressly assuming that no commission or other remuneration will be paid or given directly or indirectly for soliciting conversion. Others, regarding these conditions to be so well understood that they need not be stated or for other reasons, do not refer to these conditions.”).
72. Consistent with the 2009 Venture Capital Report, the Committee believes that opinion givers should not ordinarily give opinions on the blue sky laws of states other than those states where the opinion givers regard themselves as competent to do so. See supra note 12 (competency should be the relevant test for lawyers, not licensing in a particular state). Nevertheless, in the past, some California lawyers have given those opinions based solely upon a review of unofficial compilations of foreign state blue sky laws, qualified as follows:
With respect to the securities laws of __________, we have based our opinion solely upon our examination of such laws and the rules and regulations of the authorities administering such laws, all as reported in [an unofficial compilation]. Neither special rulings of such authorities nor opinions of counsel in that jurisdiction have been obtained.
See 2009 Venture Capital Report, supra note 2, at 180–81.
73. This no litigation confirmation conforms to its counterpart in the Transactional Opinion. For an extended discussion of its meaning and customary diligence to support it, see TRANSACTIONAL OPIN-ION, supra note 3, at 14–15 n.29; 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 62–64.
74. If the law of a state other than California is selected to govern the Transaction Documents, an “as if ” remedies opinion might be given and additional language would be required at this point in the opinion letter. See supra note 61.
75. Many of the opinions in the Venture Opinion will cover the Delaware General Corporation Law as a consequence of the issuer being a Delaware corporation. See 2009 Venture Capital Report, supra note 2, at 166. In particular, the following opinions, among others, will require the opinion preparers to consider the Delaware General Corporation Law: (i) corporate status in opinion 1, (ii) corporate power to perform each of the Transaction Documents in opinion 2, (iii) all necessary corporate action has been taken in opinion 3, (iv) the authorized and outstanding capitalization of the Company in opinion 4, (v) shares of common and preferred stock are duly authorized, validly issued, fully paid, and nonassessable in opinion 5; (vi) consents and approvals under the Delaware General Corporation Law in opinion 7, and (vii) no violation of the Restated Charter, Bylaws, or laws applicable to the Company in opinion 8. Under the internal affairs doctrine, which provides that the corporation law of the state in which a corporation is incorporated regulates the corporation’s internal affairs, the Delaware General Corporation Law will govern many of the matters covered by the opinions given in a Venture Financing.
Section 2115 of the California Corporations Code (“Section 2115”), however, provides that specified provisions of California corporation law apply to certain internal affairs of foreign corporations that have sufficient nexus to California to justify their application. CAL. CORP. CODE § 2115 (West 1990 & Supp. 2012). Generally, for a foreign corporation to be subject to Section 2115, more than half of its holders of voting securities must have addresses in California and the average of the property, sales, and payroll factors used in California state tax determinations applicable to a foreign corporation must exceed 50 percent. While the Delaware Supreme Court has held that the application of Section 2115 to a Delaware corporation is unconstitutional, see VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005), California has no definitive authority to the same effect. Opinion givers are therefore cautioned to consider the potential application of Section 2115 and its impact on the opinions in the Venture Opinion. See 2009 Venture Capital Report, supra note 2, at 166 n.8 (describes recent case law developments regarding Section 2115); supra note 48 (for further discussion of the interaction of Delaware corporation law and Section 2115).
In a Venture Financing, opinion preparers often use one of two approaches to resolve legal issues under Section 2115. One approach is to revise the transaction documents and the Company’s constituent corporate documents to comply with both California and Delaware law. This approach, however, may not always be possible because certain rights and remedies insisted on by investors may be effective under Delaware law but not California law (e.g., “pay to play” charter provisions, see infra note 90). In such situations, a second approach is to include a qualification or exception in Section E (“Certain Qualifications”) of the opinion letter for the possible invalidity of those rights and remedies under Section 2115.
Of course, if the Company is incorporated in California, the California Corporations Code would apply in its entirety, and Section 2115 would not be relevant.
76. By customary usage, the statement “[w]e express no opinion herein as to the application or effect of the law of any other jurisdiction” is understood even if not stated. See TRANSACTIONAL OPINION,
supranote 3, at 15 n.30 (citing 2007 BUSINESSTRANSACTIONSREPORT,supranote 6, at 86–91;1998 TriBar Report,supranote 8, at 631).
77. If the Company is a regulated entity, such as an investment company subject to regulation under the Investment Company Act of 1940, as amended, the law addressed by the opinion letter would include federal and California laws regulating the Company, unless those laws are expressly excluded (as is done in the Venture Opinion). Moreover, even if the Company is not a regulated entity, the opinion giver may be unwilling to cover certain laws. For instance, an opinion giver may expressly exclude compliance with laws affecting the insurance, utility, telecommunications, or banking industries from its opinion letter. If the opinion recipient wants an opinion that the opinion giver is not in a position to give, special counsel often will be engaged to give it. See TRANS-ACTIONAL OPINION, supra note 3, at 15–16 n.30 (citing 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 34).
78. This sentence is included to avoid misunderstanding. As a matter of customary practice, securities laws are understood not to be covered in an opinion letter unless, as in opinion 9, they are addressed expressly. See Principles, supra note 7, at 832 (II.D); NVCA FORM, supra note 5, at 2 n.8. The Committee has intentionally omitted an exception for securities law filings from the “consents and approvals” opinion because of this qualification. See supra note 64.
79. For a discussion of the bankruptcy and equitable principles exceptions, see TRANSACTIONAL OPINION, supra note 3, at 16 n.32; 2007 REMEDIES REPORT, supra note 6, app. 10, at 3–9.
80. Note that this paragraph should be deleted if “to our knowledge,” “known to us,” or similar language is not included in any of the opinions or confirmations being given. See TRANSACTIONAL OPIN-ION, supra note 3, at 17 n.33; 2007 BUSINESS TRANSACTIONS REPORT, supra note 6, at 15–17 (discussion of confirmations of fact). See also TRANSACTIONAL OPINION, supra note 3, at 17 n.33; 2007 BUSINESS TRANS-ACTIONS REPORT, supra note 6, at 32–34 (discussion of limitations on the basis of knowledge).
81. See TRANSACTIONAL OPINION, supra note 3, at 17 n.35 (citing 2007 REMEDIES REPORT, supra note 6, app. 10, at B-24 to B-25 (endnote 21 discusses attorney’s fee provisions)).
82. See TRANSACTIONAL OPINION, supra note 3, at 17 n.36 (citing 2007 REMEDIES REPORT, supra note 6, app. 10, at B-13 to B-14 (endnote 13 discusses forum selection clauses and consents to jurisdiction)).
83. See TRANSACTIONAL OPINION, supra note 3, at 17 n.37 (citing 2007 REMEDIES REPORT, supra note 6, app. 10, at B-15 to B-16 (endnote 15 discusses jury trial waivers)).
84. See TRANSACTIONAL OPINION, supra note 3, at 18 n.39 (citing 2007 REMEDIES REPORT, supra note 6, app. 10, at B-22 to B-24 (endnote 20 discusses arbitration provisions)). The Committee notes that many recent judicial decisions have considered challenges to the enforceability of arbitration clauses. Both federal and California case law make clear that public policy strongly favors enforcement of arbitration agreements. In the past, California courts often held that particular arbitration clauses were unenforceable because they were unconscionable. See, e.g., Armendariz v. Found. Health Psychcare Servs., Inc., 24 Cal. 4th 83, 87 (Cal. 2000); Discover Bank v. Superior Court, 36 Cal. 4th 148 (2005). The Federal Arbitration Act generally provides that an agreement to arbitrate is enforceable, except on grounds that may exist for the revocation of any contract, such as unconscionability or fraud. In AT&T Mobility LLC v.Concepcion, 131 S. Ct. 1740 (2011), the U.S. Supreme Court concluded that the Arbitration Act preempted state law where the unconscionability was based on the terms of an arbitration clause itself and, therefore, held that the Arbitration Act preempted the holding in Discover Bank. Subsequently, the U.S. Supreme Court held that where the pro-arbitration policy of the Arbitration Act conflicts with the enforcement of another federal law (such as the antitrust law) under the terms of a particular arbitration agreement, the policies of the other law must give way so long as the other law does not otherwise provide. See, e.g., American Express Co. v. Italian Colors Rest., 133 S. Ct. 2304 (2013). Applying Concepcion, California courts have upheld arbitration clauses and have not allowed class arbitrations in the absence of an agreement permitting class arbitration. See Truly Nolen of Am. v. Superior
Court, 208 Cal. App. 4th 487 (2012); see also Sonic-Calabasas A, Inc. v. Moreno, 57 Cal. 4th 1109 (2013) (under the Arbitration Act, courts applying state unconscionability principles cannot mandate procedural rules that are inconsistent with fundamental attributes of arbitration; however, a court applying an unconscionability analysis may consider the value of benefits provided to employees by state statutes in determining whether a particular arbitral scheme provides an accessible, affordable process for resolving wage disputes); see also Iskanian v. CLS Transp. Los Angeles, LLC, 59 Cal. 4th 348 (2014) (class action waivers in labor contracts are enforceable due to preemption of state law public policy by the Arbitration Act; however, waivers of California’s Private Attorney General Act (“PAGA”), permitting aggrieved persons to bring actions to enforce civil penalties for state Labor Code violations, are unenforceable as a violation of public policy; and the Arbitration Act does not preempt state law that provides for unenforceability of waivers of the rights of aggrieved persons to bring court actions as deputized actors for the state under the PAGA). As a result of the U.S. Supreme Court decisions, the Committee believes that as a general rule opinion givers need not include an exception for the enforceability of arbitration clauses in agreements among sophisticated parties in Venture Financings. Nevertheless, many opinion givers are not comfortable giving opinions on the enforceability of arbitration clauses because they believe that: (1) the law is not completely settled, (2) they do not closely follow developments in the law in this area, or (3) although arbitration clauses may be generally enforceable, they are unsure whether certain provisions of the arbitration clause are enforceable such that unenforceability of the particular provision might render the entire arbitration clause unenforceable because the unenforceable provision “permeates” the entire arbitration provision. In the case of such uncertainty, opinion givers may consider including this qualification (and may find that in many cases opinion recipients are willing to accept it).
86. The 2009 Venture Capital Report provides two forms of qualification for the capitalization opinion: one form when the opinion giver maintains the Company’s stock records and a second form when the Company or a third party maintains the Company’s stock records. See 2009 Venture CapitalReport, supra note 2, at 168–69. Because opinion givers in many cases do not maintain the Company’s stock records, the Venture Opinion uses only the second form of qualification. If the opinion giver maintains the Company’s stock records, the first form of qualification may be appropriate and that qualification, modified to adopt the definitions and style of the Venture Opinion, is as follows:
In giving the equity capitalization opinion set forth in Section C (“Opinions”), paragraph (4), we have relied without further investigation on (a) the Restated Charter, (b) the Bylaws, (c) minute books relating to meetings and written actions of the incorporator(s), Board of Directors, and stockholders of the Company, and stock records consisting of [description], that [are in our possession] [have been delivered to us by the Company for the purposes of rendering this opinion], and (d) statements in a certificate the Company has delivered to us relating to the equity capitalization of the Company (collectively, the “Capitalization Records”). We have not undertaken to verify the accuracy and completeness of that information, other than by reviewing the Capitalization Records. Accordingly, our opinion on the number and character of issued and outstanding securities means that, based upon the examination referred to above, the Capitalization Records are consistent with the information as to the number and character of outstanding securities that is set forth in Section C (“Opinions”), paragraph (4).
See 2009 Venture Capital Report, supra note 2, at 169.
87. The Committee believes that the current trend is against giving “Outstanding Options Opinions” and “No Outstanding Preemptive Rights Opinions” and, therefore, neither has been included in the Venture Opinion. See supra note 54. Nevertheless, to the extent those opinions are given, the further qualifications articulated in the 2009 Venture Capital Report are appropriate:
Accordingly, our opinion on the number and character of issued and outstanding securities means that, based upon the examination referred to above, the Capitalization Records are consistent with the information as to the number and character of outstanding stock[, options, warrants, conversion privileges, or other rights] that is set forth in Section C (“Opinions”), paragraph 4.
2009 Venture Capital Report, supra note 2, at 169.
88. 2007 REMEDIES REPORT, supra note 6, app. 10, at B-26 to B-31 (endnotes 23 and 25 discuss indemnities). Both the U.S. Securities and Exchange Commission and federal court decisions have taken the position that corporate indemnification for liabilities arising under the Securities Act is against public policy. Such limitations may apply regardless of whether indemnification is permissible under applicable state laws. See, e.g., 2007 REMEDIES REPORT, supra note 6, app. 10, at B-31 (“The public policy against permitting one party to shift liability for breaches of the securities laws to another party, the conflicting judicial policies applicable to indemnities by buyers in securities purchase transactions, and the absence of decisive relevant case law make it difficult to render an opinion regarding the enforceability of such contractual provisions. Thus, it is customary practice to include an exception in a remedies opinion relating to the enforceability of those provisions.”).
The first bracketed language in the qualification may be deleted if Section E (“Certain Qualifications”), first paragraph, last sentence limits the coverage of securities laws to only Section C (“Opinions”), paragraph 9 (the “no registration opinion”).
Note that the sample language does not exclude negligence; opinion givers should confirm that the provision is sufficiently clear that it covers negligent acts of the indemnified party in which case the brackets around “gross” should be removed. See 2007 REMEDIES REPORT, supra note 6, app. 10, at B-26 to B-28.
89. Some lawyers believe that an opinion regarding compliance by the directors, officers, or principal stockholders with their fiduciary duties is appropriate as a stand-alone opinion or is implicit in the duly authorized opinion, the validly issued opinion (Section C (“Opinions”), paragraphs 4 and 5), or the enforceability opinion (Section C (“Opinions”), paragraph 6). The Committee believes that such a belief is inconsistent with customary practice. Prior published opinion reports make clear that compliance with fiduciary duties is covered by an opinion letter only if addressed expressly and that no such opinion should be implied. To avoid misunderstanding, some opinion givers may choose to state expressly that the opinions they are giving do not cover compliance with fiduciary duties. See 2009 Venture Capital Report, supra note 2, at 189; see also supra note 34.
90. Regarding voting agreements see supra note 59. If the Transaction Documents provide for a special mandatory conversion feature, often known as a “pay-to-play” provision, the opinion giver should also consider whether a qualification is appropriate. See supra notes 57 & 75 (third paragraph). The analysis (and conclusion) may differ depending upon whether the Company is a California or Delaware corporation. See 2009 Venture Capital Report, supra note 2, at 185–87.
91. Consistent with the Transactional Opinion, the Venture Opinion takes the traditional approach to reliance by permitting only those to whom it is addressed to rely on it. See TRANSACTIONAL OPINION, supra note 3, at 19 n.41 for an extended discussion.
Hypothetical 1: Two people (Member A and Member B) agree to form a Delaware LLC, and they agree to contribute $50,000 each in start-up capital. Each member is to receive a 50% interest in the company. Member A contributes $50,000, but Member B contributes only $10,000. Does Member B own 50% of the company?
Hypothetical 2: Two people agree to form a Delaware LLC, and they both agree to contribute $50,000 in start-up capital. Each member receives a 50% interest in the LLC. The company is managed by Member A. After a period of operations, Member A decides the company is in need of additional capital. He makes a capital call for an additional $50,000 from each member. Member A contributes the additional $50,000. Member B contributes nothing. Does Member B still own 50% of the company?
* * *
The Delaware Court of Chancery was recently faced with a variation of Hypothetical 1 in Grove v. Brown, 2013 WL 4041495 (Del. Ch. Aug. 8, 2013), and its answer to the question posed above likely has implications to the answer to Hypothetical 2. Although failure to make an initial capital contribution may be somewhat unusual, LLC members and LP partners often must decide how to answer a capital call like that in Hypothetical 2. In the Grove decision, the Court of Chancery explained that a member’s failure to make the full amount of his initial capital contribution did not cause any reduction in his membership interest. If the members of an LLC or partners of an LP wish to have membership interest or partnership interest reduced for a deficiency of a capital contribution, the Court of Chancery held those parties must contract for it in the operating agreement. As explained below, in the context of capital calls, courts have enforced such provisions permitting dilution for failing to respond to a capital call. However, if the LLC agreement is silent on the subject, based on the Grove decision, a non-contributing member who fails to answer the call may find that the non-contributing member still owns the same amount of interest, and the contributing member who pays in additional capital may find that you do not always get what you pay for.
Act Permits LLC Agreement to Provide for Reduction of Membership Interest
The Delaware Limited Liability Company Act (the “Delaware LLC Act”) permits an LLC agreement to provide for the reduction of a member’s interest if that member fails to provide capital when so required. Specifically, 6 Del. C. § 18-502(c) provides:
A limited liability company agreement may provide that the interest of any member who fails to make any contribution that the member is obligated to make shall be subject to specified penalties for, or specified consequences of, such failure. Such penalty or consequence may take the form of reducing or eliminating the defaulting member’s proportionate interest in a limited liability company . . . .
(Emphasis added). This language, however, is clearly permissive. It is not one of the few mandatory provisions in the Delaware LLC Act. To the contrary, it states that an LLC agreement “may provide” for a reduction in a member’s interest if a required capital contribution is not made. The Delaware Revised Uniform Limited Partnership Act (the “Delaware LP Act”) contains a provision that similarly permits a partnership agreement to reduce a partner’s proportionate interest in the limited partnership in the event that partner fails to make a required capital contribution. See 6 Del. C. § 17-502(c). Significantly, neither Section 17-502(c) nor Section 18-502(c) distinguish between a failure to make a required initial capital contribution and a failure to make a subsequent required contribution in response to a valid call for capital.
If Operating Agreement Permits Dilution for Failure to Answer Capital Call, Delaware Will Enforce the Provision
Courts have found provisions adopted pursuant to Sections 17-502(c) and 18-502(c) enforceable.However, the Court of Chancery has held the parties to the strict language of the agreement.In Telstra Corp. v. Dynegy, Inc., 2003 WL 1016984 (Del. Ch. 2003), Telstra exercised a put option it had under the partnership agreement. If Telstra exercised the put in the first two years of the partnership’s existence, which it did, then Telstra was entitled to a purchase price that equaled the value of its capital account. A dispute arose as to whether it was appropriate to “book down” the value of Telstra’s capital account based on a decline in the company’s fair market value. Under the terms of the partnership agreement, a “book down” was only triggered upon certain events, one of which was a disparate capital contribution.
The partnership agreement permitted capital calls. However, for a call for capital, the partnership agreement required: (1) approval of the board of managers, (2) notice sent to the partners, and (3) a 90 day window for the partners to answer the call. An officer of the partnership issued the relevant call without approval of the board of managers, rendering it invalid. Dynegy provided additional funds in response to the invalid capital call. Holding the parties to the terms of the agreement and refusing to allow Dynegy to benefit from the invalid capital call, the court found that “the Partnership was not permitted to accept the defendants’ purported ‘capital contribution,’” and that “the defendants were not free under the terms of the Agreement to unilaterally make a disproportionate contribution of capital to the Partnership.” Moreover, even if the call had been issued by the board, 90 days had not passed at the time Telstra exercised its put. The court found that “[i]t is only when a partner fails to contribute its pro rata share of the capital contributions by the due date that the non-contributing partner’s Partnership interest will be diluted.” Although the Telstra court never specifically referenced Section 17-502(c), it recognized that the provision permitting a reduction in partnership interest based on a capital call to be enforceable.
Although not decided by a Delaware court, in Abuy Development, L.L.C. v. Yuba Motorsports, Inc., 2008 WL 1777412 (E.D. Mo. 2008), the U.S. District Court for the Eastern District of Missouri found that Section 18-502(c) of the Delaware LLC Act permitted a provision that reduced a partner’s 50 percent holding in YCM, a Delaware LLC, based on failure to make a capital contribution. Initially, YCM was capitalized by a contribution of funds from Abuy, and Yuba received equal capital credit for preliminary work done on the project. Subsequently, each member was required to make an additional capital contribution in response to a call issued pursuant to the agreement. Abuy not only contributed capital to satisfy its obligation, but also contributed capital on behalf of Yuba pursuant to a promissory note between Abuy and Yuba. However, Yuba then failed to pay back the loan. After default on the loan, Abuy reduced Yuba’s interest in YCM. The YCM operating agreement specifically permitted one member to loan the other funds to answer a capital call. However, if the member who had been loaned money failed to pay back the loan plus interest, then under the terms of the YCM operating agreement “the Non-Defaulting Member may elect . . . to adjust the Capital Accounts of the Defaulting Member and the Non-Defaulting Member to reflect that the Non-Defaulting Member has made such Capital Contribution on its own behalf and not on behalf of the Defaulting Member thereby increasing the Percentage Interest of the Non-Defaulting Member and reducing the Percentage Interest of the Defaulting Member. . . .” In upholding the reduction of Yuba’s membership interest, the court specifically cited to Section 18-502(c) of the Delaware LLC Act as authorizing the provision.
Although the Telstra and Abuy decisions demonstrated that courts will enforce provisions adopted pursuant to Sections 17-502(c) and 18-502(c), they failed to address what would happen to a partner’s or member’s interest if that partner or member failed to contribute capital and the operating agreement was silent as to the remedy.
Court of Chancery Refuses to Dilute Membership Interest in Absence of Provision in LLC Agreement
In Grove v. Brown, 2013 WL 4041495 (Del. Ch. Aug. 8, 2013), the Court of Chancery addressed the appropriate remedy for a failure of a member to make the full amount of his initial capital contribution where the agreement was silent on the subject. Mary Marlene Grove and Larry Grove on the one hand, and Melba Brown and Hubert Brown on the other, formed Heartfelt Home Health, LLC (Heartfelt), which was a home health-care staffing agency. Under the terms of the Heartfelt operating agreement, each member was to contribute $10,000 as an initial capital contribution, and each member was to receive a 25 percent stake in Heartfelt. In its first year of operations, Heartfelt was very successful. This success, however, led to a disagreement over the future of the business. The Groves advocated expansion into Maryland, and the Browns favored focusing on the existing business in Delaware. As will be further discussed below, the Groves and the Browns also disagreed over whether each member owned 25 percent of the company.
Unable to resolve their disagreements, the Groves proposed to sell their equity to the Browns. The Groves also threatened to seek dissolution. In response, the Browns purported to merge Heartfelt with another entity they had formed, Heartfelt Home Health II, LLC (Heartfelt II). The Browns contended that they could cause a cash out merger because they claimed to hold more than 50 percent of Heartfelt due to the failure of the Browns to make a full capital contribution. In response, the Groves filed an action for breach of fiduciary duty.
As a threshold matter, the court had to determine whether the Browns only owned 50 percent of Heartfelt, which would have denied them the legal authority to merge out the Groves. The Heartfelt operating agreement provided:
The Members initially shall contribute a total of $40,000 to the Company capital. The description and each individual portion of this initial contribution are as follows:
Hubert E. Brown Jr. $10,000 25%
Melba E. Brown $10,000 25%
Larry E. Grove $10,000 25%
  Mary Marlene Grove $10,000   25%
“The Operating Agreement further provides that profits and losses should be divided among the members ‘in proportion to each Member [sic] relative capital interest in the company.’” Although the operating agreement provided that each member would contribute $10,000 in capital, the Groves collectively contributed only $13,000. Specifically, Larry Grove had not contributed the full amount of the required $10,000. Based on this shortfall, the Browns claimed the Grove’s collective interest in the company had been reduced below 50 percent. Rejecting this argument and referring to the language cited above, the court stated:
I find that these terms are unambiguous and that the Operating Agreement therefore provides that each of the four members was – and is today – an equal 25% owner of Heartfelt. Nothing in the Operating Agreement indicates that the allocation of relative ownership interests was contingent on the Members’ actions post-signing. Though the Operating Agreement imposes an obligation on the members to provide capital to Heartfelt, the Operating Agreement does not provide that one member’s failure to do so divests that member of his or her share of the company.
The court noted Section 18-502(c) permits an LLC agreement to provide for the reduction of a member’s interest based on the failure to make a required capital contribution. The Heartfelt operating agreement, however, failed to provide for reduction or dilution of a member’s interest in the entity for failure to make such a capital contribution. Accordingly, the court found that Larry Grove held a 25 percent stake in the company despite his deficient capital contribution.
Because the procedural context of the case involved a challenge to the merger of Heartfelt with Heartfelt II, as a partial remedy, the court held there should be an accounting to determine the amount of unpaid capital owed Heartfelt. By extension, in other situations outside of the merger context, if a member has failed to pay all or some of a required capital contribution, an action for breach of contract could be brought against that member to satisfy the unpaid portion of the required contribution.
Conclusion
The policy of both the Delaware LLC Act and the Delaware LP Act is to give the maximum effect to the freedom of contract. To that end, Sections 17-502(c) and 18-502(c) provide partners in Delaware LPs and members in Delaware LLCs the right, but not the obligation, to contract for the appropriate penalties in the event a partner or member fails to make a required capital contribution. However, the case law, and particularly the recent Grove case, teaches a number of lessons regarding this freedom to determine the remedy for failure to contribute the required capital. First, both Section 17-502(c) and 18-502(c) are permissive in nature. Based on Grove, a court will not attempt to rewrite the parties’ agreement to reallocate the membership interest even if the actual contributions are disproportionate. Second, based on the Telstra and Abuy decisions, courts will strictly apply the language of LP and LLC agreements adopted pursuant to either 17-502(c) or 18-502(c) when considering whether to permit a reduction in interest. Since traditionally equity has abhorred a forfeiture, it is not surprising that courts require careful compliance with provisions that will lead to a forfeiture of some or all of a member’s or partner’s interest.
Finally, although Grove dealt with initial capital contributions, nothing about the decision limits Grove’s holding to a failure to make an initial contribution rather than a failure to answer a subsequent capital call. Therefore, if the parties to an operating agreement wish to permit a member’s interest to be reduced if that member fails to answer a capital call, the parties should make clear in the operating agreement the penalty of reduction in interest for failing to answer the capital call. Otherwise, there may be an action against the non-contributing member for an unpaid amount of the required capital contribution, but no reduction in membership interest.
Recent decades have seen substantial expansion in exemptions from the Bankruptcy Code’s normal operation for repurchase agreements. These repos, which are equivalent to very short-term (often one-day) secured loans, are exempt from core bankruptcy rules such as the automatic stay that enjoins debt collection, rules against prebankruptcy fraudulent transfers, and rules against eve-of-bankruptcy preferential payment to favored creditors over other creditors. While these exemptions can be justified for United States Treasury securities and similarly liquid obligations backed by the full faith and credit of the United States government, they are not justified for mortgage-backed securities and other securities that could prove illiquid or unable to fetch their expected long-run value in a panic. The exemptions from baseline bankruptcy rules facilitate this kind of panic selling and, according to many expert observers, characterized and exacerbated the financial crisis of 2007– 2009. The exemptions from normal bankruptcy rules should be limited to United States Treasury and similarly liquid securities, as they once were. The more recent expansion of these exemptions to mortgage-backed securities should be reversed.
Special rules exempt an increasingly wide arc of creditors from the normal operation of bankruptcy. These so-called “safe harbors” exempt the bankrupt debtor’s financial-contract counterparties from the basic rules that halt creditor collection efforts when the bankruptcy begins, that claw back preferential and fraudulent prebankruptcy transfers that harm creditors overall, and that facilitate orderly liquidation or reorganization. These safe harbors for financial contracts exist for one articulated purpose: to promote stability in financial markets.1
Yet there is little evidence that they serve this purpose. Instead, considerable evidence shows that, when they matter most—in a financial crisis—the safe harbors exacerbate the crisis, weaken critical financial institutions, destabilize financial markets, and then prove costly to the real economy. Worse, the best available evidence also shows that the safe harbors distort the capital structure decisions of financial firms by subsidizing runnable short-term financing at the expense of other, safer debt channels, including longer-term financing. When financial firms favor volatile short-term over more stable long-term debt, they (and markets generally) are more likely to experience a “run” in the event of a market shock, such as the downturn in housing prices during the most recent recession.
It is time for the Bankruptcy Code to get out of the business of regulating financial markets. Other institutions—the Federal Reserve and Treasury—are better suited for this task. The Bankruptcy Code should therefore be returned to about where it stood in 1984: safe harbors should exist only for agreements involving United States Treasury securities and several other, highly liquid assets (e.g., bank certificates of deposit, eligible bankers’ acceptances, and agency securities2 backed by the government’s full faith and credit). Safe harbors for these repos can be justified on grounds that have nothing to do with systemic risk management and they are at base sufficiently liquid and likely to retain fundamental value in a crisis that they pose no real systemic risk.3 For all other repos, such as mortgage-backed repos, the core rationale for safe harboring them—reducing systemic risk—lacks foundation. Their safe harbor should therefore be eliminated and they should be returned to ordinary bankruptcy practice.
Two of us have written on the scope of the safe harbor previously.4 We focus here in this article on the safe harbors for repurchase agreements (“repos”)— even though the protections for swaps and other financial contracts should be narrowed as well5—because the safe harbors for a wide array of repos are the most dangerous to financial stability. We are not the first to make this point.6 In this paper we aggregate and evaluate the existing evidence, sharpen arguments made by prior scholars (including ourselves) and regulators, and examine the counter-arguments that proponents of the safe harbors commonly make.
The fundamental problem is this: The repo safe harbors exacerbated the financial crisis of 2007−2009 by encouraging the use of short-term repo financing by major American financial firms. The bulk of repo volume is overnight and the vast majority has a maturity of less than three months. This expansion of repo led that market to use securities that could not, and did not, retain their value in the crisis, thereby worsening the crisis and weakening financial firms and markets. The broad expansion of short-term repo, particularly repos of mortgage-backed securities, made major American financial firms more sensitive to financial shocks, more sensitive to disruption in the housing market, and more likely to propagate those shocks through the financial system via rapid close-outs, such as those that induced massive government backing of the financial system in 2007–2009. That government backing included a guarantee of the money market industry after the Reserve Primary Fund broke the buck in the wake of Lehman’s failure, the rescue of AIG after the Lehman failure, the bailout of government-sponsored enterprises—Fannie Mae and Freddie Mae—that issue widely repo’ed securities, and the Federal Reserve’s Primary Dealer Credit Facility—sized in the tens of billions of dollars—to support the repo market. This wide and deep governmental support makes clear that, although it is often mistakenly thought (particularly by industry representatives) that the safe harbors mitigate systemic risk, the reality is that the safe harbors both (1) make too many core financial institutions more fragile, by facilitating their reliance on short-term debt that is unstable in a crisis and (2) shift the epicenter of systemic risk to other sectors of the financial market, particularly after the government buttresses the safe-harbored market.
Today, proponents of the current safe harbors sometimes argue that regulators are bringing systemic risks under control, thanks to various federal and international regulatory changes. But if systemic risks are being brought under control, what then remains of the original rationale for the safe harbors? Either systemic risk still matters in bankruptcy, or it does not. If systemic risk is relevant (as we conclude it may be), the evidence indicates that the safe harbors exacerbated systemic disturbance during the financial crisis. If systemic risk is not relevant (as proponents of the safe harbors sometimes assert), then bankruptcy should return to first principles, without the deep carve-outs (beyond U.S. Treasury securities) from the automatic stay, preference law, fraudulent conveyance law, and the limitation on ipso facto clauses.7
Hence, we recommend scaling back the repo safe harbor to approximately the 1984 scope for “repurchase agreements,”8 namely, safe harboring only repos on U.S. Treasury and agency securities backed by the government’s full faith and credit, certificates of deposits, and bankers’ acceptances. This proposal is consonant with recommendations from leading economists and legal scholars9 and federal regulators.10 The Bankruptcy Code’s safe harbors for other financial contracts should be narrowed as well, to ensure that the other safe harbors do not provide end-runs around the narrowed scope of the repo safe harbors.11 Equally important, the Bankruptcy Code’s rules governing adequate protection, setoff rights, and assumption and rejection of executory contracts should be modified to protect contracting parties better in general and to better protect financial contract counterparties in particular. The latter often face substantially greater costs from the bankruptcy process than other creditors and nonfinancial counterparties. Indeed, these costs are a driver of demand for safe-harbored financial contracts.12 Reducing these costs will reduce the demand for financial instruments that short-circuit the Bankruptcy Code.
Although we address only the Bankruptcy Code in this article, its logic would support comparably narrowing the safe harbors in other federal statutes—e.g., the Federal Deposit Insurance Act and the Dodd-Frank Act.13
I. BACKGROUND
A repurchase agreement (“repo”) is a type of short-term financing that is economically equivalent to a secured loan. In Bevill, Bresler & Schulman AssetManagement Corp. v. Spencer S&L Ass’n (In re Bevill, Bresler & Schulman Asset Management Corp.), the Third Circuit succinctly described repos as follows:
A standard repurchase agreement, commonly called a “repo,” consists of a two-part transaction. The first part is the transfer of specified securities by one party, the dealer, to another party, the purchaser, in exchange for cash. The second part consists of a contemporaneous agreement by the dealer to repurchase the securities at the original price, plus an agreed upon additional amount on a specified future date. A “reverse repo” is the identical transaction viewed from the perspective of the dealer who purchases securities with an agreement to resell.14
A repo is economically equivalent to a secured loan because the dealer receives funds immediately and promises to repay those funds, plus a premium (i.e., interest), at a future date. The transaction is secured by the securities. Courts15 and commentators16 are well aware of this economic equivalence.
Many market participants utilize the repo market, most notably the Federal Reserve, which uses the repo market to implement monetary policy, principally via repos on Treasury securities and agency debt.17 Sophisticated institutional investors use it to safely meet short and long-term liquidity needs, corporations and money market funds use it for cash management, and broker-dealers use it to finance their securities inventory and other investments. (This is sometimes called “shadow banking.”18) As of 2010, U.S. Treasury and agency securities (including agency mortgage-backed securities and securities not backed by the full faith and credit of the United States) made up about 75 percent of collateral used in repo transactions.19 The U.S. Treasury repo market is a critical component not only of the U.S. capital markets, but also of global capital markets. It has become a principal means of financing the market for U.S. government securities.
The repo market has expanded from its U.S. Treasury securities base to include other types of financial investments, such as mortgage-backed securities and mortgage loans.20 This expansion in the repo market has coincided with expansion in the Bankruptcy Code’s safe harbors for repos. The safe harbor for “securities contracts” first appeared in the Bankruptcy Code in 1982.21 Two years later, in 1984, Congress added the safe harbor for “repurchase agreements.”22 “Repurchase agreements” were defined (in section 101(47)) as agreements that provided for the transfer of one or more of the following instruments: (1) certificates of deposit; (2) eligible bankers’ acceptances; and (3) securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States.
In 2005, Congress expanded the range of safe-harbored repos by amending the definition of “repurchase agreement” to include transfers of the following additional instruments23:
mortgage loans;
mortgage-related securities (as defined in section 3 of the Securities Exchange Act of 1934);
interests in mortgage-related securities or mortgage loans; and
qualified foreign government securities (defined as securities that are direct obligations of, or that are fully guaranteed by, the central government of a member of the Organization for Economic Cooperation and Development).24
Congress also expanded the definition of “securities contract” in section 741(7) to include a
contract for the purchase, sale, or loan of a security, a certificate of deposit, a mortgage loan, any interest in a mortgage loan, a group or index of [the foregoing], . . . or option on any of the foregoing, . . . and including any repurchase or reverse repurchase transaction on any such security, certificate of deposit, mortgage loan, interest, group or index, or option (whether or not such repurchase or reverse repurchase transaction is a “repurchase agreement,” as defined in section 101).25
Although the securities contract safe harbor is available to a narrower set of market participants—a “stockbroker, financial institution, financial participant, or securities clearing agency”26—than the repo safe harbor, virtually all systemically important financial institutions are eligible for protection as “financial institutions” or “financial participants.”27
The safe harbors for repurchase agreements exempt favored creditors from the operation of normal bankruptcy practice, such as the automatic stay (stopping collection efforts outside of the bankruptcy court), avoidance recovery (of preferential and fraudulent prebankruptcy transfers from the debtor to the favored creditor), and the limitation on the creditor’s right to immediately and fully setoff and net monies it owes the debtor against sums the debtor owes it. The relevant Bankruptcy Code provisions are:
Sections 555 and 559, which protect the safe-harbored creditors’ contractual rights to liquidate, terminate, and accelerate repurchase agreements— rights that are normally suspended in bankruptcy;
Sections 362(b)(7) and 362(o), which protect repo counterparties’ setoff rights and their rights to realize against margin or other collateral posted by the debtor (exercise of these rights is normally barred by the automatic stay); and
Sections 546(f) and 548(d), which shield repo counterparties from preferential or fraudulent transfer actions seeking to recover margin, settlement, or other payments made in connection with the repo agreements.28
Together, these provisions permit counterparties to exercise nearly all out-of-bankruptcy contractual rights, notwithstanding the baseline automatic stay and avoidance powers of the bankruptcy court. As Collier explains, “[m]ost repurchase agreements afford a non-defaulting party the right to ‘close-out’ or ‘liquidate’ the agreement upon the other party’s default.”29 Inside bankruptcy, other creditors cannot exercise these contractual rights to terminate their contracts with the bankrupt debtor; safe-harbored creditors can. They are effectively exempt from bankruptcy.
Furthermore, virtually all repos contain ipso facto clauses, as do many loans and executory contracts. These clauses give the favored party the right to declare a default, terminate the contract, and accelerate any obligations owed by the debtor if it files for bankruptcy, becomes insolvent, or fails to maintain itself as financially sound.30 Clauses like these are typically nullified in bankruptcy because otherwise neither a reorganization nor even an effective liquidation is normally possible. Not so for safe-harbored financial contracts like repos. With respect to these contracts, ipso facto clauses are fully enforceable.
II. PRINCIPLES FOR POLICYMAKERS
These departures from basic bankruptcy rules need justification. Financial contracts should receive safe harbor treatment only when benefits exceed costs. Proponents of the current safe harbors typically point to two related benefits: (1) improving the liquidity of collateral and reducing financing costs and (2) reducing systemic risk.31 Neither justification, however, can support the broad departures from normal bankruptcy practice.
A. BENEFITS
1. Liquidity and Financing Costs
The safe harbors undoubtedly improve the liquidity of repurchase agreements and the underlying collateral. Because counterparties can terminate repos and liquidate collateral, regardless of any bankruptcy filing by the debtor, the safe harbors allow counterparties to avoid bankruptcy-specific costs of distress, such as inadequate protection of collateral values, deviations from absolute priority, and cherry-picking of executory contracts by the debtor (assuming in-the-money contracts and rejecting out-of-the-money contracts with the same counterparty). These costs are thought to be non-trivial and to exceed the costs associated with terminating repos and liquidating collateral outside bankruptcy.32 Because the safe harbors allow counterparties to avoid these costs, the collateral is more “liquid” in the sense that it can be sold at a price close to its fundamental value. The more liquid the collateral, the lower the costs of default to counterparties. And lower costs of default translate into better terms of trade for debtors: Debtors receive a higher purchase price for securities (a smaller “haircut”) when these securities can be liquidated at lower cost.33
2. Shadow Banking
The safe harbors played an important role in the growth of shadow banking.34 Corporate cash managers, as well as pension and mutual funds, investment banks, and other institutional investors with large cash reserves want immediate access to this cash, but would also like to earn a return on the cash until it is needed. Safe-harbored repos provide the solution: They function like demand deposits, but without the government guarantee. The cash provider earns a small return on its cash, the investment is safe because the repo’s duration is generally very short (often overnight), and the underlying collateral can be liquidated without interference from the Bankruptcy Code.35
3. Systemic Risk
Because they improve the liquidity of collateral, the safe harbors are thought to mitigate systemic risk. In the event of a debtor’s default, counterparties can quickly terminate contracts with the debtor, liquidate collateral to cover any losses, and re-hedge by entering new contracts with new debtors. In this way, the debtor’s distress will have no knock-on effects on the counterparties. In the absence of the safe harbors, counterparties would incur larger losses due to the various bankruptcy-specific costs, and these losses might trigger distress at the counterparties themselves.36 Additionally, the safe harbors may increase the supply of credit to institutions suffering liquidity crises, potentially allowing them to avoid collapse. A distressed institution typically faces a “debt overhang” problem: It cannot readily attract new loans because creditors worry that if they lend, some of the value of that loan will support the prior distressed debt and not the new loan. By reducing costs of default and by making the new lender’s recovery more certain, the safe harbors ease the debt overhang problem and thereby allow distressed institutions to attract new investment and potentially avoid default.
B. COSTS
The costs of the safe harbors are mirror-images of the benefits.
1. Liquidity and Financing Costs
Liquidity does not come for free. The safe harbors enhance liquidity in repo markets by reducing liquidity in other markets, especially markets for traditional, long-term lending. Because safe harbor benefits are available for some kinds of financing (repos, which are largely short-term credit facilities) but not others (traditional, longer-term lending and other shorter-term markets), the Bankruptcy Code is implicitly subsidizing some markets at the expense of others.37 Liquidity is shifted from one market to another. In the process, the safe harbors artificially distort the capital structure of financial institutions toward less stable, run-prone financing. Even worse, the costs of this risk-shifting are borne by the public, the U.S. Treasury, and the American taxpayer via increased financial instability.
Figure 1: Overnight Repos as a Percentage of Total Primary Dealer Repo Financing, January 5, 2005–July 22, 200938
Figure 2: Prevalence of Less Liquid Collateral in Primary Dealers’ Repo Transactions, January 5, 2005–July 22, 200939
Mortgage loan repurchase agreements, for example, substitute for warehouse loans. The former are safe harbored from normal bankruptcy rules, the latter are not. The former are thereby favored financially and made more liquid, but the latter are disfavored and made relatively less liquid. We see no principled reasons to favor the favored and disfavor the disfavored. One Federal Reserve report describes this problem and illustrates the sharp increase in overnight repo financing and illiquid collateral in the run-up to the financial crisis:
[C]onditions in 2008 [became] particularly precarious [due to] the resort to less liquid collateral in repo agreements. . . . Originally focused on the highest quality collateral—Treasury and Agency debt—repo transactions by 2008 were making use of below-investment-grade corporate debt and equities and even whole loans and trust receipts. This shift toward less liquid collateral increased the risks attending a crisis in the market since, in the event of a crisis, selling off these securities would likely take time and occur at a significant loss.40
Figures 1 and 2 illustrate the rapid growth of shortterm (overnight) financing via repo during the years after October 2005, when the Bankruptcy Code’s repo safe harbors expanded substantially. Figure 1 shows that, in terms of dollar volume, short-term repos increased sharply after 2005, while longer-term repos stayed relatively constant. Figure 2 is more important: It shows that repos involving illiquid collateral, such as mortgages and mortgage-backed securities, accounted for an increasing share of primary dealer repos. By 2008, they accounted for nearly 60 percent of all primary dealer repos. Although these figures cannot prove causal relationships, they provide suggestive evidence that the safe harbors facilitated the over-reliance of financial institutions on short-term financing with relatively illiquid collateral.
The safe harbors, in other words, plausibly encourage less stable financing for our largest and most important financial institutions, thereby making it more likely that a stressed institution will need to liquidate in a costly way. Those who might be prepared to lend long term to an important financial institution would, all else equal, be induced by the safe harbors to lend short term (via repo) and roll over that repo on a regular basis. They are then incentivized to decline to rollover (to run) in the event of a financial crisis or in the event of financial difficulty with the borrower. This broad safe harboring policy is unwise. It weakens American financial structures and institutions.41
To be sure, the foregoing argument assumes that the safe harbors merely “move” liquidity around, favoring some markets (repos) and not others (longer-term financing). The net “liquidity effect” of the safe harbors might not be zero. The safe harbors could have a net positive effect, increasing liquidity overall and lowering the cost of capital of institutions that rely on repo financing. This is plausible if the safe harbors allow counterparties to avoid substantial costs associated with the bankruptcy process, such as administrative expenses and inadequate protection of collateral values, which are deadweight costs, and violations of absolute priority (such as inappropriate distribution to shareholders). Because they avoid these costs, repo counterparties offer more liquidity on better terms to borrowers. This argument, however, implies that every creditor should be free to contract around the Bankruptcy Code. Every creditor should enjoy the safe harbors. We take no position on the longstanding academic debate42 over whether a wide array of creditors should be free to contract around bankruptcy. But if the safe harbors increase social welfare because they increase liquidity overall (and not just for the benefited creditors at the expense of other creditors), then the safe harbors should apply to all secured debt, not just financial contracts.
But one should be uncertain whether there is a net liquidity gain for the economy or, indeed, for a particular debtor. The “net liquidity effect” of the safe harbors could well be negative if they make it more difficult to reorganize a debtor that used safe-harbored repos or if they disrupt an economy-wide market. When a debtor files for bankruptcy, most counterparties are stayed from terminating their agreements with the debtor and/or engaging in self-help remedies against estate assets that serve as their collateral. These baseline bankruptcy rules do not apply to repo counterparties. These safe-harbored counterparties can, and will, rapidly close out their positions, selling their collateralized assets into the marketplace at whatever price they can get. If there is widespread selling, there can be a rapid destruction of collateral value as counterparties, unimpeded by the automatic stay, terminate and enforce their rights in debtor assets that serve as collateral. In other words, the safe harbors may have both redistributive effects (favoring repos at the expense of other financing) and deadweight costs (causing value destruction in the event of default). If the safe harbors facilitate widespread selling of the underlying collateral, and if the collateral does not maintain its fundamental value, then owners of that collateral will have reason not to sell that collateral, waiting for its value to recover. This process, which seems to have been at work in the financial crisis, dries up liquidity.
Hence, in principle, the net liquidity effect of the safe harbors could be positive, negative, or zero.
2. Shadow Banking
Safe-harbored repos allow financial institutions to offer the equivalent of demand deposits. Outside of a crisis, shadow banking expands the ability of banks to fund risky, illiquid investments such as mortgages. In a crisis, shadow banking exposes financial institutions to destructive runs. Although safe-harbored repos replicate demand deposits, they lack the FDIC guarantee that applies to true demand deposits. The “on demand” feature of safe-harbored repos is both their virtue and their vice, as the next subsection discusses in greater detail.
3. Systemic Risk
The safe harbors have long been justified on the ground that they mitigate systemic risk by reducing contagion.43 Three reasons show why this common assertion is false.
a. Raising Systemic Risk by Encouraging Short-term Finance
The additional credit that the safe harbors facilitate allows a systemically important financial institution to become larger, more leveraged with more easily runnable debt, and—as a result—more systemically important and more dangerous both before and after it becomes distressed. Repo use, for example, expanded greatly during the run-up to the financial crisis, growing faster than financial debt grew overall in the American economy.44 Many observers view the safe harbors as necessary for this expansion.
This growth in short-term finance45 rendered American financial institutions more fragile than they would have been without the safe harbors. Worse, when these institutions suffered distress, repo counterparties could refuse to renew the contracts or demand additional collateral before agreeing to renew the contracts, and they did. This “rollover risk,” when realized, drained liquidity from these institutions and thereby exacerbated financial stress instead of relieving it.
Opponents of reform often emphasize that the safe harbors increase the supply of credit to an institution suffering a liquidity crisis. They point to J.P. Morgan’s willingness to continue supplying liquidity to Lehman as it foundered. But Lehman’s acute need for liquidity was itself a product of the safe harbors, which encouraged it to rely on short-term financing and to have large safe-harbored obligations before the crisis. When Lehman foundered, it needed to replace this financing. Put differently, one of the most lauded purported benefits of the safe harbors—increasing the supply of liquidity to failing institutions—is a feature that only partially mitigates a problem that the safe harbors themselves create, namely, capital structures that overly rely on short-term, run-prone financing. Thus, even a core safe harbor benefit—facilitating crisis financing—comes packaged with serious negatives—facilitating runs, encouraging interconnectedness via repo, expanded run-prone, short-term financing, and excessive leverage.
b. Raising Systemic Risk by Facilitating Runs
Second, by permitting counterparties to “run” on failing institutions, as stated in the prior paragraph, the safe harbors accelerate failure and exacerbate the risk of systemic collapse.46 This is a lesson of the Lehman Brothers bankruptcy: during the days preceding and following the filing, counterparties refused to roll over repos (or demanded larger haircuts) and terminated other financial contracts en masse, effectively draining Lehman of liquidity.47 Had Lehman not become so dependent on safe-harbored repos—more than one-third of its liabilities were said to be in repo—it might have been better positioned to weather the crisis long enough for a more stable solution to emerge. Opponents of narrowing, who point to the Lehman close-outs as a success, ignore that the safe harbors put Lehman in the fragile position it occupied. Opponents also ignore the knock-on failures in the money market and elsewhere—failures that were every bit as serious as those that the contagion rationale for safe harbors is supposed to prevent.
c. Raising Systemic Risk by Depressing Collateral Values During a Crisis
By facilitating runs on systemically important financial institutions, the safe harbors induce the institutions’ counterparties to terminate all financial contracts en masse, via cross-default clauses, and liquidate the supporting collateral en masse. En masse liquidation of collateral other than the safest (i.e., United States government obligations) typically leads to low-price fire-sale close-outs, further weakening the target institution and temporarily depressing the market value of comparable collateral held by other institutions. These two effects—fire sales and depressed collateral values generally—spread the distress at the failing institution to other, initially healthier institutions. Recent empirical work confirms the importance of these fire-sale externalities.48
The safe harbors, in other words, facilitate contagion.49 Part of the reason they facilitate contagion is that they are built on old-school contagion concepts: If X defaults on obligations to Y, Y may suffer large losses that force it to default on its own obligations to Z, which may in turn default on its obligations to its counterparties, and so on throughout the financial system. This is the “dominos” theory of systemic risk. But systemic risk can arise from other channels: If X defaults on obligations to Y, Y will liquidate collateral posted by X. If X defaults on many obligations to many parties, all of these counterparties will liquidate the same type of collateral that Y is liquidating. Not only will Y (and the other counterparties) fetch fire sale prices for the collateral, but any other institution (say, Z) holding that type of collateral will need to mark its balance sheet accordingly to reflect the new market prices. In this way, X’s distress spreads to Z through the market for collateral, even though X does no business with Z. Because the safe harbors facilitate fire sales of collateral, they magnify this channel of contagion. One channel of contagion (dominos) is mitigated while another (the collateral channel) is exacerbated.
A growing battery of evidence highlights the importance of the collateral channel as a vector of contagion. We now know that there was a “run on repo” and other sources of short-term funding during the financial crisis50—the very harm that the safe harbors were constructed to avoid. There was panic selling across financial markets of mortgage-backed securities.51 Several Federal Reserve Governors have pointed to this panic and run as critical to the financial crisis.52 This panic selling, which was supported by overly wide safe harbors and could not have been as wide without them, may well have pushed prices of some of the underlying securities temporarily below their long-run value, making financial institutions appear to be insolvent or less solvent than they would otherwise have been.
The analytic misstep that one might make, and which safe harbor proponents appear to make, is to assume that the local benefit of the safe harbors to an individual market participant scales up to also be an aggregate benefit of the safe harbors to the entire repo market. It does not. If only one firm with one safe-harbored repo counterparty fails, then the counterparty can quickly liquidate the collateral and maintain the firm’s own liquidity, because its sale will not disrupt the market overall. This can be a good, local result. But if many counterparties of major failed firms liquidate their repo collateral simultaneously, a result that the safe harbors facilitate, then the liquidity benefit can be (and it seems was) reversed. The safe harbors encourage liquidity at low usage levels; they impede liquidity at large usage levels. Policymakers must guard against wishful thinking here, expecting that what works on the micro-level of a single failed firm with a small set of counterparties will work as well, or even in the same direction, when many firms are liquidating collateral underlying their safe-harbored repos.
C. COSTS AFTER DODD-FRANK
It could be argued that, if the safe harbors contribute to the too-big-to-fail problem, that problem is better addressed by Title I of Dodd-Frank and other statutes than by amending the Bankruptcy Code, which affects all debtors, regardless of whether they are too-big-to-fail. Title I of Dodd-Frank undoubtedly moderates the risk-taking of systemically important institutions and the associated regulatory monitoring of major financial firms further does so. Indeed, if there were widespread agreement that the Dodd-Frank Act has relegated systemic crises to history’s dustbin, we would be less concerned about the safe harbors being an unjustified deviation from bankruptcy basics, as the damage from their deviation from basic bankruptcy principles might only be slight if there were no more systemic financial crises.
But systemic crises are unlikely to be a thing of the past, and regulation is unlikely to be perfect. Some financial institutions will become too-big-to-fail, despite regulators’ best efforts, and some of those too-big-to-fail institutions will become distressed despite existing statutory and regulatory safeguards. Moreover, Dodd-Frank’s orderly liquidation authority and its regulatory initiatives are untested and may fail. A strong way to moderate these risks is to reduce the scope of the safe harbors, which allow distressed institutions to become larger, more leveraged, and more threatening to market stability. Like engineers who seek redundancy and backup in complex systems, bankruptcy reformers should seek a Code that supports financial stability, not one that undercuts it.
Finally, this systemic risk counterargument to narrowing the repo safe harbor— that systemic risk is now handled, and handled well enough, by Dodd-Frank’s Title I—undercuts, and perhaps destroys, the foundational justification for the safe harbors in the first place. Their foundational bankruptcy justification was to help control systemic risk. But the safe harbors should be eliminated—not narrowed—if systemic risk is now best addressed through the “front door” of Dodd-Frank and related regulation rather than the “back door” of the Bankruptcy Code. The primary justification for the safe harbors is their role in mitigating systemic risk. If that role has been assumed by other laws and regulations, the original foundation of the safe harbors has crumbled.
III. NARROWING THE REPO SAFE HARBORS
The challenge for policymakers is clear. The repo safe harbors increase the risk and amplitude of crises, but also increase asset liquidity and the supply of credit outside of crises. The first effect must be balanced against the second. Various proposals have been put forward to achieve this balance, but most rely heavily on a federal regulator to monitor the repo market, limit the kinds of collateral that are repo-ed, set position limits, and perhaps impose taxes that force counterparties to internalize the costs of repo-based financing to market stability.53 Indeed, many proposals would leave the safe harbors intact but use Dodd-Frank and related authority to monitor and mitigate systemic risk.
We support proposals for greater regulatory oversight of repo markets. But it is unwise to rely exclusively on federal regulators to mitigate systemic risk. Regulators are imperfect, as the recent crisis illustrates. And the current safe harbors make regulation harder and more complex by fostering shadow banking. A better approach, we think, is to narrow the repo safe harbors in a simple way that is (i) predictable, (ii) does not depend on the fallible discretion of regulators, and (iii) provides a back-stop that protects the financial system when federal regulators make mistakes. We want redundancy in systemic risk protection.
A. NARROW THE REPO SAFE HARBORS
Policymakers can strike the right balance—protecting markets but preserving the credit-enhancing effects of repo-based financing—by narrowing the safe harbors to protect only repos involving highly liquid securities backed by the full faith and credit of the U.S. government (“FFC securities”), including Treasuries and some agency securities (e.g., those guaranteed by Ginnie Mae). This category amounts to about half of the outstanding securities in the repo market, so it is not small. Repos on other collateral—such as private mortgage-backed securities, equities, bonds, and agency securities that lack the backing of the United States’ full faith and credit—should not receive safe harbor treatment.54
The case for protecting repos on Treasuries and other FFC securities is straightforward. First, safe harbor protection is consistent with longstanding public policy fostering liquidity in the market for government securities. It is cheaper for the government to issue debt when the securities it issues can be readily repo-ed by investors.
Equally important, safe harbors for repos on FFC securities are unlikely to contribute to systemic risk. Recall that the safe harbors contribute to systemic risk by exposing failing institutions to runs and collateral fire sales. Although the potential for a run exists when a failing institution has entered safe-harbored repos, the risk of collateral fire sales is minimal when the collateral consists of FFC securities. These securities are nearly equivalent to cash, are widely traded, and—due to government backing—unlikely to lose their liquidity during crises. Indeed, this is a crucial distinction between repos on FFC securities and repos on any other asset: FFC securities tend to retain their liquidity in good times and bad.55 For other assets, liquidity is endogenous: The current liquidity of the asset is no guide to its future liquidity and its capacity to be sold quickly at long-run value in a crisis.
Safe harbors for repos on FFC securities are, therefore, unlikely to increase the risk or amplitude of market crises. The opposite is true for repos on other assets. Even if the assets are liquid today, in a normal economy, they may become highly illiquid in a crisis, thereby exacerbating market crises via the collateral channel. The history of mortgage-backed securities offers a case in point, as asset-backed securities performed poorly during the financial crisis.56
A large class of Agency assets lacks FFC support but has implicit government backing, namely the mortgage securities backed by Fannie Mae and Freddie Mac, two government-sponsored entities. The empirical case for rolling back the safe harbor for repos of these agency-backed mortgage securities is closer than that for private mortgage-backed securities. During the financial crisis, these entities were put into a government-financed conservatorship and bailed out.57 Recent work by Begalle, Martin, McAndrews, and McLaughlin shows that agency-backed securities are less likely to retain their long-run value than Treasuries, which suggests that they should not receive the same safe-harbor treatment as Treasuries.58 The authors estimate the time needed to liquidate a typical large dealer’s repo portfolio without affecting market price. Even during stable, non-crisis market conditions, Treasuries can be liquidated more quickly in much larger volume—nearly twice as much daily—than agency securities without affecting market prices. A typical large dealer would need more than three weeks to liquidate its portfolio of agency securities without a price impact—a time span similar to that for liquidating private securities without price impact. By contrast, the dealer could unload its Treasury portfolio in nine days. These comparisons are unfavorable to non-FFC agency securities during stable conditions. Worse yet, during a crisis, a flight-to-quality would widen the gap, as Treasuries become more desirable.59
Despite these projections, however, non-FFC agency securities did well during the recent crisis: neither their liquidity nor their pricing deteriorated substantially.60 This surprisingly robust performance was likely a product of massive government support to both the repo markets (about 40 percent of which is agency-backed)61 and the agencies themselves. Fannie and Freddie entered federal conservatorship and received about $187.4 billion in government support.62
Agency-backed securities were, in retrospect, de facto FFC securities during the crisis. Indeed, the robust in-crisis performance of Agency securities might suggest that the repo safe harbor could be extended to both de jure FFC securities (e.g., Treasuries) and de facto FFC securities (e.g., agency-backed MBS) without increasing the risk or amplitude of market crises.
We disagree with that view. A security enjoys de facto FFC status when market participants anticipate government backing. But expectations about government support to financial markets can be erroneous, particularly because government support depends in part on political calculations in the executive branch and the Congress; the recent experience during the crisis created an anti-bailout perspective among many there. Indeed, during the crisis itself, many expected that Lehman Brothers would be bailed out, perhaps including Lehman executives; yet it was allowed, indeed encouraged, to file for bankruptcy. Put bluntly, de facto FFC securities might not be bailed out in a future crisis: the negative reaction to the 2008–2009 bailouts has been substantial.
Additionally, having a repo safe harbor for de facto FFC securities can damage the financial system: The existence of a repo safe harbor facilitates having these securities repo’ed in many financially important areas of the financial system, some of which can be fragile financial interconnections that can only exist with repo safe harbors. But repo’ing securities that cannot maintain their value and liquidity without government support can create more underlying financial fragility that, in a crisis, calls forth government support that would not otherwise be needed. Accordingly, our policy analysis is to consider the appropriateness of a repo safe harbor if the securities and their guaranteeing agencies were not bailed out. Without a bailout, agency securities lacking the government’s full faith and credit would likely have suffered serious illiquidity, similar to that of private mortgage-backed securities. Their widespread liquidation would have further degraded collateral prices in the economy, heightening the very systemic risks that the safe harbors were intended to avoid.
* * *
The foregoing discussion addresses repos of securities that are currently liquid but might be illiquid in a crisis. But today’s safe harbors also protect repos of assets that are currently illiquid, even during normal market conditions. Thanks to the safe harbors, these repos allow distressed institutions to increase in size and leverage, as noted above. In the absence of safe harbor treatment, the institutions would be limited to ordinary secured debt financing to finance their growth. To be sure, this “ordinary” secured debt might also be very short-term financing. But even if it is just as short term as repo financing, this “ordinary” secured debt is subject to ordinary bankruptcy rules, such as the automatic stay, which prevent a value-destroying run on the debtor, fire sales of its collateral, and, if the financial stress leads to a system-wide crisis, the potential degradation of system-wide liquidity if the sales put excessive downward pressure on the collateral’s price.
The repo safe harbors should therefore be limited to agreements collateralized by securities issued by the U.S. government or otherwise backed by the government’s full faith and credit. Proposed basic statutory amendments are set out in the appendix. This rollback tracks the definition of “repurchase agreement” as originally enacted in 1984. Our conclusion rests on the available empirical evidence, the logic of the relationships, and the experience during the financial crisis.63
B. SUBSTITUTION EFFECTS AND THE OTHER SAFE HARBORS
If Congress rolls back the repo safe harbor as we recommend, markets will adjust. The price for repo’ing a mortgage-backed security, for example, will rise relative to other financing channels. We anticipate several kinds of responses, some positive, some benign, and some pernicious.
A positive, or at least benign, response is that financial institutions may reduce their reliance on repo-based financing and increase their use of less run-prone debt. In the absence of safe-harbor protection, repo lenders will demand higher haircuts because the underlying collateral is less liquid. Counterparties will, at the margin, more carefully assess with whom they deal and will seek more collateral. Repo-based financing will, therefore, be more expensive and less attractive. We may therefore see substitution toward more traditional secured debt financing. This might include short-term secured debt and longer-term debt. Longer-term debt should provide more stable financing.
A less attractive response is that counterparties may try to obtain safe-harbor protection for repos using the derivatives safe harbors. We have in this paper focused on the repo safe harbor, but comparable protection is available to counterparties to swaps, forwards, options, and other derivative contracts, including combinations of these contracts. If a mortgage-backed repo does not receive protection under the repo safe harbors, counterparties could construct a synthetic repo that has the same economics as a mortgage-backed repo but receives protection under the safe harbors for swap agreements.64
This possibility presents a statutory drafting problem: the drafters must close end-run “loopholes” by narrowing the derivatives safe harbors at the same time they narrow the repo safe harbors. That task is doable, but drafting is rarely perfect, and the ingenuity of financial market players and their lawyers is great.
An even less attractive response is that repo-based financing might migrate from smaller, systemically benign institutions to the biggest, systemically important financial institutions. That would tend to occur if the largest too-big-to-fail financial institutions continue to be too-big-to-fail, inducing non-safe-harbored repo investors in the mortgage-backed sector to protect themselves by migrating further to too-big-to-fail institutions. If that is the substitution effect, then rolling back the repo safe harbors will not have made the financial system much safer than before.65
Lastly, some of the currently existing short-term repo channels are set up in ways that can only handle short-term finance. These channels cannot and will not shift to being providers of long-term debt. This inelasticity may well mean that the market adjustments from rolling back the repo safe harbors will not be immediate. But a normal economic expectation would be that the costs of using this channel will rise, while the costs of other channels will fall, and over time markets will adjust away from the more expensive channel to the less expensive one.
While we cannot assuredly predict where the substitution will occur, and when it will happen, we can state that the current broad safe harbors did not work well during the financial crisis. They had encouraged the growth of investment channels that proved to be highly unstable and they failed to contain the crisis when it erupted. In our view, our financial system could not do much worse than have the weak, run-prone structures and incentives that we have now and that the broad safe harbors promoted and still promote. The downside of malign substitution from rollback is possible but seems limited, leaving the major issue, in our judgment, only the size and breadth of the improvement.
Moreover, we repeat the point we have made earlier: in general those drafting the Bankruptcy Code should leave monetary and financial policy to the institutions designated to do so. The mortgage-backed repo safe harbors are efforts at macro financial policy, not bankruptcy policy.66
C. REDUCE BANKRUPTCY COSTS FOR FINANCIAL CONTRACT COUNTERPARTIES
The demand for safe-harbored repos derives partly from inefficiencies in the Bankruptcy Code.67 Without the safe harbors, it is said, counterparties would be exposed indefinitely to interest rate and spread risk, affecting their capital and liquidity, and would be unable to effectively hedge their risk.
These are important concerns, but they should not be overstated. In the absence of safe harbor treatment, repos are likely to be treated as secured loans, not executory contracts, by bankruptcy courts. If the status of repos as secured loans is unclear, the Code should be amended to make this clear. Like any secured loan, the repo contract should terminate upon the bankruptcy filing and the counterparty’s secured claim set equal to the value of the underlying collateral on the filing date.68 Counterparties should face the same risks and have the same protections as any secured lender in bankruptcy: The value of the collateral may vary over time and courts must adequately protect the secured party from deterioration in value.69
True, some collateral, such as mortgage-backed securities, is more volatile than the collateral underlying some secured loans. Safe-harbor proponents indicate that this volatility justifies exemption from the normal workings of bankruptcy. But the very reason asserted for bankruptcy exemption—high volatility—is a reason that should make Congress and policymakers worry that the exemption unwisely subjects the financial system to greater risk. We have that concern, and policymakers should as well.
Some of the volatility problem comes from the likelihood that the adequacy of bankruptcy protection may be adequate in form but inadequate in financial reality. Interest rate shifts may change the value of the underlying collateral and interest is not necessarily available even to secured lenders.70 A long stay might be costly to non-safe-harbored repo debt, as it can be for many secured creditors. This difficulty might warrant amendments to the Bankruptcy Code that better protects the counterparty’s interest in the collateral, as valued on the filing date.71 Additionally, in some cases the collateral will be assets that are unnecessary to an effective reorganization of the debtor, warranting a liftstay order, particularly in cases of operating companies using repo.
Lastly, proponents of wide safe harbors worry about a counterparty needing liquidity that is tied up in a bankruptcy proceeding. Above we addressed such concerns: since all creditors have such worries, this is more a reason to safe harbor all debt from bankruptcy. But another market feature blunts the strength of this problem. A counterparty with an intense need for the cash—one that cannot wait out the bankruptcy process—has modern market alternatives. A wide and deep market of claims trading has arisen in recent years in bankruptcy.72 A liquidity-constrained counterparty can sell the claim for cash to a financier that can wait out the bankruptcy process, in a way that was much harder to accomplish decades ago. We do not assert that the market for claims trading is perfect, but there is one and it blunts the force of the liquidity argument.
IV. POTENTIAL CRITIQUES
Opponents of reform often make the following arguments in favor of retaining the status quo:
(1) The safe harbors prevented a systemic meltdown following the Lehman bankruptcy.73
(2) Little would be gained by narrowing the repo safe harbors because the risk-taking activities of systemically important institutions are now constrained under recently enacted laws and regulations.74
(3) Our proposal will reduce the liquidity of mortgage-related securities and thereby undermine long-standing federal policy supporting the housing market.
(4) There is a worldwide demand for money-like obligations that monetary policymakers need to meet. Wide repo safe harbors facilitate meeting that demand.
We have addressed some of these issues obliquely above. We address each directly now.
A. LESSONS FROM LEHMAN
Opponents of reform often argue that the safe harbors mitigated the market impact of Lehman’s failure. In particular, the safe harbors prevented Lehman’s failure from destabilizing its counterparties in the dealer market. There are two problems with this argument. First, it is a selective recounting of developments in financial markets after Lehman’s collapse. Most obviously, it ignores the subsequent failure of AIG, the failure of the Reserve Fund, the needed guarantee of the entire money market, and the disarray and freezing of many financial channels. There was a major financial crisis and Lehman’s collapse is generally thought to have deepened it.
The more important problem with the argument—that the safe harbors saved Lehman’s dealer counterparties—is that it is probably incorrect.75 Lehman and its counterparties required $28 billion in Fed assistance to stabilize the Lehman repo book when it filed, the Federal Reserve reports.76 The safe harbors were, contrary to the opponents’ recounting, insufficient to stabilize even Lehman’s own repo book. And worse:
[O]ther dealers [in the tri-party repo market] experienced stress during the following days [after Lehman filed]. . . . [S]tress in this market would [apparently] have been considerably worse, absent the exceptional policy responses that took place, including the presence of the [Fed’s Primary Dealer Credit Facility].77
The Primary Dealer Credit Facility was a credit facility that the Federal Reserve created to backstop the tri-party repo market and illiquid collateral in that repo market (which we argue here should not benefit from the safe harbor).78 The Lehman Bankruptcy Examiner’s Report recounts the importance of the Fed’s Primary Dealer Credit Facility in steadying repo markets around the time of Lehman’s bankruptcy.79 The Fed’s facility was not in use just prior to the Lehman bankruptcy in mid-September; by October 1—two weeks after Lehman filed—the facility had seen repo dealers draw $148 billion on it.80
In other words, even the safe-harbored repo market needed massive government support and could not rely on the safe harbors to achieve stability. This result is hard to square with the view that the safe harbors prevented further failure after Lehman went down.
B. POST-CRISIS LAWS AND REGULATIONS
Our proposed reform—narrowing the repo safe harbors to approximately their 1984 extent—could be said to be “fighting yesterday’s war.” In a post-Dodd-Frank world, the costs of the safe harbors—especially their systemic risk effects—are now addressed and minimized by federal regulators. Indeed, any modification of the Bankruptcy Code’s safe harbors would simply complicate and undermine the coordinated efforts of federal regulators and their counterparts around the world.
This is an important argument, and would be particularly powerful if we were advocating reforms designed to be primary tools in mitigating systemic risk. That is indeed a job that should be left in the hands of regulators. But we are not proposing that the Bankruptcy Code play a larger or different role in regulating systemic risk. We are instead arguing that the Code should get out of the business of regulating systemic risk. For over twenty years, Congress has added an expanding array of safe harbor provisions to the Bankruptcy Code with the stated intent of minimizing the risk of systemic distress. We think this is a mistake, especially with respect to repos, because the available evidence suggests that the safe harbors make systemic crises more likely and more severe.
More importantly, our proposal complements current efforts by federal regulators to limit the risk-taking of systemically important firms. Despite their best efforts, regulators may make mistakes and a systemically important institution may collapse (this is precisely why Congress adopted Title II of Dodd-Frank). The broad safe harbors we now have magnify the cost of regulatory error. They allow a failing institution to become more leveraged, more dependent on runnable short-term debt, and more likely to need a bailout when it collapses. Thus, our proposal—to narrow the repo safe harbors—helps reduce the cost of regulator error. Our proposal builds redundancy into the financial regulatory system.
The importance of this redundancy should not be overlooked. Regulators responsible for financial safety regret that they lack authority to handle broad aspects of systemic risk residing in the so-called “shadow banking” system.81 If broad portions of the repo market move out of the banking system, as some believe safety regulation for banking might induce,82 then the systemic costs of the Bankruptcy Code’s subsidy to short-term repo financing could rise, to the discredit of the bankruptcy system. While riskier repo transactions declined in the wake of the financial crisis, they have climbed back up since83 and Federal Reserve regulators continue in 2014 to worry that several Wall Street firms are seriously vulnerable to a repo run.84 Narrowing the repo safe harbors to Treasuries helps to keep the shadow banking system, which is less susceptible now to direct regulation, from overly relying on mortgage-backed repos.
Moreover, Congress, via Dodd-Frank, expected bankruptcy to play an important role in resolving distress of systemically important financial institutions. The resolution planning process required in Dodd-Frank for financial institutions requires that the institutions plan for resolution under the Bankruptcy Code if they are eligible to file for bankruptcy. Title II of Dodd-Frank and many of its key regulatory interpreters expect bankruptcy to be the first line of resolution defense, with the expanded Dodd-Frank processes kicking in only if bankruptcy fails.85
C. EFFECTS ON THE HOUSING MARKET
Our proposal would eliminate safe harbor protection for repos on mortgages and mortgage-backed securities. These assets will become less liquid, the supply of credit to the housing market could decline, and it could become harder for potential homeowners to obtain mortgages.
We offer no view here about the value of subsidizing mortgages. This is a matter for policymakers in other arenas to decide. But the American housing market was robust and mortgages were common before the repo safe harbor for mortgage-backed securities became explicitly available in 2005. The benefit to housing could not have been fundamental; the impact in facilitating the financial crisis was, however, substantial. If policymakers nevertheless decide that the safe-harbor benefit to liquidity of mortgage-backed securities is worth continuing, despite its impact in the financial crisis, then it should not move forward via a type of “off-budget” financing by which major risks from their being safe-harbored are borne by the U.S. Treasury, taxpayers, and the American economy but are not otherwise accounted for. If mortgage-backed securities are to get the benefit of the safe harbors, then they should be backed by the full faith and credit of the United States, a result that policymakers and experts have recommended anyway as superior to the current implicit guarantees of government-backed, but not government-guaranteed, entities and their securities.86
D. LIQUIDITY IN MONEY MARKETS
Repos are an important part of the money market87 and the safe harbors are generally thought to play an important role in supporting the use of repos in money markets.88 Our proposal would affect liquidity in money markets by reducing the range of assets subject to repo safe-harbor protection.89 This might even lead to a “collateral shortage”: Market participants may be unable to quickly access collateral that is subject to safe-harbor protection.90
These are important downsides of our proposal. Outside of a crisis, the safe harbors increase asset liquidity, promote liquidity in money markets, and expand access to credit. In a crisis, however, the safe harbors have opposite effects. A balance must be struck between (i) rules that foster the creation of money-like claims and (ii) rules that protect financial markets from destabilizing runs in systemically important institutions. This is obvious; there is an academic consensus that such a balance must be struck.91 Although there are many ways to strike this balance, our proposal is a simple way to achieve it.
Our proposal will not prevent the financial system from creating money-like claims. First off, the Treasury market is itself broad and, in our view, should continue to have safe-harbor repos. Second, a repo rollback will shift creation of these claims from weakly capitalized financial entities to well-capitalized ones. The repo safe harbors are intrinsic to modern private money creation primarily because they protect counterparties of weakly capitalized, insolvency-prone financial entities. The safe harbors are unimportant if the entity seeking to create near-money is so well capitalized that its strength and survivability are unquestioned. Indeed, private money creation has a long history,92 and for most of that history private money was created without repo safe harbors, which are a modern phenomenon, dating from the 1980s. Narrow safe harbors, such as those that we recommend, would provide private competitive incentives for some financial entities to move toward such ultra-safe structures, so that they could profit from issuing more near-money, which weakly capitalized financially entities could not. Regulators could analogously modulate safety-enhancing financial regulation with private money creation in mind.
* * *
If our proposal has a large adverse effect on liquidity in money markets, and if federal regulators believe that the benefits of greater liquidity in these markets outweigh the potential systemic risks, regulators can expand the scope of the repo safe harbor in a simple way: The federal government can offer full faith and credit backing to a broader range of securities.
In other words, if there is a collateral shortage in money markets, or if regulatory authorities want more money-like channels with unimpeachable collateral to be built,93 public authorities ought to push for appropriate private ordering or for government full faith and credit backing. To do otherwise is to ask bankruptcy to do what it cannot. If the collateral that provides the foundation to a money channel cannot retain its long-run value in a crisis, the legal framework has not created a solid money channel. Instead it has created a money channel that can operate during stable economic times but that in a financial crisis cracks, constricts, and collapses. It fails during a financial crisis because the foundational collateral does not retain its long-run value. But if important financial institutions rely on this shaky channel, then when it cracks, government authorities are pressed to conclude that they must support the channel to prevent its full collapse. Government authorities face the choice of propping up the channel and bailing out its participants, or allowing the real economy to suffer.94
CONCLUSION
The repo safe harbors are too wide and should be narrowed. The safe harbors should be limited to United States Treasury and similar securities with the government’s full faith and credit backing them up. They should not encompass private mortgage-backed securities.
The safe harbors depart sharply from standard bankruptcy practice, effectively putting a large class of creditors outside the normal operation of the Code, by exempting them from the automatic stay, the bankruptcy court’s avoidance powers, the normal scope of setoff, and the normal treatment of ipso facto clauses. These departures demand strong justification, but there is no strong justification for mortgage-backed repos. If the safe harbors truly supported systemic financial safety, they might well be justified. But the safe harbors do no such thing. They may well indeed do the opposite by encouraging short-term financing at the expense of stable long-term financing, by facilitating more runnable debt, and by facilitating runs—and especially destructive ones—when a financial firm weakens.
The departure from core bankruptcy principles—a recent one, beginning only a few decades ago and expanding substantially as recently as 2005 and 2006—is unjustified and should be ended.
APPENDIX: STATUTORY PROPOSAL
Amend section 101(47) to read approximately as it did in 1984:
101(47): “repurchase agreement” (which definition also applies to a reverse repurchase agreement) means an agreement, including related terms, which provides for the transfer of certificates of deposit, eligible bankers’ acceptances, or securities that are direct obligations of, or that are fully guaranteed as to principal and interest by, the United States or any agency of the United States, if backed by the full faith and credit of the United States, against the transfer of funds by the transferee of such certificates of deposit, eligible bankers’ acceptances, or securities with a simultaneous agreement by such transferee to transfer to the transferor thereof certificates of deposit, eligible bankers’ acceptances, or securities as described above, at a date certain not later than one year after such transfers or on demand, against the transfer of funds;
Additionally, the definition of “securities contract” would need to be narrowed in order to prevent it from safe harboring repurchase agreements that fall outside the scope of the narrowed repo safe harbor. For example, a securities contract to purchase a security could be paired with a formally separate securities contract to sell that security back at a later time. That pairing could functionally substitute for a repo. Hence, section 741(7), which safe harbors certain securities transactions, should also be narrowed to eliminate transactions that are functionally equivalent to repos. Other conforming changes would likely be needed.
__________________
* Charles Evans Gerber Professor of Law, Columbia Law School. Much of this paper was drafted while Professor Morrison was the Paul H. & Theo Leffmann Professor of Commercial Law at the University of Chicago Law School and received generous financial support from the SNR Denton Fund.
** David Berg Professor of Corporate Law, Harvard Law School.
*** United States Bankruptcy Judge for the District of Delaware. We thank Stephen Adams, Jim Baillie, Patrick Bolton, Felton Booker, Larry Brandman, Darrell Duffie, Mark Ellenberg, David Fel-senthal, Gary Gorton, Seth Grosshandler, Howell Jackson, Stephen Lubben, Antoine Martin, Knox McIlwain, James Peck, Enrico Perotti, David Skeel, Joseph Sommer, Richard Squire, Kimberly Summe, Suresh Sundaresan, Daniel Tarullo, Bruce Tuckman, Shmuel Vasser, Eric Waxman, and conference participants at the Federal Reserve Bank of New York (Conference on the Risks of Wholesale Funding) and Harvard Law School for discussion and comments on this paper and earlier work on the scope of the repo safe harbors.
The authors are members of the Advisory Committee on Derivatives, Financial Contracts, and Safe Harbors of the American Bankruptcy Institute’s Bankruptcy Commission to Study the Reform of Chapter 11.
1. See, e.g., Exploring Chapter 11 Reform: Corporate and Financial Institution Insolvencies; Treatment of Derivatives, Hearing Before the H. Subcomm. on Regulatory Reform, Commercial & Antitrust Law of the H. Comm. of the Judiciary, 113th Cong. 6 (2014) (statement of Seth Grosshandler) [hereinafter Grosshandler Statement], available athttp://goo.gl/QpTsgK (“safe harbors” have proven to be very effective in containing the risk of contagion by allowing counterparties to terminate volatile financial contracts with the debtor quickly, thus limiting their exposure to possibly catastrophic losses from the failure of the debtor. This is the very reason why Congress enacted the safe harbors in the first place.”).
2. On agency securities and the safe harbors generally, see Shmuel Vasser, Derivatives in Bank-ruptcy, 60 BUS. LAW. 1507, 1511–13 (2005). Bankers’ acceptances are not in modern times an important category, although the category persists in the statute.
3. The U.S. Treasury repo market has become a principal means of financing the market for United States government securities. TOBIAS ADRIAN ET AL., FEDERAL RESERVE BANK OF NEW YORK STAFF REPORT—REPO AND SECURITIES LENDING 1, 17 (2013), available athttp://www.newyorkfed.org/research/staff_reports/sr529.pdf.
4. Franklin R. Edwards & Edward R. Morrison, Derivatives and the Bankruptcy Code: Why the Special Treatment?, 22 YALE J. ON REG. 91, 101 (2005); Mark J. Roe, The Derivatives Market’s Payments Priorities as Financial Crisis Accelerator, 63 STAN. L. REV. 539 (2011).
5. Much of the prior scholarship advocates narrowing the safe harbors generally, but does not focus on the specific case for narrowing the repo safe harbors. See, e.g., Edwards & Morrison, supra note 4; Stephen J. Lubben, Repeal the Safe Harbors, 18 AM. BANKR. INST. L. REV. 319 (2010); Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. CIN. L. REV. 1019, 1036 (2007); Roe, supra note 4; Michael Simkovic, Secret Liens and the Financial Crisis of 2008, 83 AM. BANKR. L.J. 253 (2009); see also Charles W. Mooney, Jr., The Bankruptcy Code’s Safe Har-bors for Settlement Payments and Securities: When Is Safe Too Safe?, 49 TEX. INT’L L.J. 243 (2013).
6. See generally sources cited at supra notes 4 and 5. Our proposal resembles reforms advocated by legal scholars and economists. See, e.g., Thomas Jackson & David Skeel, Transaction Consistency and the New Finance in Bankruptcy, 112 COLUM. L. REV. 152, 179 (2012) (“In our view, each of these costs would be well addressed by our proposal to exempt repos that are collateralized by cash or cash-like securities from the automatic stay.”); Darrell Duffie & David A. Skeel, A Dialogue on the Costs and Benefits of Automatic Stays for Derivatives and Repurchase Agreements, in BANKRUPTCY NOT BAILOUT: A SPECIAL CHAPTER 14, at 133 (Kenneth E. Scott & John B. Taylor eds., 2012) (same); Gary Gorton & Andrew Metrick, Regulating the Shadow Banking System, 2 BROOKINGS PAPERS ON ECON. ACTIVITY, Fall 2010, at 269, 287 (proposing that banks and similar financial institutions benefit from the repo safe harbor only with respect to repos on Treasuries and other assets approved by regulators).
Our proposal is also compatible with other potential reforms for limiting the systemic risk potential of repo markets. See, e.g., Viral V. Acharya & T. Sabri Öncü, The Repurchase Agreement (Repo) Market, in REGULATING WALL STREET: THE DODD-FRANK ACT AND THE NEW ARCHITECTURE OF GLOBAL FINANCE 319 (Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson & Ingo Walter eds., 2010) (advocating an FDIC-like “repo resolution authority” to regulate repo markets); Enrico Perotti & Javier Suarez, A Pigovian Approach to Liquidity Regulation, 7 INT’L J. CENT. BANKING 3 (2011) (advocating a tax on short-term funding such as repos).
7. On the connection between repo safe harbors and collateral fire sales, see generally BRIAN BE-GALLE, ANTOINE MARTIN, JAMES MCANDREWS & SUSAN MCLAUGHLIN, FEDERAL RESERVE BANK OF NEW YORK STAFF REPORT—THE RISK OF FIRE SALES IN THE TRI-PARTY REPO MARKET (2013), available athttp://www.newyorkfed.org/research/staff_reports/sr616.html; Gaetano Antinolfi et al., Repos, Fire Sales, and Bankruptcy Policy (Fed. Reserve Bank of Chi., Working Paper No. 2012-15, 2012), available at http://ssrn.com/abstract=2189583; Sebastian Infante, Repo Collateral Fire Sales: The Effects of Exemp-tion from the Automatic Stay (Fed. Reserve Bd. Fin. & Econ. Discussion Series No. 2013-83, 2013), available athttp://www.federalreserve.gov/pubs/feds/2013/201383/201383pap.pdf.
8. The 1984 Code safe-harbored securities transactions between securities dealers and similar entities. Mortgage-backed securities were not as widespread in the marketplace at that time.
9. See, e.g., Duffie & Skeel, supra note 5; Jackson & Skeel, supra note 5; sources cited at supra note 4.
10. See THOMAS M. HOENIG & CHARLES S. MORRIS, RESTRUCTURING THE BANKING SYSTEM TO IMPROVE SAFETY AND SOUNDNESS 16 (2011), available athttp://goo.gl/pUmTqC (“[T]he bankruptcy law for repurchase agreement collateral should be rolled back to the pre-2005 rules. This change would eliminate mortgage-related assets from being exempt from the automatic stay in bankruptcy when a borrower defaults on its repurchase obligation.”). Thomas Hoenig was then-President of the Federal Reserve Bank of Kansas City and is now Vice Chairman of the Federal Deposit Insurance Corporation.
11. We do not here address the safe harbors for swaps and other derivatives transactions.
12. See Jun Kyung Auh & Suresh Sundaresan, Bankruptcy Code, Optimal Liability Structure, and Secured Short-Term Debt (Columbia Bus. Sch. Research Paper No. 13-8, 2013), available at http://ssrn.com/abstract=2217669.
13. Banking statutes govern the resolution of banks, but the Bankruptcy Code is the initial legal structure to resolve bank holding companies, most bank affiliates, insurance holding companies, and many nonbank financial institutions.
15. E.g., Granite Partners, L.P. v. Bear, Stearns & Co., 17 F. Supp. 2d 275, 301 (S.D.N.Y. 1998) (“any attempt to determine whether a repo or reverse repo transaction is more like a secured loan than a purchase and sale by weighing economic factors on a finely tuned balance scale would be an essentially formalistic and ultimately unproductive exercise” (quoting In re Bevill, Bresler & Schulman Asset Mgmt. Corp., 67 B.R. 557, 597 (D.N.J. 1986))).
16. E.g., Vasser, supra note 2, at 1513 (“A repo is essentially a current sale and a forward contract. Economically, however, it is hard to distinguish a repo from a secured loan where the underlying securities serve as collateral, since the repurchase price includes interest on the imputed loan created by the repo.”).
18. See, e.g., Gorton & Metrick, supra note 5; Enrico Perotti, The Roots of Shadow Banking, in SHADOW BANKING WITHIN AND ACROSS NATIONAL BORDERS (Stijn Claessens, Douglas Evanoff, Luc Laeven & George Kaufman eds., forthcoming 2014).
20. Kenneth D. Gardade, The Evolution of Repo Contracting Conventions in the 1980’s, FED. RES. BANKOF N.Y. POL’Y REV., May 2006, 27, 27–28 (2006); see also In re Bevill, Bresler & Schulman Asset Mgmt. Corp., 878 F.2d 742, 745–46 (3d Cir. 1989); 5 COLLIER ON BANKRUPTCY¶¶ 559.04, 559.LH (Alan N. Resnick & Henry J. Sommer eds., 15th ed. 2007).
22. Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. No. 98-353, § 391, 98 Stat. 333, 364–65. The Senate Report addressing the 1984 amendments noted that the “Lombard-Wall proceedings and their extensive press coverage have had an adverse impact on the financial markets and undermined the primary purpose of Public Law 97-222 [which introduced the “securities contract” safe harbor] because the repo market is subject to the same ripple effects as other securities markets.” S. REP. NO. 98–65, at 47 (1983) (citation omitted).
23. The 2005 expansion is discussed in detail in Edward R. Morrison & Joerg Riegel, Financial Contracts and the New Bankruptcy Code: Insulating Markets from Bankrupt Debtors and Bankruptcy Judges, 13 AM. BANKR. INST. L. REV. 641 (2005).
24. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, § 907, 119 Stat. 23, 171–72 (codified as amended at 11 U.S.C. § 101(47) (2012)).
25. Id. § 907, 119 Stat. at 173–74 (codified as amended at 11 U.S.C. § 741(7) (2012)); Financial Netting Improvements Act of 2006, Pub. L. No. 109-390, § 5, 120 Stat. 2692, 2695–98 (codified as amended at 11 U.S.C. § 101(25)(a) (2012)).
27. A “financial participant,” for example, includes an entity that entered into protected financial transactions (swaps, repos, forwards, etc.) worth at least $1 billion in notional value (or $100 million in mark-to-market value) at some point during the fifteen months preceding the bankruptcy filing date. Id. § 101(22A).
28. For the baseline bankruptcy rules, see generally id. § 362(a)(7) (setoffs); id. § 362(d) (automatic stay); id. §§ 365, 541(c)(1) (debtor’s contract right is property of the estate); id. § 365(e)(1) (providing for unenforceability of ipso facto clauses that make the debtor’s bankruptcy a default under its contract); id. § 547 (requiring return of preferences); id. § 548 (fraudulent conveyance liability for mismatched consideration).
29. 5 COLLIER ON BANKRUPTCY, supra note 20, ¶ 559.04.
31. See, e.g., Grosshandler, supra note 1. These purported benefits to the American economy are not fully distinct. They overlap.
32. In the model of Auh & Sundaresan, supra note 12, these bankruptcy-specific costs drive the demand for safe-harbored repos. In the absence of these costs, the safe harbors for repos would have no effects on liquidity.
33. Grosshandler, supra note 1, at 4 (“One of the tangible effects of the safe harbors under ‘business as usual’ conditions, that is, prior to a bankruptcy, is the increase of the liquidity of Safe Harbored Contracts, which reduces both the cost of these transactions and the costs to the issuers of the assets underlying the transactions—the securities or commodities being bought or sold, the mortgages and credit card receivables being financed, the risks being hedged. These benefits flow directly from the certainty provided to market participants that, in the event of the failure of their counterparty, they will be able to realize the value of their bargained-for security, crystalize their loss and hedge the risk related to their counterparty’s failure.”).
34. See generally Gorton & Metrick, supra note 5, at 276–79.
35. A transactionally complex implication: Repos are often used to hedge derivative positions and to short securities. Id. at 278–79. Because repo collateral can be “rehypothecated,” repos provide an important vehicle for shorting securities, which can improve market efficiency. While this market is a useful one for its participants, it is unclear whether the safe harbors are vital for it.
36. To ease discussion, we use the terms “borrower,” “lender,” and “collateral” in place of “seller,” “purchaser,” and “purchased securities,” notwithstanding that repos are structured formally as purchases and sales of assets, and not as secured loans. This vocabulary of collateral, borrower, and lender is conventional in the industry.
37. In the event of financial failure, non-safe-harbored creditors (oftentimes longer-term creditors) will be less likely to be paid immediately, while safe-harbored creditors (oftentimes shorter-term creditors) are permitted to immediately liquidate collateral—this thereby contributes to a market preference for safe-harbored debt over non-safe-harbored funding, all else equal.
38. This figure comes from Tobias Adrian, Christopher R. Burke & James J. McAndrews, The Fed-eral Reserve’s Primary Dealer Credit Facility, FED. RES. BANK OF N.Y.: CURRENT ISSUES IN ECON. & FIN., Aug. 2009, at 1, 2 (2009) (Figure 1 in original). We added the vertical line for October 2005, to identify the years before and after the repo safe harbors were expanded.
39. Id. at 4 (Figure 3 in original). We added the vertical line for October 2005, to identify the years before and after the repo safe harbors were expanded.
41. Some of this disfavoring of long-term finance over short-term finance arises from how baseline bankruptcy rules treat the time value of money. Appropriate compensation for the time value of any delay to both sets of creditors, prioritized at the underlying priority level of the principal amount, would even up the bankruptcy value of safe-harbored and non-safe-harbored investments. (Because the safe-harbored investors can close out immediately, they are less concerned with the time value of any delay in realization than are non-safe-harbored investors.) This possibility should be an issue for further analysis.
42. See, e.g., Robert K. Rasmussen, Debtor’s Choice: A Menu Approach to Corporate Bankruptcy, 71 TEX. L. REV. 51 (1992); Alan Schwartz, A Contract Approach to Business Bankruptcy, 107 YALE L.J. 1807 (1998).
43. Steven L. Schwarcz & Ori Sharon, The Bankruptcy-Law Safe Harbor for Derivatives: A Path De-pendence Analysis, 71 WASH. & LEE L. REV. (forthcoming 2014), available at http://ssrn.com/abstract=2351025 (describing the justification at page 14).
44. Total financial sector debt was reported in 2010 to have been twenty times larger than it was in 1981. The repo market overall was fifty times greater than its 1981 size. Much of the greater growth in repos was during the 2000–2007 run-up to the financial crisis. Fed. Reserve Bd., Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States 9 (Sept. 17, 2010), available at http://www.federalreserve.gov/releases/zl/20100917/zl.pdf; Statistical Supplement to the Federal Reserve Bulletin, FED. RES. BD., www.federalreserve.gov/pubs/supplement/default.htm (last updated May 30, 2014) (Table 1.43 of the bulletin); U.S. Government Securities Dealers—Positions and Financing, Statis-tical Supplement to the Federal Reserve System, FED. RES. ARCHIVAL SYS. FOR ECON. RESEARCH, http://www.fraser.stlouisfed.org/publications/frd/page/314888 (last visited Apr. 4, 2014).
45. Overnight repos rose from being one-half of primary dealer repo financing in early 2005 to about 70 percent of primary dealer repo financing in 2008–2009. Adrian et al., supra note 38, at 3 (Chart 2). We understand that the overnight share of repos has persistently been above 50 percent of the overall repo market.
46. The role of the Bankruptcy Code’s safe harbors in facilitating “runs” has been explored in many studies by economists, regulators, and legal scholars. Recent examples include Gaetano Antinolfi et al., Repos, Fire Sales, and Bankruptcy Policy (Fed. Reserve Bank of Chi., Working Paper No. 2012-15, 2012), available athttp://ssrn.com/abstract=2189583; Auh & Sundaresan, supra note 12.
47. See, e.g., ADAM COPELAND, ANTOINE MARTIN & MICHAEL WALKER, FEDERAL RESERVE BANK OF NEW YORK STAFF REPORT—REPO RUNS: EVIDENCE FROM THE TRI-PARTY REPO MARKET 26–27 (2012), available athttp://www.newyorkfed.org/research/staff_reports/sr506.html (documenting a collapse in tri-party repo collateral posted by Lehman during the week before its bankruptcy); Michael J. Fleming & Asani Sar-kar, The Failure Resolution of Lehman Brothers, 20 FED. RES. BANK OF N.Y. ECON. POL’Y REV (forthcoming 2014) (describing how the run of the counterparties for Lehman’s reverse repo assets, which were a large part of Lehman’s holdings, left Lehman cash-constrained); Kimberly Anne Summe, Lessons Learned from the Lehman Bankruptcy, in BANKRUPTCY NOT BAILOUTS: A SPECIAL CHAPTER 14, at 79 (Kenneth E. Scott & John B. Taylor eds., 2010) (reporting that 80 percent of Lehman’s derivative portfolio was terminated within the first five weeks after the bankruptcy filing).
48. Fernando Duarte & Thomas M. Eisenbach, Fire-Sale Spillovers and Systemic Risk (Fed. Reserve Bank of N.Y. Working Paper No. 645, 2014), available athttp://ssrn.com/abstract=2340669.
There is an apparent puzzle at the heart of the 2007 credit crisis. The subprime mortgage sector is small relative to the financial system as a whole and the exposure was widely dispersed through securitization. Yet the crisis in the credit market has been potent. Traditionally, financial contagion has been viewed through the lens of defaults, where if A has borrowed from B and B has borrowed from C, then the default of A impacts B, which then impacts C, etc. However, in a modern market-based financial system, the channel of contagion is through price changes and the measured risks and marked-to-market capital of financial institutions. When balance sheets are marked to market, asset price changes show up immediately on balance sheets and elicit response from financial market participants. Even if exposures are dispersed widely throughout the financial system, the potential impact of a shock can be amplified many-fold through market price changes.
Tobias Adrian & Hyun Song Shin, Liquidity and Financial Contagion, FIN. STABILITY REV.—SPECIAL ISSUE ON LIQUIDITY, Feb. 2008, at 1, 1.
50. Gary B. Gorton & Andrew Metrick, Securitized Banking and the Run on Repo, 104 J. FIN. ECON. 425, 428 (2012); Arvind Krishnamurthy, Stefan Nagel & Dmitry Orlov, Sizing Up Repo (Nat’l Bureau of Econ. Research Working Paper No. 17768, 2012), available athttp://www.nber.org/papers/w17768. To be sure, we do not think that a complex phenomenon such as the financial crisis grew solely from an overly wide ambit for the repo safe harbors. Rather our view is that a negative economic event occurred, could occur again, and the wide safe harbors played a supporting role. Without that support, we do not believe the crisis would have been averted. But if multiple reforms are undertaken, the financial system can be made safer. Narrowing the repo safe harbor is one of the appropriate reforms in a wider package.
51. The “deleveraging spiral” that led to en masse fire sales of mortgage-related securities is described by Federal Reserve economists in BEGALLE, MARTIN, MCANDREWS & MCLAUGHLIN, supra note 7, at 2.
52. Daniel K. Tarullo, Member, Bd. of Governors of the Fed. Reserve Sys., Shadow Banking and Systemic Risk Regulation, Remarks at the Americans for Financial Reform and Economic Policy Institute Conference (Nov. 22, 2013) [hereinafter Tarullo, Shadow Banking and Systemic Risk Regulation], available athttp://federalreserve.gov/newsevents/speech/tarullo20131122a.htm; Jeremy C. Stein, Member, Bd. of Governors of the Fed. Reserve Sys., The Fire-Sales Problem and Securities Financing Transactions, Remarks at the Federal Reserve Bank of Chicago and International Monetary Fund Conference on Shadow Banking Within and Across National Borders (Nov. 7, 2013), available athttp://www.federalreserve.gov/newsevents/speech/stein20131107a.pdf.
While presiding over one of the Fed’s regional banks and serving as a voting member of the Federal Open Market Committee (FOMC), the current FDIC vice chair called for a repo rollback along the lines outlined here. See Hoenig & Morris, supra note 10, at 16–17. Other, academic analyses have concluded similarly. See Skeel & Jackson, supra note 5, at 177–79; Roe, supra note 4.
53. See the proposals listed at supra notes 4 and 5.
54. Here is a breakdown of the collateral backing the American repo market: U.S. Treasury securities (at 34.7% of the market) and full faith and credit obligations of U.S. agencies (5.9%) would remain safe harbored. Equities (at 4.5%), private mortgage-backed securities and collateralized mortgage obligations (at 3.9%), corporate bonds (at 3.5%), and a miscellaneous category (at 2.7%) would not be safe harbored. Of the government-sponsored mortgage-backed securities and collateralized mortgage obligations (at 45% of the entire repo market), approximately one-quarter were backed by the full faith and credit of the U.S. government (such as bonds guaranteed by Ginnie Mae), amounting to 11% of the total repo collateral; they would be safe harbored. Bonds guaranteed by Fannie Mae and Freddie Mac are not guaranteed by the full faith and credit of the United States. See US Repo Market Factsheet, SIFMA (June 27, 2012), available athttp://www.sifma.org/research/item.aspx?id=8589939674.
55. Even U.S. Treasury securities could become illiquid, but that illiquidity is likely to arise only when the U.S. government is insolvent. Were that to occur, systemic risk would be a problem with or without the safe harbors. The nation would be facing an economic crisis of such severity that safe harboring Treasuries would be a minor issue.
56. COPELAND, MARTIN & WALKER, supra note 47, at 32.
57. See Press Release, U.S. Dep’t of the Treasury, Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers (Sept. 7, 2008), available athttp://www.treasury.gov/press-center/press-releases/Pages/hp1129.aspx (announcing conservatorship for Fannie and Freddie).
58. BEGALLE, MARTIN, MCANDREWS & MCLAUGHLIN, supra note 7, at 14–18.
59. Id. at 15–16 (“It is worth noting that these estimates are conservative. The assumption regarding the number of days to liquidate is for normal market conditions taking into account historical daily turnover in each asset class and is meant to avoid signaling effects. Under stressed market conditions, liquidating most asset classes would take longer. One possible exception is Treasury securities, which tend to benefit from flight-to-quality episodes.”).
60. COMM. ON THE GLOBAL FIN. SYS., THE ROLE OF MARGIN REQUIREMENTS AND HAIRCUTS IN PROCYCLICALITY 11 (Bank for Int’l Settlements CGFS Paper No. 36, 2010), available atwww.bis.org/publ/cgfs36.pdf.
61. And one-quarter of the agency securities here do receive the full faith and credit of the United States (the quarter guaranteed by Ginnie Mae), but are mixed in with the data on agency-backed securities’ performance during the crisis.
62. See OFFICE OF MGMT. & BUDGET, EXEC. OFFICE OF THE PRESIDENT, BUDGET OF THE UNITED STATES GOV-ERNMENT, FISCAL YEAR 2015, APPENDIX: GOVERNMENT-SPONSORED ENTERPRISES 1–3 (2014) (describing total expenditures to Fannie and Freddie as $116.1 billion and $71.3 billion, respectively), available at http://www.whitehouse.gov/sites/default/files/omb/budget/fy2015/assets/gov.pdf.
63. We do not address considerations beyond those relating to financial stability and systemic risk. Other opponents of safe harbors may point to rapid close-outs as impeding reorganization of industrial firms, which they probably do. But because that process lacks the potential for knock-on effects to the entire economy, we are unsure of the correct policy. If the safe-harbored debts are a small part of an industrial firm’s capital structure (in contrast to the one-third or more that it constituted for Lehman and other major financial firms), refinancing via section 364 debtor-in-possession prioritized financing should be possible.
64. For a description of synthetic repos, see MOORAD CHOUDHRY, THE REPO HANDBOOK 192–95 (2002). One can conceptualize this as follows: A counterparty buys the security from the debtor under one contract and simultaneously enters a total return swap with the debtor under a separate and formally distinct contract. The total return swap requires the debtor to make periodic interest payments and requires the counterparty to pay any changes in the value of the securities. When the swap matures, the counterparty will sell the security back to the debtor. Through these three transactions, the parties replicate a repo. Each transaction—the two securities contracts and the swap—is safe harbored by the Code.
65. Another possibility is that, in the absence of safe-harbor protection, repo counterparties insist that their bank counterparties be well-capitalized, with capital levels even greater than those required by regulators. This would be a systemically positive effect.
66. Bankruptcy policymakers should, however, be aware of how bankruptcy policy can tilt financing away from the stable long term to the less stable short term. Better attention to how interest is paid in bankruptcy, or not paid, on long-term undersecured debt and the adequacy of protection could strengthen long-term financing channels.
67. See, e.g., Grosshandler, supra note 1, at 8 (“Absent safe-harbor protection, counterparties would be subject to the Bankruptcy Code’s automatic stay and assumption/rejection powers, which would subject Safe Harbored Contract counterparties to a variety of risks. Unlike other contracts, the value of Safe Harbored Contacts typically can change rapidly based on the fluctuating value of the underlying assets or collateral, prevailing market conditions and other factors. The inability of counterparties to terminate such contracts and foreclose on collateral exposes them to risks that cannot be hedged effectively. If the debtor is given the right to assume or reject Safe Harbored Contracts in bankruptcy, this effectively gives the debtor an indefinite option to perform or terminate the contract, making it impossible to effectively hedge the related risks in an adequate manner. It could also potentially give the debtor the right to ‘cherry pick’ between contracts, exacerbating losses to creditors. Although the Bankruptcy Code provides protections to secured creditors, the mechanisms are not timely enough and are too cumbersome to obtain to effectively protect counterparties under volatile Safe Harbored Contracts, especially on a large scale, such as during the failure of a systemically important financial institution.”).
68. See Skeel & Jackson, supra note 5, at 173–80. Indeed, the predecessor to the mortgage repo was the warehouse secured loan. See supra Part II.B.1.
69. In the unlikely event that a repo were treated as an executory contract, the counterparty would face similar challenges as those raised with a secured loan. For example, under section 365(d)(2) of the Code, the trustee in a Chapter 11 case has until confirmation of a plan to assume or reject an executory contract. But the statute also provides that “the court, on the request of any party to such contract or lease, may order the trustee to determine within a specified period of time whether to assume or reject such contract or lease.” 11 U.S.C. § 365(d)(2) (2012).
71. And the difficulty might justify revisiting whether adequate protection for an extended length stay should encompass the time value of money, prioritized at the level of the basic obligation.
72. See, e.g., Victoria Ivashina, Benjamin Iverson & David C. Smith, The Ownership and Trading of Debt Claims in Chapter 11 Restructurings (Harvard Bus. Sch. Working Paper, 2013), available athttp://www.ssrn.com/abstract=1573311; Douglas G. Baird & Robert K. Rasmussen, Antibankruptcy, 119 YALE L.J. 648 (2010).
73. See, e.g., Grosshandler, supra note 1, at 6–7 (“The effectiveness of the safe harbors in containing contagion was demonstrated during the bankruptcy of Lehman Brothers. None of Lehman Brothers’ counterparties (many financial institutions among them) failed because of losses under Safe Harbored Contracts with Lehman. Almost all counterparties exercised their safe-harbored rights to terminate, net and exercise rights against collateral, with only approximately 3% of Lehman’s derivatives book remaining outstanding after three months following its bankruptcy petition. If these counterparties were not protected by the safe harbors, these positions would have been indefinitely frozen, causing potentially catastrophic capital and liquidity implications for counterparties in addition to any losses under the contracts. While subsequent failures (and near-failures) occurred during the financial crisis, they had other causes—mainly losses caused by outsized exposures to the subprime mortgage market and the seizure of the inter-bank credit market. The effects of these dynamics were exacerbated by the political uncertainty caused by letting Lehman fail, while shoring up other institutions, which led to or exacerbated runs on not just broker-dealers, but on insured depository institutions (the first time runs had occurred since the Great Depression).”).
74. Id. at 13–14 (“Take for example the criticism that the safe harbor for repurchase agreements has created an incentive for large financial institutions to rely excessively on short-term repurchase agreements rather than on other forms of funding. The banking and securities regulators are uniquely positioned to address any such issues. In fact, regulators have already taken steps to reduce reliance on short-term funding through tougher capital and liquidity requirements, and plan further action. These rules address specific concerns about the funding profile of major financial institutions without increasing risks to counterparties that would arise if the safe harbors were instead narrowed or eliminated.”).
78. On September 14, 2008, fear that a Lehman failure would “put other financial institutions at risk” led the Fed to expand the Primary Dealer Credit Facility. Adrian, Burke & McAndrews, supra note 38, at 3. “The facility proved to be a critical recourse for primary dealers at the time of the Lehman Brothers bankruptcy.” Id. at 9.
79. See Report of the Examiner Anton R. Valukas at 1390−99, In re Lehman Brothers Holdings, Inc., Case No. 08-13555 (JMP) (Bankr. S.D.N.Y. Mar. 11, 2010), available athttp://lehmanreport.jenner.com. The examiner describes Lehman’s direct reliance on the facility, allowing it to pay counterparties. Id. at 1399.
80. Fed. Reserve Bd., Federal Reserve Statistical Release H.4.1: Factors Affecting Reserve Balances (Oct. 2, 2008), available athttp://www.federalreserve.gov/releases/h41/20081002/ (showing outstanding loans of $147.7 billion through its Primary Dealer Credit Facility).
81. Tarullo, supra note 46 (Federal Reserve governor concludes that “completion of this task [of promoting financial safety] will require a more comprehensive set of measures, . . . some of which must cover financial actors not subject to prudential regulatory oversight.”). Moreover, “[w]e would do the American public a fundamental disservice were we to declare victory without tackling the structural weaknesses of short-term wholesale funding markets,” Tarullo had previously concluded. Peter Eavis, A New Fed Thought for ‘Too Big to Fail’ Banks: Shrink Them, N.Y. TIMES DEALBOOK (May 3, 2013, 1:32 PM), http://dealbook.nytimes.com/2013/05/03/fed-governor-pushes-for-measure-aimed-at-strengthening-large-banks/.
82. National Public Radio: New Rules Force Big Banks to Keep a Bigger Cushion (Nat’l Pub. Radio broadcast Apr. 9, 2014) (analysis of Karen Shaw Petrou, Federal Financial Analytics), available at http://goo.gl/txkMbJ (“[I]f the big banks can’t [operate in a market] because of these [new] rules, the business is going to go to non-banks.”).
84. See Eric Rosengren, Broker Dealer Finance and Financial Stability: Keynote Remarks at the Conference on the Risks of Wholesale Funding (Aug. 13, 2014), available athttp://www.bostonfed.org/news/speeches/rosengren/2014/081314/081314text.pdf (Rosengren is the president of the Federal Reserve Bank of Boston); John Carney, Wall Street’s Reason to Fear the Repo, WALL ST. J., June 22, 2014, at 6.
85. See Implementation of the Dodd-Frank Act: Hearing Before the S. Comm. on Banking, Housing & Urban Affairs, 112th Cong. 82–88 (2011) (statement of Martin J. Gruenberg, Chairman, Federal Deposit Insurance Corporation), available athttp://www.fdic.gov/news/news/speeches/chairman/spdec0611.html (“If the firms are successful in their resolution planning, then [Dodd-Frank’s Orderly Liquidation Authority] would only be used in the rare instance where resolution under the Bankruptcy Code would have serious adverse effects on U.S. financial stability.”); The Bankruptcy Code and Financial Institution Insolvencies: Hearing Before the Subcomm. of Regulatory Reform, Commercial & Antitrust Law, H. Comm. of the Judiciary, 113th Cong. 12 (2013) (statement of Jeffrey M. Lacker, President, Federal Reserve Bank of Richmond), available athttp://goo.gl/9MybDd (“[T]he Dodd-Frank Act envisions bankruptcy without government support as the first and most preferable option in the case of a failing financial institution.”); see also Exploring Chapter 11 Reform: Corporate and Financial Insti-tution Insolvencies; Treatment of Derivatives: Hearing Before the Subcomm. of Regulatory Reform, Commer-cial & Antitrust Law, H. Comm. of the Judiciary, 113th Cong. 5 (2014) (statement of Thomas H. Jackson), available athttp://goo.gl/6iVMPj (describing FDIC view that Dodd-Frank expects bankruptcy, not Orderly Liquidation Authority, to be the normal mode of resolution for distressed System-atically Important Financial Institutions).
87. Zoltan Pozsar, Shadow Banking: The Money View 5 (U.S. Treasury, Office of Fin. Research Working Paper No. 14-04, 2014), available athttp://goo.gl/3obp6I.
88. See, e.g., Gorton & Metrick, supra note 5, at 284 (“The rise of shadow banking was facilitated by a demand-driven expansion in the bankruptcy safe harbor for repos.”).
89. Our proposal might reduce the extent to which repo’d assets are rehypothecated. We see this as a virtue, however, because it should reduce financial interconnectedness involving weakened securities—a problem during the financial crisis.
90. On collateral shortages, see Gorton & Metrick, supra note 5, at 289–90. Cf. Chrystin On-dersma, Shadow Banking and Financial Distress: The Treatment of “Money-Claims” in Bankruptcy, 2013 COLUM. BUS. L. REV. 79.
92. GARY GORTON, MISUNDERSTANDING FINANCIAL CRISES: WHY WE DON’T SEE THEM COMING 10–25 (2012).
93. The view that we need more near-money channels is not unanimous. Jeremy Stein, prior to joining the Federal Reserve, suggested that the greater problem may be the excessive manufacture of near-money obligations. Jeremy C. Stein, Monetary Policy as Financial Stability Regulation, 127 Q.J. ECON. 57 (2012).
Prior to the . . . crisis there was a credit boom . . . in housing. The mortgages were typically securitized into bonds that were used as collateral in repo. During the credit boom, over 1996–2007, . . . mortgage-backed securities grew by 1,691 percent. When house prices started to decline these mortgage-backed securities became questionable, leading to the financial crisis, when the short-term debt was not renewed, leading to almost a complete collapse in the volume of collateral. . . . The decline in house prices led lenders to question the value of the collateral in mortgage-backed bonds, as well as other securitizations.
