Failure is not an option—at least not until it happens. Starting a venture with the attitude that failure is not an option may reflect the American spirit, but the reality is that attitude alone does not control the fate of the venture—even if it did, events can change attitude, precipitating the decline of a once-promising idea. Market or other forces often affect whether a venture fails or succeeds, and failure is a definite possibility for most ventures. Advisors working with venturers in their euphoric, optimistic days of formation must maintain a realistic perspective and help them draft provisions of their entity documents that effectively address the possibility of failure. For instance, the preference for particular contribution-default remedies can change as a venture’s promise and condition change. Consider how the members’ preference for interest dilution and damages can change as the fortunes of a venture change. Recognizing such preferences should affect the venturers’ decisions as their advisors help them draft the entity documents. A recent case from the Delaware Superior Court and earlier cases from the Kansas Court of Appeals help illustrate the legal repercussions of drafting contribution-default remedies for LLC or limited partnership ventures that fail. The cases all considered contribution-default remedies in LLC operating agreements, but the principles should apply to limited partnership agreements as well.

The operating agreement in Canyon Creek Development, LLC v. Fox, 46 Kan. App. 2d 370, 263 P.3d 799 (2011), allowed a majority in interest of the members (i.e., those holding more than 50 percent of the ownership interests (percentage interests) in the LLC) to issue a capital call. The majority in interest (following a contribution to service the LLC’s debt, which was excepted from the Majority-in-Interest capital call rule) did issue such a call, and Fox, one of the members, defaulted on his obligation to contribute additional capital. The LLC’s operating agreement provided that if a member defaulted on a contribution obligation, the other members had the right, but not the obligation, to cover the defaulted amount. The agreement further provided that in the event that a member covered a defaulting member’s default amount, the percentage interests of the members would be adjusted to reflect each member’s contribution as a percentage of total contributions.

The contributing members, having obtained a majority interest in the LLC through additional contributions, appointed themselves managers and caused the LLC to sue Fox for, among other things, breach of the operating agreement, claiming that the LLC was entitled to damages for his failure to satisfy his additional contribution obligation. Fox argued that the dilution in his interest in the LLC that he suffered consequent to his default was the contractually agreed-upon remedy. He further claimed there could not be in substitution or addition a suit for damages (in effect specific performance). The court recognized that Kansas state law provides:

• an operating agreement may specify the penalties or consequences to members who fail to comply with the terms and conditions of the operating agreement (KSA § 17-7691);
• that a member who fails to make a required contribution is obligated, at the option of the LLC, to contribute cash equal to the value of the agreed obligation (KSA § 17-76-100(a));
• that reduction in membership interest was an acceptable penalty for defaulting on a contribution obligation (KSA § 17-76-100(c)); and
• a catch-all providing that the rules of law and equity apply, if not otherwise provided in the act (KSA § 17-76-135).

The court was satisfied that the interest-dilution provision was clearly stated and that the operating agreement did not provide for any additional remedies. It noted that a remedy such as damages is so fundamental that failure to mention it in an operating agreement is an expression of clear intent that damages cannot be assessed against a member who defaults on a contribution obligation absent such a stated remedy.

By contrast, although the operating agreement under consideration in Skyscapes of Castle Pines, LLC v. Fischer, 337 P.3d 72 (Kan. App. 2014) (slip opinion), provided an interest-dilution remedy for contribution-defaults, the court found that was not the exclusive contribution-default remedy in the agreement. This case involved a real estate venture that collapsed along with the real estate market generally in the late 2000s. When one member refused to make contributions required by a managers-initiated capital call, see Brief of Appellee, 2014 WL 2113037 (Kan. App. Apr. 7, 2014), the LLC sued the defaulting member. The court found that the Skyscapes operating agreement did not make interest-dilution the sole remedy for contribution-defaults. In fact, the court stated that interest dilution does not extinguish the defaulting member’s personal liability. This operating agreement specifically provided that the rights and remedies of the parties under the agreement are not mutually exclusive and preserved equitable remedies. The court noted that money damages (a remedy at law) might be inadequate in some instances and that nothing in the operating agreement was intended to limit any rights at law or by statute or otherwise for breach of a provision.

The Skyscapes court recognized that the situation under which default occurs could affect parties’ preferences for different remedies. In the situation Skyscape faced, the court observed that in the circumstance of a failing venture, the participants would have strong economic incentive to avoid complying with a capital call, and interest-dilution as a remedy would be singularly ineffective. The contributing members would not “be too happy about making up the delinquency and, thereby, garnering a greater interest in what had turned into a losing proposition.” The preferable remedy for the other members and the entity would be suing to collect from the defaulting member the assessed but delinquent contribution. Based upon that reasoning, the court concluded that it “seems unlikely the operating agreement would have been written to limit the participants’ remedies that way.”

The Skyscapes court distinguished the Skyscapes operating agreement from the Canyon Creek operating agreement in holding that the defaulting member was personally liable to make the additional capital contribution. Although both agreements included interest-dilution remedies, the Skyscapes agreement did not make that the exclusive remedy. The Skyscapes preservation of remedies and other provisions provided other remedies that the entity could seek against a member who failed to satisfy contribution obligations.

The operating agreement in Vinton v. Grayson, 189 A.3d 695, 2018 WL 2993550 (Super. Ct. Del. June 13, 2018), granted Vinton, the manager, sole authority to make capital calls in good faith. Any member who failed to make an additional contribution within 45 days after the notice of the capital call automatically transferred 50 percent of the member’s units to the contributing members. A noncontributing member forfeited the remaining 50 percent of the member’s units by failing to make the contribution within 180 days after the first notice of the capital call. The operating agreement also provided: “The rights and remedies provided by this Agreement are given in addition to any other rights and remedies a Member may have by law, statute, ordinance or otherwise.” Given that the Kansas and Delaware statutes were similar, the Delaware court considered both the Canyon Creek and the Skyscapes rulings in its decision. It found that the preservation-of-remedies clause in the instant agreement approximated the provision in the Skyscapes agreement. Furthermore, the court noted that for the mandatory interest-transfer (and dilution) provision to be the exclusive remedy, the court would expect to see an explicit statement to that effect.

The lesson to be drawn from these three cases is that an LLC operating agreement or limited partnership agreement (entity agreement) may provide that interest-dilution (or readjustment-of-interests including forfeiture) is the exclusive remedy if a member defaults on a contribution obligation. What is less clear is whether an entity agreement must expressly provide that interest-dilution is the exclusive remedy, or whether failure to provide for any other remedy is sufficient to create exclusivity. The court in Canyon Creek found that the absence of a provision for other remedies made interest-dilution the sole remedy. The court in Vinton suggested that the absence of a statement that interest-dilution is the exclusive remedy, combined with other language preserving other options, indicated that the LLC could pursue a damages remedy. The court in Vinton also relied upon a preservation-of-remedies clause in the operating agreement to hold that the LLC had a cause of action for damages against the defaulting member. Absent such a preservation-of-remedies provision, perhaps the Vinton court, like the Canyon Creek court, would have found that interest-dilution was the exclusive remedy.

The combination of these cases provides a road map for either making interest-dilution the exclusive contribution-default remedy, or preserving damages as a remedy. To make interest-dilution the exclusive remedy, the entity agreement should provide for that remedy, should state that it is the exclusive remedy for failure to meet a contribution obligation, and either not include a preservation-of-remedies clause or, if one is included for other purposes, exclude from its scope contribution default. To provide for interest-dilution or damages as a remedy, an entity agreement should state that interest-dilution is not the exclusive remedy. The entity agreement may accomplish that with a preservation-of-remedies provision, but an express statement avoids ambiguity.

Drafting an entity agreement to establish interest-dilution as the exclusive contribution-default remedy or as one of multiple contribution-default remedies is only part of the challenge attorneys face in advising clients with respect to this issue. Clients may also seek advice about whether interest-dilution should be the exclusive remedy. The court in Skyscapes recognized that nondefaulting members will be disappointed if the LLC is unable to recover damages from a defaulting member of a failing LLC, and that interest-dilution would be singularly ineffective in such circumstances. The defaulting member would, of course, be relieved to know that the agreement did not require throwing good money after bad. If every member defaults, all might avoid the good-money-after-bad situation. Parties have the freedom to contract and determine which contribution-default remedies to include in their entity agreements. The difficulty they face is making that choice upon formation of the entity or as part of an amendment to an existing entity agreement.

At the time of formation, parties should be optimistic about a venture’s prospects. In that state of mind, the members may think about how they will deal with a weak member—one who is unable to meet a capital-call obligation. The optimism bias that infects all the members will blind them from seeing the possibility that one of them might be the member facing financial hardship and the inability to meet a capital-call obligation in the future. Thus, the members will be open to a contribution-default remedy that will be painful to the defaulting member. Under the influence of their optimism bias, they may believe that at the time of the future capital call, the entity will be increasing in value, and interest-dilution will be a painful and suitable remedy against the defaulting member. Thus, they will prefer interest-dilution with an eye toward upside potential.

Attorneys should remind the venturers that it is possible for the entity to lose money. If the venture is in a loss situation with doubtful future prospects, then perhaps no member will want to be liable to make any additional capital contributions. Attorneys should help members consider whether they want to be liable to make additional capital contributions to a failing entity. At the start of a venture, the members would not foresee the venture failing, but they should be able to appreciate that they would not want to throw good money after bad and would want a mechanism in place that would limit their liability for making additional contributions to a failing entity. Thus, contrary to the Skyscapes court’s view that the members will not be too happy if interest-dilution is the exclusive contribution-default remedy, one could understand why, at the time of formation, the members would agree to interest-dilution as the exclusive remedy. The Skyscapes court may have been presumptuous in focusing solely on the state of mind of the members when the entity was failing. Their preference most likely would have been quite different at the time of formation.

One must also question the contributing members’ motive in bringing a claim for damages instead of opting for interest-dilution. Making interest-dilution the sole remedy could be a form of Ulysses pact. The members in both Skyscapes and Vinton opted to bring damages claims against the defaulting members instead of applying interest-dilution. Those members may be kicking themselves now. The value of real estate in many markets across the country has increased in value significantly since the financial crisis. Members who contributed to a losing venture during the crisis and awaited the market upswing should have profited significantly from an interest-dilution remedy. As the market rebounded, the contributors owned property that they acquired at a low price. In the midst of a crisis, they may not realize that interest-dilution will be their best alternative. If they recognize this possibility at formation, they can include interest-dilution as the sole contribution-default remedy to ensure that they benefit from the cheap membership interests instead of seeking damages from defaulting members.

Members may have additional interests to address in choosing default remedies. If only certain members are personally guaranteeing the bank debt, they are especially incentivized to have the entity collect contributions and apply them to pay down the bank debt. Even if all of the members have guaranteed an entity liability, as appeared to be the case in Skyscapes, the contributing members would most likely prefer that the defaulting member be obligated to make the additional contribution to avoid legal action from the lender. The preference could be practical or perceptional. As a practical matter, the contributing members may have deeper pockets, and if the guarantors are jointly and severally liable on the guarantee, the lender could collect the entire balance from them. From a perception standpoint, the contributing members may prefer not to be named in legal action by the lender. Their concern may be multidimensional. As members of the entity, their identities may not be publicly known. Legal action by the lender to collect on the guarantee would publicize their identities. A public legal battle about an unpaid debt could also harm the reputations of the members and make them less attractive as investors in other deals. Consequently, the existence of guarantees on an entity’s liability may incentivize contributing members to have the entity proceed against the defaulting member under a breach-of-agreement theory.

A challenge members will face with interest-dilution remedies in failing LLCs or partnerships is computing the interest adjustments when at least one member defaults and at least one other member acts on a capital call. The dilution denominator will affect the adjustments and in some situations could make the computations of adjustments challenging. Examples of contribution-denominated adjustments and value-denominated adjustments illustrate the challenge of adjusting interests in loss LLCs or partnerships that have negative value. The agreements in Canyon Creek and Skyscapes, see Brief of Appellee, 2014 WL 2113037 (Kan. App. Apr. 7, 2014), provided for contribution-denominated adjustments, computing a member’s percentage interests by dividing the member’s total contributions by the total contributions to the entity. Thus, if a member has contributed $250,000 to an LLC, and the total contributions to the LLC equal $1,250,000, the member will have a 20-percent interest in the LLC ($250,000 ÷ $1,250,000). If that same member contributes another $500,000 to the LLC and no other member makes a contribution, the member’s percentage interest will become about 43 percent ($750,000 total member contributions ÷ $1,750,000 total contributions to entity). The value of the entity does not affect a member’s interest if percentage interests are contribution-denominated. Although contribution-denominated interest adjustments raise interesting and challenging tax and financial questions (e.g., is there a taxable capital shift if value differs from contributions, and does the contributor pay a premium or receive a discount on the additional interests acquired?), they are easy to compute.

Value-denominated interest adjustments, on the other hand, use the members’ share of the value of the entity’s assets to determine their percentage interest. For instance, if a member has a 20-percent interest in an LLC that has assets valued at $1,500,000, the member’s share of that value would be $300,000. If the member makes a $500,000 contribution, and no other member makes a contribution, the value of the LLC’s assets will increase to $2,000,000. The value of the member’s share in those assets will be the member’s $300,000 precontribution value plus the member’s $500,000 contribution, or $800,000. Thus, the member’s post-contribution interest will be 40 percent ($800,000 member’s precontribution value + additional member contribution ÷ $2,000,000 entity precontribution value + additional member contribution). Determining the value of an entity’s assets could be difficult, but once the members know that value, they can easily determine their interests in the entity using value-denominated adjustments.

Computing value-denominated adjustments becomes more challenging if an entity has negative value. To illustrate, an LLC might burn through all member capital contributions and borrow $1,000,000 to fund operations. After that money is spent, the entity would owe $1,000,000 and have no assets, so its value would be negative $1,000,000. Assume a member makes a capital contribution of $500,000, no other member makes a contribution, and the operating agreement provides for interest-dilution as a remedy in such situations. If the LLC provides for contribution-denominated adjustments, then computing the adjustment will be straightforward, even though the entity has negative value.

The contributing member may, however, be disappointed to find that the contribution, which provides the entity its only capital, might have nominal effect on the interest adjustment. If the operating agreement provides for value-denominated adjustments, then computing the adjustments will be a challenge. If, prior to the contribution the contributing member’s percentage interest was 20 percent, then the value of that interest would be negative $200,000. Following the contribution, the LLC’s value would be negative $500,000. The member’s share of that value depends upon the member’s percentage interest, and the member’s percentage interest depends upon the effect that the member’s contribution has on the value of the LLC and the value of the member’s interest. The contribution would appear to change the value of the member’s interest from negative $200,000 to positive $300,000, and change the value of the entity from negative $1,000,000 to negative $500,000. Imagining how a member’s interest in an entity could be positive while the entity’s value is negative is a challenge. Computing the members’ interest in the entity following the contribution to a negative-value entity is also a challenge. Given that math does not appear to provide an obvious answer, members should consider how they will address interest adjustments in entities that have negative value if they do not provide for damages as a remedy.

Last, consideration must be given to the capacity to enforce whatever rights remedy may be provided for in a particular entity agreement. In both Canyon Creek and Skyscapes, the manager-managed LLC was the plaintiff against the defaulting member. In contrast, Vinton was brought by the members who had satisfied their respective contribution obligations against the member who had not; the LLC itself does not appear to have been a party to the action. This raises the question of standing. The operating agreement is a contract to which each of the members and the LLC are parties. See, e.g., Elf Atochem N. Am., Inc. v. Jaffari, 727 A.2d 286, 287 (Del. 1999). There is no dispute that the obligation to contribute capital is for the LLC’s benefit; members do not contribute capital to other members. For example, section 18-502 of the Delaware LLC Act refers to how a member “is obligated to a [LLC]” and the “right of specific performance that the [LLC] may have against such [defaulting] member.” The defendant, Grayson, argued in the Vinton case that only the LLC, and not the other members, could bring an action to enforce his capital contribution obligation. Applying the “Rights and Remedies Cumulative” provision of the operating agreement at issue in the Vinton case, namely:

[t]he rights and remedies provided by this Agreement are given in addition to any other rights and remedies any Member may have by law, statute, ordinance or otherwise. All such rights and remedies are intended to be cumulative and the use of any one right or remedy by any Member shall not preclude or waive such Member’s right to sue any or all other rights or remedies[,]

the court held, “Here, as signatories to the Route 9 Agreement, each of the Member Plaintiffs has standing to sue Grayson for his breach.”

Reasonable minds may differ as to whether the Vinton court properly characterized the claims as direct. Regardless, the decision is the decision. Going forward, drafters must consider and address who does (and does not) have standing to enforce (and collect upon) defaulted capital-contribution obligations.

An LLC’s management structure may also affect whether the entity makes a capital call and whether it brings a cause of action against the defaulting members. In Canyon Creek, the contributing members obtained control of the entity following their contributions and the resulting interest adjustment. If they had successfully caused the LLC to obtain an award for damages, presumably Fox’s contribution would have realigned the members’ interests to the predefault percentages. At those percentages, the contributing members would not have a controlling interest. If the interest adjustment is retroactive, the members would not have had authority to issue the capital call. That dynamic creates interesting management considerations. Can members use contribution-default remedies to obtain temporary control, only to use that authority to obtain a contribution that effectively causes the contributing members to cede control? Such dynamics may affect whether contributing members bring a direct action against the defaulting member or cause the entity to bring the action.

Contribution-default remedies appear in most entity agreements and partnership agreements. The three cases discussed in this article consider the enforceability of contribution-default remedies in ventures that were losing money and appear to have had negative value. The issues raised in such situations may differ from issues that arise in ventures that have positive, increasing value. This article scratches the surface of legal, financial, and tax issues that contribution-default remedies raise. The questions raised but unanswered in this article are some of many that warrant detailed consideration. Advisors must begin to carefully account for these and other questions, and commentators should continue to research and explore the nuances of these provisions.

The prescription opioid epidemic ravaging the country claims almost 100 lives daily with an accompanying annual cost upward of $500 billion dollars. Current estimates suggest nearly two million Americans are dependent on or abuse prescription opioids. 

As would be expected with what has been described as a “national health emergency,” there is no lack of finger-pointing (but substantially less discussion of who should take responsibility for adequately addressing it). The usual suspects are the pharmaceutical companies who promote highly addictive opioid painkillers through aggressive marketing programs, the healthcare providers who prescribe them–at times just to placate patients–and the distribution channel of pharmacies that make them available 24/7. 

There is, however, a fourth player in the opioid epidemic drama that, until recently, hadn’t been the subject of very much attention. It now finds itself under much closer scrutiny for its role in allegedly getting and keeping patients addicted to opioid painkillers while not doing enough to help fix a problem it is accused of helping create and perpetuate. 

Who is this player?  It is the payors–the private and public insurance companies and programs that cover the vast majority of Americans. These include the well-known commercial companies as well as government programs such as Medicare, Medicaid and the collection of State and local health insurance programs.

Fueling the Epidemic

Various studies, most recently one by the Johns Hopkins University Bloomberg School of Public Health, strongly suggest that payors have not done enough to combat the opioid epidemic. The Johns Hopkins study, for example, concluded that major insurer coverage policies for drugs to treat lower back pain–one of the more common types of chronic, non-cancer pain for which prescription opioids have been overused–“missed important opportunities” to steer patients toward safer and more effective treatments than prescription opioids. (These studies collectively go on to also say that providers continue  to play a role, albeit at times unwittingly, in expanding the epidemic rather than working to reduce it).   

While there are a variety of payor policies and actions blamed for the ongoing increase in prescription opioid use (and abuse), they fall into three basic areas.

Prescription Opioids are Too Price Accessible

In an open market, there is usually a direct relationship between price and demand. This is perhaps nowhere more evident than with prescription opioid painkillers. The logic is simple:  if opioid-based medicines cost less than safer alternatives, including non-narcotic medicines, then prescribers and consumers will opt for the addictive opioids rather than less addictive medicines.

This economic reality has been consistently borne out by researchers. The Johns Hopkins study showed that both public and commercial insurance plans tend to make covered opioids available relatively cheaply to patients. How cheaply?  The median commercial plan, for example, places 74 percent of opioid painkillers in Tier 1, the lowest cost category, and the median commercial co-pay for Tier 1 opioids was just $10 for a month’s supply.

In stark contrast, studies show that only one-third of the more than 40 million people covered by Medicare have access to an available painkiller skin patch that contains much less potent opioids as its key active ingredient. Other plans simply do not cover non-addictive alternatives to opioids or have co-pays that are higher than those for opioids. Many plans also require pre-authorization for the safer, alternative painkillers.

As Rep. Elijah Cummings, the ranking member of the House Committee on Oversight and Government Reform, has said, the insurance industry has, in effect, created incentives that may steer patients to the very drugs that are fueling the opioid crisis.

The government has had to intervene to curb the increased consumption of opioids that has accompanied these lower prices. In 2016, Massachusetts set a seven-day limit on initial opioid prescriptions.^[1] North Carolina imposed a five-day limitation on opioid prescriptions which went into effect on January 1, 2018.^[2] The Florida Agency for Health Care Administration limits narcotics prescriptions in the Medicaid program to a maximum seven-day supply.^[3]

Other states have even imposed a limitation on the prescribed dosage amount. Maryland has limited opioid prescriptions to the lowest effective dose in a quantity no greater than what is needed for the expected level of pain.^[4] Arizona is proposing legislation that would cap maximum prescription dosages and set a five- or fourteen-day limitation on prescriptions.^[5]

Prescribers are Rewarded  for  Putting or Keeping Patients on Opioids

A previous article discussed how the U.S. Government, through its Medicare program, may also be contributing to the opioid epidemic by including pain questions on patient satisfaction surveys. The Centers for Medicare and Medicaid Services (CMS) have used the Hospital Consumer Assessment of Healthcare Providers and Systems (HCAHPS) survey, a set of 32 questions administered to a random sample of hospital patients about their experience of care, since 2008.^[6] The results of these surveys are posted on CMS’s “Hospital Compare” website.^[7] Now, as part of the Affordable Care Act’s Hospital Value-Based Purchasing Program, CMS is withholding 1 percent of Medicare payments—30 percent of which is tied to HCAHPS scores—to fund the incentives of the program.^[8] The belief is that these surveys pressure doctors to prescribe unnecessary opioids in hopes of getting a better score on patient surveys. As various studies have shown, opioid use has been associated with higher patient satisfaction scores.^[9]

It is easy to spot the conflict here. Tying money to great reviews can easily lead to undue pressure on doctors to prescribe opioids to make a patient happy in order to get a good score. Perhaps the biggest area affected by patient satisfaction surveys has been the emergency room. Several studies suggest that ER doctors have drastically changed their practice in order to avoid negative patient satisfaction reports.^[10] Prescribing painkillers, even when not entirely necessary, is often necessary to get paid by Uncle Sam.

Two surveys of more than 800 emergency physicians by Emergency Physicians Monthly and the South Carolina Medical Association reported that more than 50 percent of the ER docs routinely ordered tests and procedures, prescribed medications, and even admitted patients to the hospital unnecessarily. Why? Because patient satisfaction affects their bottom line.

Compounding the problem are savvy patients aware of how the system now works. One physician wrote that drug seekers “are well aware of the patient satisfaction scores and how they can use these threats and complaints to obtain narcotics.”

Lax Application of Utility Management Protocols

Another factor identified by the Johns Hopkins study is that many insurers failed to apply evidence-based “utilization management” rules to discourage opioid overuse and encourage safer and more effective alternatives. What’s more, many of the utilization management rules in place were applied as often to non-opioids as opioids.

While utilization management takes various forms depending on the clinical setting and payor policies, the most common are quantity limits, step therapy and prior authorization. Here are some of the ways that not correctly applying these rules exacerbates the opioid crisis:

• Quantity Limits. While the S. Centers for Disease Control and Prevention Guideline for Prescribing Opioids for Chronic Pain is for a short-term supply, many insurance policies allow for 30-day supplies. The danger here is that duration of early prescriptions is associated with a patient converting to chronic use.
• Step Therapy. This is a strategy that makes riskier opioids the “last resort” for pain management after other, non-narcotic medications have failed to provide pain relief. By permitting opioids to be a “first step,” the risk of addiction and/or chronic use increases. Unfortunately, fewer than 10 percent of government and commercial plans require step therapy for opioids.
• Prior Authorization. The idea is that requiring a provider to get in touch with the insurer before prescribing an opioid will help reduce the number of prescriptions or encourage quantity control or step therapy. The reality is that only a minority of plans require this.

Only recently has the Centers for Medicare & Medicaid Services (CMS) urged state Medicaid agencies to require quantity limits, step therapy or prior authorization to limit access to particular opioids. ^[11] On February 1, 2018, CMS issued a Draft Call Letter announcing that it is considering new strategies to reduce opioid overutilization under Medicare Part D, including limiting initial prescription fills for treatment of acute pain with or without a daily maximum dose.^[12]

The Way Forward

Providers have a stake in working with payors–commercial and public–as well as with distribution channels to continue to develop integrated solutions to the opioid crisis. Aside from the human toll on their communities, they also are not immune to the economic costs. Studies have clearly shown that the epidemic is increasing hospitalizations and that is hits emergency rooms especially hard.

Some estimates put the average cost of treating an overdose patient in the intensive care unit at almost $100,000. If a majority–or even a minority–of these patients are underinsured or uninsured, the resulting uncompensated care costs can easily cripple a provider that is already operating on a razor-thin margin.

Nonetheless, there are opportunities for healthcare providers to contribute to fighting the opioid crisis. They can support initiatives being undertaken by such groups as America’s Health Insurance Plans that seek to combat opioid abuse. They also can develop, implement and maximize the value of programs designed to identify potential opioid abusers and limit the prescribing of opioid painkillers. Finally, they can negotiate contracts with payors that require prompt authorization and fair reimbursement for non-opioid alternatives where indicated. 

^[1] H.4056, 2016 Leg., 189^th Sess. (Ma. 2016).

^[2] H.B. 243, 2017 Gen. Assemb., 175^th Sess. (N.C. 2017).

^[3] Christin Sexton, Florida Medicaid program limits opioid prescriptions, Palmbeachpost.com (February 20, 2018), available at https://www.palmbeachpost.com/news/state–regional-govt–politics/florida-medicaid-program-limits-opioid-prescriptions/xaRsMNmfOBpGs7574oRpdN/

^[4] Maryland Prescriber Limits Act of 2017

^[5] Arizona plan to combat opioids would limit dosages, amount, U.S. News (Jan. 19, 2018), available at https://www.usnews.com/news/best-states/arizona/articles/2018-01-19/arizona-plan-to-combat-opioids-would-limit-dosages-amounts

^[6] Centers for Medicare and Medicaid Services. Survey of patients’ experiences (HCAHPS). http://www.medicare.gov/hospitalcompare/Data/Overview.html. Accessed September 3, 2018.

^[7] Centers for Medicare and Medicaid Services. Official hospital compare data archive. https://data.medicare.gov/data/archives/hospital-compare. Accessed September 3, 2018.

^[8] Hospital Consumer Assessment of Healthcare Providers and Systems. HCAHPS fact sheet. November 2017. https://www.hcahpsonline.org/globalassets/hcahps/facts/hcahps_fact_sheet_november_2017.pdf. Accessed September 4, 2018.

^[9] Sara Heath, Opioid Use Associated with Higher Patient Satisfaction Scores, Patient Engagement Hit, available at https://patientengagementhit.com/news/opioid-use-associated-with-higher-patient-satisfaction-scores. Accessed September 3, 2018.

^[10] See for example, Kelly, S., Johnson, G.T., and Harbison, R.D. “Pressured to prescribe”: the impact of economic and regulatory factors on South-Eastern ED physicians when managing the drug seeking patient. J Emerg. Trauma Shock. 2016; 9: 58–63

^[11] U.S. Dep’t of Health and Human Servs., CMCS Informational Bulletin, Best Practices for Addressing Prescription Opioid Overdoses, Misuse, and Addiction (Jan. 28, 2016), available at https://www.medicaid.gov/federal-policy-guidance/downloads/CIB-02-02-16.pdf. Accessed September 3, 2018.

^[12] CMS, Fact Sheet, 2019 Medicare Advantage and Part D Advance Notice Part II and Draft Call Letter, Feb. 1, 2018, available at https://www.cms.gov/newsroom/mediareleasedatabase/fact-sheets/2018-fact-sheets-items/2018-02-01.html. Accessed September 3, 2018.

Joy Stephenson-Laws

Introduction

On August 24, 2018, in a rare, 73-page decision interpreting the Foreign Corrupt Practices Act (“FCPA”), the Second Circuit in United States v. Hoskins^[1] largely rejected a Department of Justice (“DOJ”) interlocutory appeal and limited the FCPA’s reach, holding that foreign nationals who cannot be convicted as principals under the FCPA also cannot be held liable for conspiring to violate or aiding and abetting a violation of the statute. The decision, written by Judge Pooler (joined by Chief Judge Katzmann and Judge Lynch, who also wrote a concurring opinion), concluded that, due to affirmative legislative policy and extraterritoriality concerns, the FCPA’s application was limited to the three specific categories of individuals and entities identified in the statute, namely, U.S. issuers and U.S. “domestic concerns” (and their officers, employees, and agents, even if foreign), and anyone who engages in any act in furtherance of a corrupt payment while in U.S. territory. To the extent that Hoskins, a U.K. citizen working for a French company, did not fall within any of these three categories, the Court stated that he could not be charged as a co-conspirator of, or with aiding and abetting, someone who did.^[2] 

In reversing the district court’s opinion in part, the Court reiterated, however, that any individual (including a foreign national) who does fall within one of those three enumerated categories can be charged with conspiracy to commit a FCPA violation, since neither the affirmative legislative policy exception nor extraterritoriality bases of its decision would apply.^[3] As a result, the Court ultimately reinstated the conspiracy charge in keeping with the government’s assertion that it could prove that Hoskins acted as an agent of a domestic concern.^[4] Thus, while Hoskins certainly has implications for the government’s enforcement of the FCPA against foreign nationals, given the breadth of the FCPA’s jurisdiction and the agency doctrine that the DOJ relied upon in seeking reinstatement of its conspiracy charge, the practical impact of the decision is likely to be fairly limited.

Factual Background

As noted, the FCPA prohibits corrupt conduct involving three categories of individuals or entities:

(1) issuers of securities registered under the Securities Exchange Act, or any officer, director, employer, or agent thereof, or any stockholder acting on behalf of the issuer, (2) any U.S. “domestic concern” – a U.S. citizen, resident, or company, or any officer, director, employer, or agent thereof, and (3) any foreign person or business that commits an act in furtherance of a corrupt payment while in the United States.^[5]

In Hoskins, the government alleged that defendant Hoskins, a foreign national employed by the U.K. subsidiary of Alstom, S.A. and working in France, approved and authorized payments to two consultants retained by Alstom’s U.S.-based subsidiary, Alstom Power, knowing that a portion of these payments would be used to bribe Indonesian officials.^[6] The government alleged not only that Alstom Power was a U.S. domestic concern, but that certain acts in furtherance of the scheme occurred in the United States, including through U.S. executives who discussed the scheme in person, by phone, and electronically while in the United States, and that certain of the funds used for bribes were held in accounts in the United States.^[7] However, while Hoskins was allegedly in communication with U.S.-based Alstom employees about the bribery scheme, the government conceded that he never committed any act in furtherance of the scheme while in the United States.^[8]

The government charged Hoskins in Count One of the Indictment with a two-object conspiracy to violate the FCPA’s anti-bribery provisions, with the first object a violation of the prohibition on domestic concerns or their agents from violating the FCPA, and the second object a violation on the prohibition on foreign nationals from engaging in any acts relating to a bribery scheme while present in the United States.^[9] Hoskins was also charged with six counts of substantive violations of the FCPA’s anti-bribery provisions, both as an agent of a domestic concern (Alstom Power), and with aiding and abetting that domestic concern.^[10]

Procedural History

Hoskins moved in the district court to dismiss the government’s conspiracy count because “it charged that he was liable even if he did not fit into one of the statute’s categories” of relevant individuals, which Hoskins argued was an impermissible attempt by the government to bypass the “narrowly-circumscribed groups of people” for whom “the FCPA prescribes liability.”^[11] The government cross-moved in limine as to the substantive counts, arguing that, even if Hoskins did not himself fall within one of those enumerated categories, Hoskins could still be liable for conspiring to violate, or aiding and abetting others who violated, the FCPA, to the extent others with whom he participated in the offense fell within one of the three categories, and Hoskins should be precluded from arguing otherwise.^[12] 

The district court denied the government’s motion in limine and granted Hoskins’ motion to the extent the government failed to allege that Hoskins fell within one of the three categories of individuals or entities to whom the FCPA applied. In so holding, the court reasoned that Congress had not intended “to impose accomplice liability on non-resident foreign nationals who were not subject to direct liability” under the FCPA.^[13] However, the court denied Hoskins’ motion to the extent that the government charged him with conspiring to violate, or aiding and abetting a violation of, the FCPA as an agent of Alstom’s U.S. subsidiary, since he would then be expressly covered by one of the enumerated categories of individuals covered by the FCPA.^[14] In light of its rulings, the district court dismissed the first object of the conspiracy count except to the extent the government could prove Hoskins was an agent of a U.S. domestic concern, and the second object in its entirety because Hoskins had not committed any act within the United States.^[15]   

The Second Circuit Decision

On appeal, the Second Circuit affirmed in part and reversed in part the lower court’s decision.^[16] In so ruling, the Court focused on whether “a person [can] be guilty as an accomplice or a co-conspirator for an FCPA crime that he or she is incapable of committing as a principal.”^[17] The Second Circuit concluded that a defendant could not be, based on concerns relating to (1) the “affirmative legislative policy” exception and (2) the presumption against extraterritoriality.

Affirmative Legislative Policy Exception

The Court explained that “the firm baseline rule” of conspiracy and complicity law is that individuals can be found liable for offenses they did not (or even could not) commit themselves as a principal, either as an accomplice who aided or abetted the commission of the offense or for the separate crime of conspiring to commit the offense.^[18] However, there is a “narrowly circumscribed” exception to this rule: the “affirmative legislative policy exception,” which is triggered where “it is clear from the structure of a legislative scheme that the lawmaker must have intended that accomplice liability not extend to certain persons whose conduct might otherwise fall within the general common-law or statutory definition of complicity.”^[19]

The Court then examined two leading cases that define the contours of the affirmative legislative policy exception in the Second Circuit: Gebardi v. United States^[20] and United States v. Amen.^[21] In Gebardi, which contemplated violations of the Mann Act (prohibiting the interstate transportation of women for purposes of prostitution), the Supreme Court held that Congress did not intend for women who simply agree to be transported to be liable under the statute, and “a necessary implication of that policy” was to limit their liability for a conspiracy charge under the statute.^[22] In Amen, the Second Circuit applied Gebardi’s reasoning to find that the continuing criminal enterprise statute similarly evinces an affirmative legislative policy to limit conspiracy or accomplice liability to the “kingpin” individuals who Congress intended as targets of the statute, and not third parties.^[23]

Applying Gebardi and Amen, the Court examined the FCPA’s text, structure, and legislative history to determine whether “an affirmative legislative policy [could] be discerned.”^[24] The Court found that each of these, and in particular the FCPA’s extensive legislative history, reflected Congress’s intent to limit liability to the statute’s enumerated categories of defendants.^[25] As a result, “the government may not override that policy using the conspiracy and complicity rules” to find Hoskins liable for conspiring to violate the FCPA if he does not fall within one of the categories of individuals covered by the FCPA.^[26]

In reaching this holding, the Court rejected the government’s narrower reading of Gebardi, as well as its more expansive reading of the jurisdictional reach Congress intended to afford the FCPA.^[27] (Notably, the government’s position was consistent with the guidance it provides to companies and individuals in its FCPA Resource Guide, which has now been expressly refuted by the Second Circuit.)  The Court pointed out that the government’s position “would transform the FCPA into a law that purports to rule the world,” and that would ignore Congress’s “desire[] that the statute not overreach in its prohibitions against foreign persons.”^[28]

Presumption Against Extraterritoriality 

The Court separately held that even if no affirmative legislative policy existed, the presumption against extraterritoriality still prohibits Hoskins’ conspiracy or complicity liability to the extent he falls outside of the categories of defendants covered by the FCPA.^[29] Specifically, the Court explained that there is a presumption against the extraterritorial application of domestic law to individuals and entities outside of the United States. When a U.S. statute nonetheless is intended to apply extraterritorially, the presumption “operates to limit that provision to its terms.”^[30] As a result, the presumption works to limit the FCPA “to its terms” by restricting extraterritorial liability under the FCPA to the statute’s specifically enumerated categories of defendants, unless the government could demonstrate congressional intent otherwise.^[31] Because “the extraterritorial reach of an ancillary offense like aiding and abetting or conspiracy is coterminous with that of the underlying criminal statute” and because the legislative history demonstrated Congress’s intent to keep the FCPA’s reach circumscribed, the Court noted that the presumption therefore narrowed conspiracy and complicity liability under the FCPA to the specific provisions of the statute.^[32] Accordingly, the Court held that the presumption provided an independent basis to conclude that Hoskins could not be charged with conspiracy and accomplice liability except to the extent he could be charged as a principal.^[33]

Reinstating the Second Object of the Conspiracy

While the Second Circuit affirmed the district court’s conclusion regarding the general limitations on charging conspiracy and aiding and abetting liability under the FCPA, it reversed the lower court’s decision dismissing the second object of the conspiracy, in which Hoskins was charged with conspiring with foreign nationals who engaged in proscribed conduct while in the U.S. but had not himself committed any act on U.S. territory.^[34] The Court noted that the government argued that it could prove that Hoskins had acted as an agent of a “domestic concern” – Alstom Power – in violating the FCPA.^[35] The Court explained that, assuming the government was able to prove that, Hoskins fell within one of the three enumerated categories of individuals to whom the statute applied, and neither the affirmative legislative policy exception nor the presumption against extraterritoriality would be offended if Hoskins was also prosecuted for a conspiracy whose object was to violate the FCPA with foreign nationals who acted within the United States, even if he did not do so himself.^[36] 

Concurring Opinion

Judge Lynch issued a concurring opinion in which he largely agreed with Judge Pooler’s reasoning, but explained that he viewed the case as a close one, in which the “important purposes” of the FCPA had to be balanced against an “intru[sion] into foreign sovereignty” due to the “novel” nature of the FCPA’s already expansive jurisdiction.^[37] Judge Lynch noted that it was unlikely that Congress had anticipated a scenario like Hoskins, in which a senior official of a French company could potentially escape liability for directing an American subsidiary and its employees to undertake certain acts in furtherance of a bribery scheme, and that this potentially led to a “perverse” result where lower level employees and others who were agents of that U.S. company could be charged but not Hoskins.^[38] That said, Judge Lynch concluded that the legislative history of the FCPA combined with the presumption against extraterritoriality led him to conclude that the Court had reached the right result.^[39]

Conclusion

Although the Second Circuit’s decision limits the government’s ability to prosecute foreign nationals for conspiring to commit or aiding and abetting a violation of the FCPA, the practical implications of the decision seem limited. It applies only to a small class of foreign nationals and entities – those who engaged in a bribery scheme in which there is otherwise jurisdiction under the FCPA, but who are not themselves U.S. nationals or residents, or agents, employees, or officers of either a U.S. issuer or domestic concern, and who have not acted within the United States. That said, the ruling is significant as one of the few cases limiting the FCPA’s jurisdiction due to the statute’s unique, extraterritorial nature, which may encourage charged defendants in other cases to challenge the DOJ’s broad interpretation of its jurisdiction.

^[1] No. 16-1010, — F.3d —-, 2018 WL 4038192 (2d Cir. Aug. 24, 2018).

^[2] Hoskins, 2018 WL 4038192 at *65, 71.

^[3] Id. at *71-72.

^[4] Id. at *73.

^[5] 15 U.S.C. § 78dd-1–3.  

^[6] Hoskins, 2018 WL 4038192, at *6-7.

^[7] Id. at *7.

^[8] Id.

^[9] Id. at *8.

^[10] Id. at *9.

^[11] Id.; see also United States v. Hoskins, 123 F. Supp. 3d 316, 318-19 (D. Conn. 2015).

^[12] Hoskins, 2018 WL 4038192, at *10.

^[13] Hoskins, 123 F. Supp. 3d at 327.

^[14] Id.

^[15] Id.

^[16] The Court concluded that it had jurisdiction to review the lower court’s decision pursuant to 18 U.S.C. § 3731, which permits interlocutory appeal in criminal cases when there has been a dismissal of a count – even a partial dismissal, as was the case here.  Hoskins, 2018 WL 4038192, at *12.  Interlocutory appeal is justified in such instances, the Court noted, because a potential ground for conviction has been lost.  Id. at *14-17.

^[17] Id. at *18.

^[18] Id. at *18-20.

^[19] Id. at *21-22.

^[20] 287 U.S. 112 (1932).

^[21] 831 F.2d 373 (2d Cir. 1987).

^[22] Gebardi, 287 U.S. at 123.

^[23] Amen, 831 F.2d at 382.

^[24] Hoskins, 2018 WL 4038192, at *29.

^[25] Id. at *37-65.

^[26] Id. at *65.

^[27] Id. at *29-36.

^[28] Id. at *59.

^[29] Id. at *65-71.

^[30] Id. at *67.

^[31] Id.

^[32] Id. at *68-69.

^[33] Id. at *71.

^[34] Id. at *73.

^[35] Id. at *72.

^[36] Id.

^[37] Id. at *13 (Lynch, J., concurring).

^[38] Id. at *15-16 (Lynch, J., concurring).

^[39] Id. at *16 (Lynch, J., concurring).

Jonathan S. Kolodner, Lisa Vicens, Jennifer Kennedy Park, Olivia H. Renensland

For the past year the #MeToo movement has altered the landscape of corporate conduct and accountability, not only for senior management but for corporate boards as well, as evidenced by the recent controversy surrounding CBS’s former Chairman and CEO Moonves. Since the disclosures last October regarding Harvey Weinstein’s conduct, over 100 senior executives, across a variety of industries, resigned or were fired as a result of allegations regarding sexual misconduct. Workplace sexual harassment is prevalent, and until the #MeToo movement, largely silent.

In announcing its Strategic Enforcement Plan for FY2017-2021, the U.S. Equal Employment Opportunity Commission (EEOC) indicated that preventing systemic harassment was one of its top six priorities. In its recent release of preliminary sexual harassment data for FY2018, the EEOC noted a 50 percent increase in the number of sexual harassment lawsuits filed from FY2017.

Though the majority of publicity surrounding the #MeToo movement focused on the media and entertainment industries, the legal industry should consider this a wake-up call as it is certainly not immune from scrutiny nor potential litigation, as evidenced by the gender bias lawsuits filed this year.

Recently, the American Bar Association and the Minority Corporate Counsel Association released a study, “You Can’t Change What You Can’t See: Interpreting Bias in the Legal Profession”. A survey of over 2800 in-house and law firm attorneys found that 25 percent of the women respondents reported some form of unwelcome sexual harassment at work and more than 70 percent of all respondents encountered sexist comments or jokes.

Recently, Aon reviewed the employment practices liability (EPL) claims filed against its law firm clients from 2005-2017 and found that a total of 1,315 charges of wrongful conduct were filed during that period. The most frequently filed charges included retaliation, wrongful termination and discrimination based on disability, gender, age and race. On these claims, law firms and their insurers paid a total of $91,101,674 in judgements and settlements, and in excess of $44 million in defense costs, the latter of which Aon believes were underreported due to self-representation by law firms. The primary EPL offenders—75 percent—were male lawyers.

EPL should be a priority for all law firms if for no other reason than the sheer economic opportunity cost of misconduct. As a risk mitigation strategy, firms should consider adopting the following best practices as an integral component of their enterprise risk management program:

1. Institute a Code of Conduct if one does not already exist. The Code is the firm’s blueprint for the rules of engagement and is a reflection of the tone at the top and the firm’s ethical and organizational culture. While policies and procedures are tactical, the Code should set forth the firm’s mission, corporate values, and at a minimum, include the following: a) a zero tolerance stance regarding workplace misconduct and b) a clear non-retaliation policy, particularly given that retaliation was the most common EEOC claim filed in FY2017, representing 48.8 percent of the total charges filed. Similarly, retaliation was the most frequently cited of Aon’s EPL claims as well.
2. Routinely review, update, and follow firm policies and procedures with respect to workplace conduct. The firm’s policies and procedures are the means by which the Code of Conduct is implemented; having policies, however, is not sufficient. In fact, in reviewing selected gender bias lawsuits against law firms, there is a marked propensity to ignore and or fail to follow internal policies. To do so suggests that compliance is not taken seriously, that policies are merely a formality, and/or that management is irresponsible.
3. Take training and discipline for infractions seriously. In the wake of #MeToo, the expectation is that employers will offer anti-sexual harassment training, and in some states, it is legally mandated. Requirements vary by state, with multiple nuances. For example, while the Commonwealth of Pennsylvania currently has a limited policy that requires that Commonwealth employees are “educated in sexual harassment issues,” in the state of Delaware, House Bill 360, which is scheduled to take effect January 1, 2019, requires all employers with more than 50 employees to conduct anti-sexual harassment training every two years. Bottom line, law firms need to know the sexual harassment training requirements of the jurisdictions in which they operate in order to be compliant.

   Further, training on the firm’s workplace policies and procedures should not stop at on-boarding orientation. To be effective, it needs to me mandatory, ongoing, conducted annually (regardless of the legislative mandates, some of which only require bi-annual training), and, preferably, interactive. This is not an optional exercise and should be applied consistently, regardless of status within the firm. No one gets a pass. Just as important, the disciplinary measures need to be applied consistently as well, which conveys the message that status does not proffer immunity.

4. Understand how far liability extends under state legislation. As with training, coverage protections vary by state. Under the proposed Delaware law, sexual harassment protections extend not only to employees (including those placed by employment agencies), but also to unpaid interns, employment applicants and apprentices. Other jurisdictions such as New York are even more comprehensive, holding employers liable for instances of sexual harassment involving non-employees, including contractors, sub-contractors, vendors and consultants, provided the employer knew or should have known that the non-employee was subjected to sexual harassment in the employer’s workplace.

Combining these best practices will mitigate, though not totally eliminate, the risk of sexual harassment and other employment practice liability claims. Further, taking these steps demonstrates the firm’s commitment to a respectful and non-toxic workplace–a responsibility that employees will continue to hold law firms accountable for well into the future.

The growing wave of sexual harassment cases against high-profile figures has revealed that the use of nondisclosure or confidentiality provisions in settlement agreements has forced many women to keep their sexual harassment allegations private, which, in some respects, may allow harassers to continue their misconduct. When confidentiality is made a term of a settlement agreement, the parties are generally prohibited from disclosing not only settlement terms, but also facts relating to the underlying dispute. The controversy over settlement agreements that include confidentiality provisions reached a fever pitch when it came to light that dozens of women and girls who accused former USA Gymnastics team doctor Larry Nassar of abusing them had signed such agreements. Other well-known individuals accused of harassment or abuse who have been protected by confidentiality clauses under similar circumstances include Harvey Weinstein, Kevin Spacey, Bill O’Reilly, and Bill Cosby. The inclusion of confidentiality or nondisclosure provisions in settlement agreements for employment-related cases, including sexual harassment and discrimination claims, has long been standard practice. However, the recent news stories, along with the outpouring of sexual harassment allegations from the #MeToo movement, has reignited the debate over whether confidentiality requirements should be enforceable in sexual harassment or abuse cases.

Critics of confidentiality agreements argue that such agreements enable abusers by silencing victims and allowing harassers to continue their misbehavior, assuming, as was alleged in the USA Gymnastics scandal, that those with power and potential oversight over the abuser did nothing to stop the conduct. The abuser may be undeterred and even emboldened knowing that the public may never learn of the misconduct. On the other hand, other victims may feel isolated and fail to come forward for fear of not being believed.[1] In most cases, nondisclosure agreements impose steep financial costs in the event the accuser discloses at a later time. For instance, Olympic champion gymnast McKayla Maroney had entered a nondisclosure agreement with USA Gymnastics that, if enforced, would have resulted in a $100,000 penalty if she spoke about her abuse by Dr. Nassar or the settlement. USA Gymnastics later said they would not enforce the nondisclosure agreement. Opponents of confidentiality provisions in settlement agreements argue that the greatest benefit of banning such provisions means that serial harassers would lose the ability to buy the silence of their victims.

The inclusion of confidentiality provisions in settlement agreements for sexual harassment and discrimination claims has historically been a standard practice. A chief reason for an employer to settle a sexual harassment or discrimination claim is to avoid the possibility of a public trial and prevent any negative publicity. Moreover, confidential settlements prevent plaintiff’s attorneys who represent employees from creating a standard rate for settlements against a specific employer. Because trials can be costly, time consuming, and risky, barring nondisclosure provisions altogether for sexual harassment and discrimination claims could discourage employers from settling cases; this may result in plaintiff’s attorneys taking fewer sexual harassment cases, which could prove detrimental to victims. In addition, nondisclosure agreements can provide some benefit to accusers who do not want to be identified. Absent a confidentiality provision, victims may fear that a vindictive former boss will publicly smear them or hurt their efforts to find new employment.

Against the backdrop of the mounting criticism of nondisclosure agreements, there has been a growing trend by lawmakers at both the federal and state levels to prohibit confidentiality agreements for sexual harassment claims. One notable change in recent months at the federal level is a change to the tax treatment of settlements in claims of sexual harassment and discrimination. Specifically, 26 U.S.C. § 162(q) of the new tax law that took effect in 2018 eliminates tax deductions for settlements, payouts, and attorney’s fees in cases related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement. Under the new law, employers may no longer deduct attorney’s fees or settlement payments if a nondisclosure provision is used in a case related to sexual harassment or abuse. Congress is also exploring changes to allow for more transparency. For example, a bill was recently introduced entitled the Sunlight in Workplace Harassment Act which seeks to require companies to publicly report sexual harassment data. Under the proposed law, companies would be required to report payments for settlements related to sexual harassment and discrimination. Moreover, companies would be required to disclose the average length of time it took to resolve a sexual harassment complaint. There has been noteworthy change occurring at the state level as well. In 2016, California became the first state to bar nondisclosure agreements in civil cases that could be prosecuted as felony sex crimes. In July of 2018, a budget bill signed into law by New York Governor Andrew Cuomo will prohibit mandatory arbitration clauses and ban nondisclosure clauses in settlements, agreements, or other resolutions of sexual harassment claims, unless the condition of confidentiality is the complainant’s preference. State legislatures in Pennsylvania, New Jersey, and several other states have considered similar bills with the intent of banning the use of confidentiality provisions in sexual harassment and other employment-related cases.

In closing, the changing legal landscape regarding confidentiality agreements for sexual harassment and discrimination claims underscores the fact that employers must be mindful of possible changes in the future as well as recently implemented changes, such as the federal tax law. Employers should meaningfully consider the pros and cons of including nondisclosure agreements that relate to sexual harassment and discrimination claims in their employment-related agreements. Employers should certainly weigh the negative publicity and potential fallout that could result from attempting to enforce such provisions. Finally, even though there is no legal requirement to change existing agreements, employers should at least consider proactively reexamining their current agreements. A number of companies have taken such action. Most significantly, Microsoft announced in December of 2017 that it was waiving the contractual requirement for the arbitration of sexual harassment claims in its arbitration agreements for the limited number of employees who had this requirement.

[1] See Juliana Batista, Behind Closed Doors: The Advantages and Disadvantages to Mediating Sexual Harassment Complaints, 70 Disp. Resol. J., 87, 89 (2015) (explaining that the settlement of sexual harassment cases often means that the “public is denied the settlement information and [is] consequently unable to develop a deep understanding of patterns, trends, and common practices that should be used to resolve sexual harassment cases”).

Uncertainty is bad for business. The interpretation by the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC) of “an instrumentality of a foreign government” under the Foreign Corrupt Practice Act (FCPA) might discourage business between U.S. and Colombian companies. The compliance programs of American companies can turn into lengthy procedures with long chains of people involved, making business decisions expensive and time-consuming because they could involve hiring foreign attorneys, mitigating a broad category of risks, and hiring employees that understand the Colombian political situation and its laws.

The FCPA prohibits bribing a foreign official for the purposes of influencing any act or decision of the foreign official in his or her official capacity. 15 U.S.C. § 78dd-2(a)(1)(A)(i). A “foreign official” under the FCPA, among other factors, is any officer or employee of a foreign government, or any department, agency, or instrumentality of a foreign government. 15 U.S.C. § 78dd-2(h)(2). However, Congress has not defined what constitutes an “instrumentality of a foreign government.” Rather, courts have filled the gap by defining an instrumentality as a company controlled by a foreign government that performs a function the foreign government treats as its own. For example, in United States v. Esquenazi, 752 F.3d 917, 925 (11th Cir. 2014), the Eleventh Circuit held that there is a two-pronged test to determine whether a company is an instrumentality of a foreign government. The first element is that there must be control from the foreign government over the state-owned company. For the Esquenazi court, “control” existed when the formal designation of the company was public, the government had a majority interest in the company, and the government had the ability to hire and fire the company’s principals, among other factors of control. The second element of the test is that the state-owned company must perform a function the government treats as its own. The Esquenazi court found a government function when the company has a monopoly over the activity that it carries out, when the government subsidizes the costs of the services, when the company provides services to a large population, and when the foreign country perceives the company is performing a governmental function. These factors are not an exhaustive list of all the factors courts can consider to determine what is an instrumentality of a foreign government, however.

The DOJ and the SEC have jurisdiction to investigate actions that violate the FCPA and adopted the Esquenazi factors in their for companies which adds other elements from cases to determine what an instrumentality is, Crim. Div. of the U.S. Dep’t of Just. & the Enf’t Div. of the U.S. Sec. and Exch. Comm’n, A Resource Guide to the U.S. Foreign Corrupt Practices Act, (p 20) (2015). In addition to their investigatory function, the DOJ and the SEC enforce the FCPA, applying the various factors listed in the guide. Deputy Attorney General Rosenstein has stated that the U.S. government will enforce the FCPA against foreign and domestic companies. In addition, Attorney General Jeff Sessions stated that the DOJ “will continue to strongly enforce the FCPA and other anti-corruption laws.”

Unfortunately, neither the DOJ nor the SEC has explained how the factors relate to each other, or how many factors are required to conclude that a foreign company is an instrumentality of a foreign government. When the courts, the DOJ, or the SEC conclude that a foreign company is an instrumentality of a foreign government, all of its employees become government officials under the FCPA. Nevertheless, this conclusion may conflict with the foreign country’s laws. For example, in Colombia, the distinction between a government official and a private employee is blurred when state-owned companies are involved because not all the employees of a state-owned company are government officials. Thus, American companies could risk sanctions by the DOJ or the SEC because Colombian laws are not clear on this subject.

The Colombian government owns stock in several companies, from one percent to 99 percent of the companies’ stock. Nevertheless, to know whether employees of a state-owned company are government officials requires a case-by-case analysis according to Colombian Constitutional Court. Corte Constitucional [C.C.] [Constitutional Court], mayo 4, 2011, M.P: Gabriel Eduardo Mendoza Martelo, Sentencia C-338/11, Gaceta de la Corte Constitucional [G.C.C.] (p. 22) (Colom). If the Colombian government owns more than 90 percent of the stock, there is little room for debate as to whether the company is an instrumentality of the government because Colombian law expressly provides that conclusion. Id. at 24. However, if the Colombian government owns less than 90 percent, the line is blurred between a government official and private employee. For example, the Colombian Constitutional Court held that Ecopetrol, a company of which the Colombian government owns 88.49 percent of stock, is part of the government’s structure, and its employees are government officials despite the fact that Ecopetrol’s bylaws provide that its employees are private. Corte Constitucional [C.C.] [Constitutional Court], septiembre 12, 2007, M.P: Clara Inés Vargas Hernández, Sentencia C-722/07, Gaceta de la Corte Constitucional [G.C.C.] (p. 54) (Colom). Another example is Interconexión Eléctrica S.A. E.S.P. (ISA), where the Colombian government owns 51 percent of the stock and the courts considered ISA an instrumentality of the Colombian government. Consejo de Estado [C.E.], Sala de Consulta y Servicio Civil septiembre 20, 2007 M.P: José Enrique Arboleda Perdomo, Radicación 1.840 (p.5) (Colom).

If the Esquenazi factors are applied to Colombian state-owned companies, where the distinction between a government official and private employee is not clear, is possible to obtain a contradictory conclusion. For example, the Colombian government owns 32.5 percent of the stock of Colombia Telecomunicaciones (Telefoníca), a cable, phone, and internet company. Due to the stock ownership, the Colombian government has one seat on the board of directors. The Colombian government and the public perceive Telefoníca as a private company, although Telefoníca is part of the government. Nevertheless, Colombian courts have not yet ruled whether Telefoníca is part of the government or if its employees are government officials. In Telefoníca’s case, the Esquenazi factors support two contradictory conclusions: that Telefoníca is an instrumentality of the Colombian government because it is part of the government, and that Telefoníca is not an instrumentality because the public and the government perceive that Telefoníca does not perform a government function. Consequently, the Esquenazi factors are not clear enough to apply to the hard cases and may promote decisions against the laws of foreign countries.

Another example of the lack of clarity of application of the Esquenazi factors is the special obligation that Colombian state-owned companies owe to Comptroller General of the Republic (CGR) investigations. The CGR, Colombia’s equivalent to the U.S. Government Accountability Office, annually conducts an internal investigation in state-owned companies to protect public money. The companies must answer all the requests made by the CGR and are subject to an annual report that includes an assessment of the company’s administration. Only the companies that have government participation (over 100 state-owned companies) are specially obligated to allow the CGR’s investigation.

Under the broad application of the instrumentality definition, any Colombian company subject to the CGR’s investigations could be considered an instrumentality of the Colombian government. According to the DOJ and SEC guides, a state-owned company is an instrumentality of a foreign government when the state-owned company has special obligations. The Colombian state-owned companies have the obligation to allow the CGR’s investigations, answer its questions, and submit reports to the CGR. Therefore, the DOJ and the SEC may conclude that any state-owned company is an instrumentality of the Colombian government because the company has special obligations and provides services to the public at large, and the company is performing a governmental function. However, for the Colombian government, not all the state-owned companies are instrumentalities of the government. Consequently, American companies’ compliance programs must take into consideration the risk that if they are dealing with any Colombian state-owned company, the DOJ and the SEC might conclude that the Colombian company is an instrumentality of the Colombian government.

American companies’ compliance programs must mitigate a broad category of risks, and is a proper way to avoid sanctions from the DOJ or the SEC. Another way American companies can avoid sanctions is to avoid making any payment to a foreign employee or official, although in business some payments are allowed. Nowadays, the legal denominations of a Colombian company—LLC., Inc., or Co.—is not enough to determine whether it is an instrumentality of the government. American companies must know whether the Colombian government owns stock in the Colombian company, directly or through another company. In addition, American companies must know whether the Colombian company is subject to the CGR’s investigations.

The lack of clarity as to what is “an instrumentality of a foreign government” increases the possibility that the DOJ or the SEC will open an investigation against a company. In Colombia, state-owned companies are a risk to American companies because the DOJ and the SEC may start an administrative procedure alleging that the American company is dealing with a Colombian government official when in reality it is a private employee. Hence, companies’ compliance programs must mitigate a broad category of risks, including the possibility of dealing with a private employee who could be considered a government official.

To mitigate such risks, American companies must have qualified employees that understand Colombia’s political situation and its laws, which could include hiring attorneys in Colombia. Given lack of clarity as to what constitutes an instrumentality, the company may seek the DOJ’s opinion about the Colombian company’s status, and that could take time. Before an American company engages in a negotiation with a Colombian company, the American company should take steps to determine whether the Colombian company is considered an instrumentality of the government under the Colombian law or under the broad interpretation of the DOJ and the SEC. However, compliance programs can turn into costly and lengthy procedures, with long chains of people involved, making decisions expensive and time-consuming. Finally, the combination of Esquinazi factors and the eagerness of the DOJ and the SEC to enforce the FCPA could affect U.S.-Colombian business, discouraging investment in oil, energy, banking, telecommunications, transportation, agriculture, and health because the American companies are at risk of investigation if the Colombian companies are dealing with a foreign official.

On October 3, 2018, the United States Supreme Court held oral argument for New Prime Inc. v. Oliveira, No. 17-340, a case concerning Section 1 of the Federal Arbitration Act (“FAA”).  Section 1 of the Federal Arbitration Act (“FAA”) provides that the FAA does not apply “to contracts of employment of seamen, railroad employees, or any other class of workers engaged in foreign or interstate commerce.” 9 U.S.C. § 1.  Specifically, the Court is addressing two issues: (1) whether a court or an arbitrator must determine the applicability of Section 1; and (2) whether Section 1 of the FAA’s exemption for contracts of employment includes, as a matter of law, independent contractor agreements. The underlying dispute arises from an independent contractor agreement between the parties pursuant to which Oliveira’s trucking company,located in Missouri, provided services to New Prime, a national trucking company. The underlying agreement specifically stated that there was no employer/employee relationship created between the parties and that any disputes would be resolved through arbitration. Subsequent to entry into the agreement, a dispute over the rate of payment arose and Oliveira joined in a class action under, inter alia, the Fair Labor Standards Act. New Prime sought to compel arbitration and Oliveira opposed, contending, among other things, that the FAA barred arbitration because it was a contract of employment. The Fifth Circuit affirmed the district court’s decision that the court, not the arbitrator, was to decide whether Section 1 of the FAA was applicable and that independent contractor agreements fell within the purview of the FAA’s Section 1 exemption.

On appeal, New Prime argued that courts must give deference to arbitration clauses under the FAA and uphold prior court precedent creating a “presumption of arbitrability.” As such, arbitrators should be able to decide this threshold jurisdictional issue. Oliveira’s response to this argument—that this question in the first instance should be decided by the court and not the arbitrator—was adopted by the lower courts. Oliveira contends that while parties may delegate some threshold issues to the arbitrators, arbitrability covers which issues have been submitted to arbitration, but not all potential threshold issues, such as the application of the FAA.

With respect to the second issue, whether Section 1 of the FAA’s exemption for contracts of employment includes, as a matter of law, independent contractor agreements, New Prime argues the applicability of the FAA to an independent contractor agreement is outside the scope of the exemption provided by Section 1. New Prime advances a narrow reading of this exemption and points to the underlying purpose of the FAA, which was to balance judicial hostility to arbitration agreements in general. For purposes of comparison, New Prime identifies other statutes in which the ADR-related provisions governing employment-related disputes did not include independent contractor agreements. New Prime presents an interesting analysis of the literal meaning of employment agreement terms, including, but not limited to, citations to Black’s Law Dictionary, which defines an employment contract as one between an employer and employee, and does not include independent contractor agreements.  In response, Oliveira argued that the FAA does not define the term “employment contract” and that the plain meaning should be utilized in rendering any determination. Further, Oliveira points to language from other Supreme Court cases where the term contracts of employment were found to include independent contractor agreements. Moreover, Oliveira refers to other statutes enacted contemporaneously with the FAA, wherein similar interpretations, or definitions, support this proposition. 

Additional parties have filed amicus briefs, such as the Customized Logistics and Delivery Association—they raise a concern that excluding independent contractors from using arbitration will impact other sectors of the transportation industry and may result in significant cost increases in the transportation industry. The Chamber of Commerce and the Society for Human Resource Management also submitted amicus briefs supporting New Prime, and cautioned that consumers will bear the brunt of any increase in costs due to the unavailability of arbitration as an option to resolve certain disputes.

Follow up next month for the decision of the Court, as well as for additional information on the second case slated for oral argument on October 29, 2018, Lamps Plus, Inc. v. Varela, No. 17-988.

By Leslie Ann Berkoff

I. Introduction

The recent popularity of cryptocurrencies and blockchain-based tokens among investors has raised implications under U.S. securities laws, including whether these tokens are securities.

Legal issues aside, as a simplified illustration, a blockchain is a “shared digital ledger, also called a distributed ledger, for storing and tracking transactions,” with each peer user of the ledger holding a unique digital key to the ledger.[1] Blockchains and, more broadly, distributed digital ledgers[2] are often touted as having an revolutionary effect on how transactions can be conducted and how people can interact with each other by eliminating intermediaries.[3] Numerous variations of such digital ledgers currently exist on the market; they were mostly developed by different consortiums that consist of technology companies and/or financial institutions.[4]

The digital assets that move across a blockchain or a distributed ledger are termed “tokens,” “coins,” or “cryptocurrencies.” Among the most common existing coins are bitcoin (originated on the original blockchain) and ether (originated on the well-known ethereum ledger), which can be easily exchanged for fiat currencies (e.g., U.S. dollars) in the open market and used to purchase other digital (and even nondigital) products, thus bearing a strong resemblance to the traditional concept of currency.[5]

Technology companies and even traditional business entities have come to realize the potential of blockchain’s commercial use and are using it in a number of ways. One of those ways is an initial coin offering (ICO) that is expected to lead to the completion of blockchain-based projects. An ICO is an event in which a blockchain-based project or entity raises capital by issuing tokens to purchasers in exchange for a contribution of value in the form of either fiat currency or digital currencies.[6]

The rest of this article will explain why ICOs and digital assets in general implicate the U.S. securities laws. Part II gives an overview of the orders, actions, and statements by the Securities and Exchange Commission (SEC) leading up to Director Hinman’s speech (the Hinman Speech),[7] including the famous “The DAO Report” and the SEC’s cease-and-desist order against Munchee Inc. (Munchee Order).[8] Part III points to alternatives to ICOs that are less likely to run afoul of the securities laws and SEC regulations. The purpose of this article is two-fold: (1) to analyze how the SEC applies old laws to emerging issues and develops its jurisprudence, and (2) to provide some guidance to counsels and practitioners who are or will be structuring a transaction involving digital assets.

II. The SEC’s Developing View on Digital Assets

Like bitcoin or ether, digital assets sold today can function as a medium of exchange, unit of account, or store of value.[9] Increasingly, however, these tokens begin to represent other rights, such as a right to participate in the developer’s profit distribution or a right to access the blockchain-based platform once it is placed into commercial production. Depending on the circumstances, these other rights could cause digital assets to fall in the definition of “securities” under the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the Securities Laws).[10]

Under the Securities Laws, all securities offered and sold in the United States must be registered with the SEC or must qualify for an exemption from the registration requirements. In addition, any entity or person engaging in the activities of an exchange must register as a national securities exchange or operate pursuant to an exemption from such registration. Thus, whether a token is a security becomes crucial for token issuers and people who facilitate the promotion and issuance of tokens. As discussed below, the SEC evaluates whether tokens are securities by considering whether they are “investment contracts,”[11] which must satisfy the Howey test: The instrument is (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others.[12]

1. Pre-Munchee Order SEC Actions and The DAO Report

Before ICOs heated up in the latter half of 2017,[13] the SEC brought sporadic actions against security intermediaries alleging fraudulent behaviors. However, in those administrative proceedings or cases, bitcoins or digital tokens were only tangential ingredients that were not the focus of the SEC’s analyses.[14]

The DAO Report published in July 2017 represented the first instance in which the SEC truly opined on the nature of digital tokens.[15] The blockchain company Slock.it created and sold DAO tokens to the public in exchange for ether. DAO tokens granted token holders certain voting and ownership rights.[16] According to the company’s promotional materials, DAO token holders would share in the anticipated earnings from projects funded by their investment in DAO tokens and would have the ability to make a profit by reselling DAO tokens in a secondary market.[17]

In evaluating whether DAO tokens are securities, the SEC did not hesitate to apply the Howey test: “[A] security includes ‘an investment contract’ . . . . This definition embodies a ‘flexible rather than a static principle’ [and] in analyzing whether something is a security ‘form should be disregarded for substance.’”[18]

Observing that “‘money’ need not take the form of cash” and that DAO token holders gave something of value (i.e., ether), the SEC quickly concluded that the first prong is met.[19] Next, given that ether contributed by DAO token holders was pooled and made available to the DAO platform to fund projects, the returns on which would be shared by holders, purchasers of DAO tokens invested in a common enterprise and reasonably expected profits in the form of “increased value of investment.”[20]

Most ink was spilled on the last prong that the profit is to be derived from “the entrepreneurial or managerial efforts of others.” The trick, compared to the facts that made the first three prongs an easy pass, is that DAO token holders did have some voting right to decide what business projects to be deployed. The question was whether the managerial efforts of Slock.it were nonetheless the significant ones driving the value of The DAO in light of DAO token holder’s decision-making power as to projects. The SEC answered in the affirmative because: (1) Slock.it and its co-founders held themselves out as experts in the ethereum network and led investors to believe they could be relied on to make The DAO a success; (2) Slock.it and its co-founders actively monitored, operated, and safeguarded The DAO and investor funds; (3) DAO token holders could vote only on proposals filtered by Slock.it and its co-founders using limited information provided to the holders and had no role in negotiating terms of the contracts; and (4) there was no practical way for DAO token holders to consolidate their votes into powerful blocs.[21] In other words, “the voting DAO Token holders [had were] akin to those of a corporate shareholder.”[22] Because DAO token holders were unable to assert actual control over the business, they necessarily relied on the managerial and entrepreneurial efforts of Slock.it and its co-founders.

Through The DAO Report, the SEC spoke directly to digital token issuers for the first time. In a certain sense, the message conveyed in The DAO Report was a mild, friendly warning given that the SEC decided not to pursue any enforcement action, and a considerable portion of the report reiterated the Securities Laws, which in retrospect might be unfortunate because practitioners and businesses mistook it for an opportunity to test the regulator’s limit. Another aspect of The DAO Report that tends to be downplayed is the SEC’s reminder that a marketplace meeting the definition of an “exchange” under the Exchange Act on which securities (including digital assets that are securities) transactions take place must register with the SEC pursuant to the Securities Laws and regulations. This “afterthought” that was squeezed in to the end of The DAO Report turned out to be crucial in the SEC’s more recent enforcement activities, as discussed below.

2. The Munchee Order

Many think The DAO is not even a close case; after all, except that the instruments were called “tokens,” not “shares,” DAO tokens shared many of the attributes of a traditional equity stock.[23] Creative people predictably would not allow their tokens to be pigeonholed to the type of “security tokens” created by The DAO.

The thinking prompted the burgeoning of the so-called utility tokens, which replaced the profit-sharing attribute of DAO tokens (or the like) with a certain consumer utility attribute. In fact, token issuers can customize the terms of the tokens in whatever way they see fit, typically in an informational “white paper” document from which prospective purchasers know to what features of the tokens they are subscribing. Utility tokens represent a right to use the issuer company’s products or services instead of any interest in the company itself. After The DAO Report, an increasing number of companies began issuing utility tokens to raise funds for the development of its products or services to which prospective token holders will have access.

On December 11, 2017, the SEC issued a cease-and-desist order against Munchee Inc., a California company that created an iPhone app for reviewing restaurants, for offering and selling unregistered tokens, which in the SEC’s view was a security. Notably, the Munchee Order was the first SEC enforcement action against an ICO that made no fraud allegations.[24] The tokens sold by Munchee (MUN tokens) were utility tokens allowing holders to purchase goods or services in the to-be-improved “ecosystem” of the app.[25] The SEC found that Munchee indicated that it would take steps to increase the value of the tokens, which made purchasers of MUN tokens to have a reasonable expectation of obtaining future profits predominantly from the efforts of Munchee and its agents.[26] Accordingly, the SEC found that MUN tokens were securities, and the offering and sale of MUN tokens was subject to the Securities Laws.

Applying the same Howey test, the Munchee Order focused on the third prong: a “reasonable expectation of profits.” This is a sensible approach because when people buy a garden-variety merchandise, they are paying for the utility offered by the merchandise, not its potential to appreciate in value; even though it is plausible that certain consumer goods could increase in value over time, this alone usually is not what motivated consumers to make the purchase in the first place.[27] By building in MUN tokens a feature that would allow holders to engage in various activities in the new app ecosystem (i.e., consumer utility), Munchee was pulling MUN tokens out of the investment instrument basket and putting them into the consumer goods basket. The implication was that purchasers of MUN tokens probably did not have a reasonable expectation of profits.

The SEC took issue with Munchee’s strategy, and the Munchee Order on the whole exemplified how the SEC interpreted “form should be disregarded for substance.” Not limited by Munchee’s self-labeling, the SEC looked at facts evidencing a reasonable expectation of profits among MUN token purchasers, including: (1) although Munchee told potential purchasers MUN tokens could be exchanged for goods or services after Munchee created an ecosystem, no one was able to buy any good or service with MUN tokens before the ecosystem became operational;[28] (2) on Munchee’s website and in its white paper, Munchee indicated that “MUN tokens would increase in value”;[29] (3) in public appearances, Munchee and its agents primed purchasers’ expectation of profit through statements and endorsements of others’ statements that MUN tokens would increase in value and that purchasers would receive a significant return by buying MUN tokens early;[30] (4) Munchee specifically targeted potential purchasers interested in investing in cryptocurrencies, not its app users or restaurants, by promoting MUN tokens in digital asset investment forums where prospective investors gather and paying third parties to publish promotional statements in those forums;[31] and (5) Munchee intended that MUN tokens would trade in a secondary market, and Munchee represented that it would buy or sell MUN tokens using its retained holdings in order to ensure a liquid secondary market.[32] Munchee did much more than a garden-variety retailer would do to promote its merchandise but at the same time neglected what a retailer should do—to market the good to people who find it most useful. Taken together, these facts support the SEC’s conclusion that Munchee was priming prospective purchasers’ expectation of profits.

The Munchee Order tells us that whether a token is called an investment token or a consumer good, the inquiry does not stop there. The Munchee Order went so far as to say, “Even if MUN tokens had a practical use at the time of the offering, it would not preclude the token from being a security.”[33] It is unnecessary for the SEC to make statements on facts that were not present in the instant case; perhaps the SEC wanted to show its strong determination that the economic-reality analysis would be applied in each and every case involving ICOs and to deter issuers who would try evading scrutiny by introducing the slightest variation to its digital assets.

3. Post-Munchee Order SEC Actions

On the same day that the Munchee Order was issued, SEC Chairman Jay Clayton released a statement to both main street investors and securities market professionals who play a role in ICOs.^[34] Predictably, the statement picked on utility tokens: “Merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security.”[35] Chairman Clayton, however, left it open to structuring an ICO not involving the offering of securities. He noted that, “a participation interest in a book-of-the-month club may not implicate [] securities laws,” whereas “many [utility] token offerings appear[ed] to have gone beyond this construct and [were] more analogous to interests in a yet-to-be-built publishing house with the authors, books and distribution networks all to come.” It is yet to be seen what kind of utility tokens is (or is not) akin to a participation interest in a book club that is already built and running.[36] All we know is that no lines will be drawn, and the same case-by-case factual analysis will continue to apply.

The Munchee Order set in motion a series of efforts targeting the ICO market in a broader scope. The Clayton statement not only cautioned investors against investing in cryptocurrencies or ICOs without making adequate inquiry into the specifics of an offering, but also called on market professionals (e.g., broker-dealers, investment advisers, exchanges, and lawyers) to focus on “the protection of our Main Street investors” by ensuring that offerings of securities be accompanied by important disclosures, and the Securities Laws be complied with in all respects. This message echoes The DAO Report’s warning that a marketplace where trading of securities occurs must register as a national exchange or, if certain conditions are met, a broker-dealer. Lastly, the Clayton Statement “promised” that “the SEC’s Division of Enforcement [would] continue to police this area vigorously.”

In the same vein as the Munchee Order and the Clayton statement, the SEC continued to closely monitor ICO-related activities,[39] but the SEC’s post-Munchee Order focus seemed to be shifting from token issuers to market professionals who facilitated ICOs. In January this year, Chairman Clayton sent additional warning signals to securities professionals, especially lawyers, that when the ICOs had many of the key features of a securities offering they should counsel clients that the product being promoted was likely a security.[40] The chairman observed that “federal securities laws apply regardless of whether the offered security . . . is labeled a ‘coin’ or ‘utility token,’” and that the SEC was “disturbed” by “form-based arguments” made by lawyers, trading venues, and financial services firms that “depriv[ed] investors of mandatory protections.”[41]

On February 21, 2018, the SEC filed a complaint against a bitcoin-denominated platform and its founder for, among other things, operating an unregistered securities exchange.[42] An SEC official stressed that “[p]latforms that engage in the activity of a national securities exchange, regardless of whether that activity involves digital assets, tokens, or coins, must register with the SEC or operate pursuant to an exemption.”[43] As already reminded in The DAO Report, a system meeting the definition of an “exchange” is “any organization, association or group of persons . . . which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities”[44] and must register as a national securities exchange or operate pursuant to an appropriate exemption, one such frequently used exemption being an alternative trade system (ATS) that can register as a broker-dealer and comply with only Regulation ATS.[45] In any event, for an entity operating a digital token system or considering to operate one, as well as lawyers advising such an entity, it is worth reading the Regulation ATS adopting release and studying the illustrations in that release.[46]

4. The Hinman Speech

Half a year after the Munchee Order, the Hinman Speech marks another milestone in the SEC’s public dialogue in the digital assets field. Perhaps most interesting to the digital asset industry is the much-anticipated reassurance that ether is not a security.[47] From the perspective of the Securities Laws, the Hinman Speech repeats and continues The DAO Report and the Munchee Order: (1) how the instrument is labeled bears no significance on the Howey analysis;[48] (2) the prong analyzing investor’s reliance on a third-party promoter should be given primary consideration when applying the Howey test to digital assets;[49] and (3) whether the creation of a digital asset has a consumer purpose and whether people purchase it out of consumptive motivation will be evaluated based on various objective factors.[50] Whether a digital asset is a security does not inhere to the instrument; rather, the real question is whether the manner in which it is offered and sold creates a reasonable expectation of profits to be derived predominantly from the promoter’s efforts. This explains why simply restyling a digital asset as a “utility token” is doomed to fail.

Apart from crystalizing the entire Howey test into the last two prongs in the context of applying the Securities Laws to digital assets, Hinman implicitly made a pragmatic argument when addressing why ether and bitcoin should not be securities:

The disclosures required under the federal securities laws nicely complement the Howey investment contract element about the efforts of others. As an investor, the success of the enterprise . . . turns on the efforts of the third party. . . . Without a regulatory framework that promotes disclosure of what the third party alone knows of these topics and the risks associated with the venture, investors will be uninformed and are at risk. . . . [I]f the network on which the token or coin is to function is sufficiently decentralized—where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts—the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede.[51]

Because both bitcoin’s and ether’s operation and their respective networks are so decentralized that basically every user is on the same page and no central third party determines the fate of the network, “applying the disclosure regime of the federal securities laws to the offer and resale of [bitcoin and ether] . . . would add little value.”[52] In other words, protection under the Securities Laws will be meaningless because there will not be a promoter to be sued and be held accountable in the event bad things happen.

Hinman noted that most of the ICOs he has seen have touted promoters’ ability to create an innovative application of the distributed ledger technology and targeted passive investors, and the lack of a clear business model often left purchasers no choice but to rely on the efforts of the promoters to build the network. Therefore, even though digital assets offered in those ICOs are not technically securities themselves, just like orange groves in Howey, “[a]t that stage, the purchase of a token looks a lot like a bet on the success of the enterprise and not the purchase of something used to exchange for goods or services on the network.”[53] Hinman indicated, however, that the network on which certain digital assets operate may eventually mature, and at some point those digital assets would become the new “ether” to which the application of the Securities Laws would add little value.

III. Alternatives to Noncompliant ICOs

If a network could achieve the same degree of decentralization as the bitcoin network or the ethereum network, then it would probably be blessed by the SEC. Outside bitcoin and ether, however, regulatory uncertainty still accompanies each and every coin offering in the United States, and it is rare, if ever possible, for a network to begin in a sufficiently decentralized form. As suggested by Hinman, one way around this is to begin fundraising through traditional equity or debt offering, and once the network is up and running, distribute blockchain-based digital assets to potential users. Nevertheless, this route may not be desirable or executable for all digital asset issuers, and separating fundraising from token sale may deprive some crypto-enthusiasts’ opportunity to participate in the early stage of developing a perhaps groundbreaking project. The rest of this Part III briefly outlines three options for structuring legally compliant ICOs: Regulation D, Regulation S, and Regulation A.

Citing Regulation D, Chairman Clayton acknowledged that “[i]t is possible to conduct an ICO without triggering the SEC’s registration requirements,” which provides a private placement exemption.[54] The private placement exemption, Rule 506(c), allows an issuer to raise an unlimited amount of capital so long as there are no more than 35 purchasers who are not “accredited investors”[55] (AI), and the non-AI purchasers, either alone or with their representatives, possess a certain level of financial sophistication.[56]

Similar to what people can do in other unregistered offerings, an ICO can be structured to comply with Regulation S such that the digital assets will be deemed to be offered and sold outside the United States and not subject to the SEC’s jurisdiction.[57] Regulation S requires that each offer or sale of securities by an issuer be made outside the United States: (1) in an “offshore transaction,”[58] (2) with no direct selling efforts in the United States, and (3) be subject to any additional conditions as determined by the category of the securities being offered or sold.[59]

 The third alternative is Regulation A, which as amended by the JOBS Act in 2015, allows a qualified issuer[60] to raise up to $50 million from the public without complying with the full SEC registration process. However, the issuer may only sell to non-AIs if the purchase price paid by such non-AIs does not exceed 10 percent of the greater of their annual income or net worth (for natural persons) or 10 percent of the greater of its revenue or net assets (for entities).[61] The issuer must file an offering statement, and the SEC must qualify it before the issuer can start to sell the securities.[62]

There are, however, obvious tradeoffs associated with the exempted offerings discussed above, including restrictions on publicity, investor qualifications, and limited resales, which may in some cases decrease the appeal of an ICO as a means of raising capital. For example, under Regulation D, general solicitation is disallowed if the digital assets, assuming they are securities, end up being sold to non-AIs.[63] In addition, digital assets offered pursuant to Regulation D and Regulation S are not freely transferrable in a secondary market.[64] From the perspective of a prospective purchaser, digital assets offered pursuant to these exemptions might be less desirable because the investor verification process (i.e., to verify the AI status for Regulation D offerings, and for Regulation S offerings to verify the non-U.S. person status) goes against the pseudonymous principle of most distributed ledgers. Regulation A, on the other hand, seems to have fewer publicity and resale limitations, but the $50 million cap may not satisfy ambitious entrepreneurs’ capital need (or expectation).[65]

IV. Conclusion

At the end of 2017, the SEC began to send subpoenas and information requests to technology companies and, remarkably, to their advisors and lawyers as well.[66] “[T]he wave of subpoenas includes demands for information about the structure for sales and pre-sales of the ICOs”—the “most concrete sign of the SEC’s intention to crack down on the sudden emergence of coin offerings.”[67]

Before any congressional action to carve out a special regulatory regime for blockchain and cryptocurrency, the 1946 Howey test will continue to guide the SEC’s analysis and perhaps the courts’ analysis as well. As the SEC becomes impatient with token issuers and their advisors, it is difficult to make more creative arguments without confronting the SEC head on,[68] and it is probably more prudent to seek the SEC’s view before proceeding with any definitive offering plan. According to Director Hinman, “[the SEC is] happy to help promoters and their counsel work through these issues. We stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.”[69]

What all this means for lawyers is that when clients seek advice in connection with ICOs, which clients may include token issuers, ICO promoters who played a similar role to underwriters, and trading platforms that may be viewed as unregistered exchanges, lawyers should ask whether the proposed action will compromise the purpose of investor protection laws and regulations, the lens through which the SEC is determined to scrutinize the markets for digital assets.

Of course, none of the above is relevant to fraudulent ICOs. Any fraud, not just fraudulent ICOs, deserves to be hit as hard as possible.

*I am grateful to Rebecca Simmons for her helpful guidance and comments. All views expressed in this article are my own.

[1]           Tawnya Plumb, Blockchain: What’s in It for Lawyers?, 41 Wy. Law., Feb. 2018, at 50. The decentralized feature of blockchains is thought to make a blockchain more immune to hacking than a centralized database. Id.

[2]           For the rest of the article, blockchain and digital or distributed ledger will be used interchangeably.

[3]           For a general overview of what distributed ledger technology can do for the business community, see Bryce Suzuki, Todd Taylor & Gary Marchant, Blockchain, 54 Az. Atty. 12, 14–17. (Feb. 2018).

[4]           See Peter Gratzke, David Schatsky & Eric Piscini, Banking Together for Blockchain: Does It Make Sense for Your Company to Join a Consortium?, Deloitte Insights, Aug. 16, 2017 (noting that a growing number of companies join together to develop new distributed ledger-based infrastructures).

[5]           See Arjun Kharpal, All You Need to Know About the Top 5 Cryptocurrencies, CNBC, Dec. 14, 2017 (showing that, as of the end of 2017, market cap of bitcoin was $275.1 billion and that of ether was $71.1 billion); Elise Moreau, 13 Major Retailers and Services That Accept Bitcoin, Lifewire, Mar. 7, 2018 (listing major consumer vendors that accept bitcoins as payment method). Bitcoin, ether, and other coins having similar attributes to real-world currency are sometimes called “cryptocurrencies.” Cryptocurrencies and other types of tokens are generally referred to as “digital assets” in this article.

[6]           See SEC Investor Bulletin: Initial Coin Offerings (July 25, 2017) [hereinafter SEC Investor Bulletin] (noting that developers, businesses and individuals are using token sales to raise money for developing digital platforms). In fact, an ICO turned out to be an astounding device for raising money. As an example, the initial offering of “Basic Attention Tokens,” which allows holders to access a blockchain-based publishing and advertising platform, raised $35 million in 24 seconds. Becker Goldstein et al., Basic Attention Token (BAT) Token Launch Research Report (Oct. 30, 2017).

[7]           William Hinman, Dir., SEC Div. of Corp. Fin., Remarks at the Yahoo Finance All Markets Summit: Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018) [hereinafter Hinman Speech].

[8]           In re Munchee Inc., SEC Release No. 10445, File No. 3-18304 (Dec. 11, 2017) [hereinafter Munchee Order].

[9]           SEC Investor Bulletin, supra note 7.

[10]         15 U.S.C. §§ 77b(a)(1) (2016).

[11]         Id. (“The term ‘security’ means any note, stock . . . investment contract . . . or warrant or right to subscribe to or purchase, any of the foregoing.”).

[12]         United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852 (1975); SEC v. Howey, 328 U.S. 293, 301 (1946).

[13]         Holden Page, 2017’s ICO Market Grew Nearly 100X from Q1 to Q4, Crunchbase, Jan. 11, 2018, (showing that the ICO market saw an exponential growth in the third and fourth quarters of 2017).

[14]         Cyber Enforcement Actions (last updated Sept. 26, 2018) [hereinafter SEC Enforcement Actions] (listing up-to-date enforcement actions with respect to digital currency/ICOs). In these cases, the SEC alleges fraudulent behavior of certain broker dealers and exchange platforms, but none of these concerns the question of whether the tokens are unregistered securities.

[15]         Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Release No. 81207 (July 25, 2017) [hereinafter The DAO Report] (concluding that The DAO tokens, a digital asset, were securities).

[16]         Id. at 5.

[17]         Id. at 1.

[18]         Id. at 11 (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967); SEC v. Howey, 328 U.S. 293, 299 (1946)).

[19]         Id.

[20]         Id. at 11–12.

[21]         Id. at 12–15.

[22]         Id. at 15.

[23]         The Supreme Court identified the characteristics associated with common stock to be: (1) the right to receive dividends contingent upon an apportionment of profits; (2) negotiability; (3) the ability to be pledged or hypothecated; (4) the conferring of voting rights in proportion to the number of shares owned; and (5) the capacity to appreciate in value. Landreth Timber Co. v. Landreth, 471 U.S. 681, 686 (1985).

[24]         Since The DAO Report, the SEC filed a complaint on September 29, 2017, against Recoin Group Foundation, LLC; DRC World Inc. a/k/a/ Diamond Reserve Club; and Maksim Zaslavskiy, alleging that a businessman and two companies defrauded investors in a pair of ICOs purportedly backed by investments in real estate and diamonds, and the SEC filed complaint in December 2017 against Plexcorps (a/k/a and d/b/a Plexcoin and Sidepay.Ca), Dominic Lacroix, and Sabrina Paradis-Royer halting an ICO-based fraud that had raised up to $15 million from thousands of investors since August by falsely promising a 13-fold return in less than one month’s time. SEC Enforcement Actions, supra note 15.

[25]         See Munchee Order, supra note 9, at 1–2.

[26]         Id. at 2.

[27]         In the context of applying the Howey test, the Supreme Court drew the line between the motivation of a consumer and that of an investor, and only the presence of an investing motivation is relevant to the question whether the instrument is a security: “[W]hen a purchaser is motivated by a desire to use or consume the item purchased . . . the securities laws do not apply.” United Hous. Found., Inc. v. Forman, 421 U.S. 837, 854–53 (1975).

[28]         Munchee Order, supra note 9, at 9.

[29]         Id. at 4.

[30]         Id. at 5–6.

[31]         Id.

[32]         Id. at 5.

[33]         Id. at 9.

[34]         Public Statement, SEC Chairman Jay Clayton Statement on Cryptocurrencies and Initial Coin Offerings (Dec. 11, 2017) [hereinafter Clayton Statement]. The Clayton statement is not formal SEC guidance or a statement of the SEC, but is instead an informal statement by the chairman.

[35]         Id.

[36]         The chairman suggested that all (or almost all) of the token offerings he had seen as of his statement involved the offer or sale of securities. The SEC has yet to bring another enforcement action against a nonfraudulent ICO after the Munchee Order.

[37]         Clayton Statement, supra note 35

[38]         Id.

[39]         To date, the SEC brought seven enforcement actions involving ICOs or digital assets since the Munchee Order, but none involved analysis of whether the token being offered is a security. SEC Enforcement Actions, supra note 15.

[40]         SEC Chairman Jay Clayton, Opening Remarks at the Securities Regulation Institute (Jan. 22, 2018).

[41]         Jay Clayton & J. Christopher Giancarlo, Regulators Are Looking at Cryptocurrency, Wall St. J., Jan. 24, 2018.

[42]         Press Release 2018-23, Security Exchange Commission, SEC Charges Former Bitcoin-Denominated Exchange and Operator with Fraud (Feb. 21, 2018).

[43]         Id. See also 15 U.S.C. § 78e (making it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security or to report any such transaction unless the exchange is registered as a national securities exchange or is exempted from such registration).

[44]         15 U.S.C. § 78c(a)(1). The SEC Rule 3b-16(a) further refines the definition into a two-part test that the organization must: (1) bring together the orders for securities of multiple buyers and sellers; and (2) use established, nondiscretionary methods under which such orders interact with each other, and the buyers and sellers entering such orders must agree to the terms of the trade. 17 C.F.R. § 240.3b-16(a).

[45]         The DAO Report, supra note 16, at 16–17.

[46]         63 Fed. Reg. 70844 (Dec. 22, 1998).

[47]         The SEC leadership has previously indirectly conceded that bitcoin is not a security. See, e.g., Clayton Statement, supra note 35, at n.2 (stating that bitcoin is a commodity and is subject to the regulations of the Commodities Futures Trading Commission). Ether is the second largest virtual currency by market cap (the largest being bitcoin) that can be held and transferred on blockchains, function as a medium of exchange for other goods or services, and be used to create decentralized applications on the ethereum network, making it a much more versatile digital asset than bitcoin. Therefore, considerable legal consequences and commercial disruptions would follow if the SEC declared ether a security.

[48]         Hinman analogized digital assets, which are essentially computer codes, to orange groves in Howey. Neither digital assets nor orange groves are securities by nature, but if promoters offer and sell digital assets in the same way the Howey company sold orange groves (i.e., to cause prospective purchasers to believe that profit can be derived solely from the efforts of promoters), then the offer and sale of computer codes becomes an offer and sale of securities. See Hinman Speech, supra note 8.

[49]         Hinman cited a nonexhaustive list of factors to assess whether a third party—a person, entity, or coordinated group of actors—drives the expectation of a return on the digital asset. Id.

[50]         Id. (listing nonexclusive factors to consider how digital assets can be structured like a consumer item).

[51]         Id. (emphasis added).

[52]         Id.

[53]         Id. (emphasis added).

[54]         Clayton Statement, supra note 35. Notably, Kodak and its partner filed an SEC notice to offer rights to purchase KODAKCoins in future sales pursuant to Rule 506(c). JD Alois, KODAKCoin to Issue SAFT, Seeks $176.5 Million ICO, Crowdfund Insider, Mar. 19, 2018.

[55]         In the case of an individual, to qualify as an AI, the investor must meet certain thresholds concerning its net worth and annual income. See 17 C.F.R. § 230.215.

[56]         17 C.F.R. § 230.506(b)(2)(ii).

[57]         17 C.F.R. § 230.901.

[58]         “Offshore transaction” means (1) the offer is not made to a person in the United States, and (2) the buyer is outside the United States or the transaction is executed outside the United States. 17 C.F.R. § 230.902(h).

[59]         Regulation S divides securities into three categories. Category 1 securities include those issued by “foreign private issuers” as defined in SEC Rule 405. Among other alternatives that are irrelevant here, an offering or sale of Category 1 securities complies with Regulation S if there is no “substantial U.S. market interest” as defined under Regulation S or, if there is substantial U.S. market interest in the securities, the offering or sale is directed to a single country other than the United States in accordance with local laws. Categories 2 and 3 securities consist of securities offered by foreign reporting issuers and U.S. domestic issuers. Regulation S imposes more onerous conditions on these two categories of securities which include, among other things, placing legends on marketing materials, additional undertakings by distributors to comply with Regulation S, and a distribution compliance period during which offer or sale cannot be made to U.S. persons other than distributors. 17 C.F.R. § 230.903.

[60]         One of the qualifications is that the issuer is a nonreporting company organized under the laws of the United States of Canada. 17 C.F.R. § 230.251(b)(1), (2).

[61]         17 C.F.R. § 230.251(d)(2).

[62]         The offering statement consists of two parts: (1) notification and (2) an offering circular. 17 C.F.R. § 230.252(a). An offering circular is an abridged version of the traditional disclosure document. Some blockchain companies have filed Form 1-A with the SEC (i.e., the form for Regulation A offerings), but we have yet to see one qualified by the SEC.

[63]         17 C.F.R. §§ 230.502(c) and 506(c).

[64]         Securities offered pursuant to Rule 506 are “restricted securities,” and any resale must comply with Rule 144 to avoid being viewed as a distribution and, thus, the reseller an underwriter. 17 C.F.R. § 230.202(d). For purpose of Regulation S, a resale transaction will be deemed to occur outside the United States if it is made in an offshore transaction without directed selling efforts in the United States. 17 C.F.R. § 230.904.

[65]         Funderbeam, Initial Coin Offerings Funding Report (Oct. 2017), at 11 (showing that funds raised for the top 10 ICOs in 2017 all exceed $50 million); id. at 4 (average size of ICOs increasing rapidly).

[66]         Jean Eaglesham & Paul Vigna, Cryptocurrency Firms Targeted in SEC Probes, Wall St. J., Feb. 28, 2018.

[67]         Id.; see also Nathaniel Popper, Subpoenas Signal S.E.C. Crackdown on Initial Coin Offerings, N.Y. Times, Dec. 28, 2018.

[68]         As an example, the so-called Simple Agreement for Future Tokens (SAFT) is structured as a sale of the right to purchase utility tokens that will be released in the future; although such rights are admittedly securities and to be offered to AIs only, people using SAFT contemplate that once the investors exercise their right to purchase the utility tokens, the securities (i.e., the rights) disappear and all that is left is the utility tokens, which are pure nonsecurities. Predictably, there is indication that the SEC had SAFT in mind when sending out the waves of subpoenas. See Brady Dale, What If the SEC Is Going After the SAFT?, Coindesk, Mar. 6, 2018.

[69]         Interestingly, Hinman called out SAFT specifically. He warned against applying the opinion expressed in the Hinman Speech to a hypothetical SAFT in the abstract. Instead, he encouraged people with questions on a particular SAFT to consult with securities counsel or the SEC directly. Hinman Speech, supra note 8, at n.15.

Subject to court approval, Tesla will appoint two additional new independent directors in connection with its settlement of fraud charges brought against Tesla CEO Elon Musk and settlement of other charges against the company. 

Tesla at present has nine directors. One is Musk, who will step down as chairman of Tesla for at least three years as part of the SEC settlement; one is Musk’s brother; and the other seven directors are independent under NASDAQ independence standards, according to Tesla’s most recent proxy statement. 

Of those seven independent directors, however, three have ties to SpaceX, the private rocketry company also founded by Musk. Accordingly, five of nine Tesla directors are either Musk family members or have connections to other Musk projects beyond Tesla Board of Directors membership. The board may, technically, have a majority of directors who are independent, but it also has a majority of directors with actual or potential conflicts of interest.

Director independence in any company is not valuable for its own sake. Independence is a proxy for what investors actually need: decision makers with integrity, whose judgments on behalf of the company and its shareholders are rendered after thoughtful and fair consideration of the salient facts, untainted by favoritism, or undue deference to management.

In Tesla’s circumstances, regardless of whether specific exchange standards for independence are met, it is fair to consider whether any director can truly be independent.

After all, Musk’s vision, personality and history of business success have driven the company.  Musk has a unique ability to bring capital, engineering talent, and a grasp of an emerging market into a package that investors will value. Tesla lists its dependence upon Musk as a Risk Factor in its Form 10-K.  And Musk owns more than 20% of the company.

Can any board really be expected to fire Musk as CEO, or take disciplinary steps that might cause him to leave the company? And if a board doesn’t have that level of freedom in its oversight of CEO, is the board truly independent?

The short answer: maybe.

Compared to CEOs at other companies, who lack Musk’s celebrity and wealth and who are not visionary genius founders with a huge stock position, Musk has more leverage in negotiating with the Tesla Board of Directors over matters such as business strategy, personnel, pay, and similar issues.

However, it is possible that at this point in Tesla’s development, Musk is no longer an indispensable figure. The market for electric vehicles is proven, and key technologies have been developed. If Tesla’s remaining business issues are dealing with supply chain and financial questions, while maintaining cutting edge research and engineering into the future, genius may be less important than execution.

If Musk’s chief contribution to the company now is the ability to use his celebrity to generate publicity that Tesla doesn’t have to pay for, the board may have greater freedom, and success, in demanding that Musk meet the standards for CEO behavior that apply to everyone else.

At a minimum, the Tesla Board of Directors needs to ensure that the company has a succession plan in place and an organizational structure that permits Tesla to survive the departure of Musk, with or without a continuing relationship. Such business planning, as a question of sustainability, would be part of planning against a sudden death of visionary founder anyway.  Anything that is in Musk’s head and hasn’t already been reduced to paper, or that is kept as trade secret, needs to be made available to the next generation of leaders. 

Other tech companies with visionary founders have transitioned to operating without them. HP continued beyond Hewlett and Packard. Microsoft weathered Bill Gates’ departure from an operational role. Apple survived the first departure of Steve Jobs in the 1990s, and then after his return survived his death.

Two independent directors, by themselves, do not ensure that Musk will no longer engage in the behavior that gave rise to the SEC charges in the first place. The board acts as a group, and no individual director can act alone to rein in a CEO whose behavior is, at a minimum, erratic regardless of whether it rises to the level of fraud.  

Tesla’s need for capital, more than the independence of its directors, may provide the board the upper hand.  Musk didn’t build a company by himself.  To be realized, his vision needed engineers, designers, marketing personnel—and, most of all, investors. As Tesla’s recent stock price in the public market has shown, regardless of whether the  board is willing or able to hold Musk accountable, investors don’t like reckless behavior. 

The SEC brought serious charges against Musk: securities fraud, specifically, sending out knowingly false Twitter comments whose purpose seemed to be inflicting economic punishment on Tesla short sellers. Musk’s behavior not only generated a combined $40 million in SEC fines for him and the company, it also exposed Tesla to economic damage from private securities claims. 

A board cannot allow dishonest or illegal behavior by an executive to go without consequences, regardless of whether the SEC steps in. An oversight body that ignores erratic executive behavior or tolerates executive dishonesty has failed in its duties. That means Musk’s next misstep will not be just a problem for him, it will be a problem for the board. 

Which might be enough to keep them truly independent.