The Eleventh Circuit recently found in favor of Blue Bell Creameries, Inc. by rejecting its own earlier dicta and explicitly expanding the preference payment defense known as “new value.” This provides additional protection for companies doing business with a debtor in the 90 days prior to bankruptcy.

The Scoop: Bruno’s v. Blue Bell

In 2008, Blue Bell Creameries (Blue Bell) was a steady supplier of ice cream to Bruno’s Supermarkets, LLC (Bruno’s). In the 90 days before Bruno’s bankruptcy filing, Bruno’s paid Blue Bell approximately $560,000. Meanwhile, during those 90 days, Blue Bell delivered approximately $435,000 in products to Bruno’s, only some of which was paid for.

Bruno’s filed for bankruptcy and then sued Blue Bell, claiming that the entire $560,000 was a “preference.” A “preference” in bankruptcy vernacular is any transfer of an interest of the debtor in property to or for the benefit of a creditor, based on an antecedent debt, made while the debtor was insolvent, and made within 90 days of the bankruptcy, that provides the creditor with more than it would receive in a chapter 7 liquidation. See 11 U.S.C. § 547(b). A common example of a preference applicable here is when a debtor seeks to claw back payments it made within 90 days before the bankruptcy to an unsecured supplier, despite the debtor having received the goods or services related to such payments. Although this may seem inherently unfair to the supplier, the underlying bankruptcy policy is that equally situated creditors should be treated equally—no one creditor should be “preferred,” or receive payment leading up to bankruptcy, while others do not.

Chocolate or Vanilla?: Eleventh Circuit Dicta Conflates Unavoidable and Unpaid

Here, the $560,000 was admittedly a preference on its face. However, Blue Bell asserted the statutory defense known as “new value.” Basically, a trustee may not avoid a preference to the extent that, after such transfer, such creditor gave new value to the debtor. The wrinkle is that such new value must not have been satisfied by an “otherwise unavoidable transfer . . . .” 11 U.S.C. § 547(c)(4)(B) (emphasis added). The Eleventh Circuit previously stated that this phrase had “generally been read to require . . . that the new value must remain unpaid.” Charisma Inv. Co. v. Airport Sys., Inc. (In re Jet Florida Sys., Inc.), 841 F.2d 1082, 1083 (11th Cir. 1988) (emphasis added). Blue Bell challenged the “unpaid” language of Jet Florida, arguing that it should be able to utilize all new value delivered during the 90-day preference period, whether paid for or not, to shield that same dollar amount from being clawed back.

The bankruptcy court, relying on the “unpaid” language in Jet Florida, gave Blue Bell credit only for amounts that were unpaid, and ultimately held that the trustee could avoid about $440,000 of the over $560,000.

Dessert Is Served: Paid New Value Still Counts

On appeal, the Eleventh Circuit disagreed with the bankruptcy court. The Circuit Court rejected its own Jet Florida language as nonbinding dicta and joined the Fourth, Fifth, Eighth, and Ninth Circuits in holding that new value need not remain unpaid for the creditor to use the new value defense. Three factors swayed the court.

First, the plain language of the statute reads “unavoidable,” not “unpaid.” As both parties agreed, the transfers were preferences and therefore avoidable by the trustee, thus satisfying the “not . . . otherwise unavoidable” requirement of the statute. Second, although the predecessor statute to section 547(c)(4) required new value to remain unpaid, the current statute abandoned that language. One can reasonably conclude that Congress intentionally removed the unpaid limitation to the new value defense by removing the explicit language. Finally, policy considerations indicated that new value need not remain unpaid. If courts decided otherwise, then creditors such as Blue Bell would be hesitant to extend credit to distressed businesses such as Bruno’s in their run up to bankruptcy. This would thwart a key purpose of chapter 11 bankruptcy, which is to reorganize a debtor’s business so that it may pay creditors and regain profitability in the future. In addition, encouraging short-term creditors such as Blue Bell to extend credit to distressed businesses such as Bruno’s will help longer-term creditors. This extension of credit will therefore help distressed businesses from entering bankruptcy in the first place—a better result for all involved.

On August 13, 2018, President Donald Trump signed into law the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) as part of the John S. McCain National Defense Authorization Act for Fiscal Year 2019. FIRRMA amends section 721 of the Defense Production Act of 1950, the statute that governs the operations and powers of the Committee on Foreign Investment in the United States (CFIUS, or the Committee).

Prior to FIRRMA, CFIUS had jurisdiction to review a transaction by or with any foreign person that could result in control of a U.S. business by a foreign person.  Although “control” for purposes of CFIUS jurisdiction is a flexible concept that can reach a large number of minority investments, the legislative sponsors of FIRRMA were concerned that there were a number of foreign investment transactions that did not qualify as involving the acquisition of “control,” or did not involve an investment in a U.S. business, but that still presented threats to national security that needed to be addressed. One of the central concerns of the sponsors was that foreign government-sponsored investment could be used as part of a strategy to neutralize or surpass the United States’ advantages in technology by gaining access to technologies with potential military applications such as robotics, artificial intelligence and automation through non-control investments.  In addition to expanding CFIUS’s jurisdiction, FIRRMA also reforms certain elements of the CFIUS review process that will have impacts on all transactions that are subject to CFIUS jurisdiction.

FIRRMA will have a significant impact on structuring considerations and the parties’ assessment of deal risk where foreign parties are involved in a transaction, and especially foreign governments or foreign government-controlled parties. As a result of the jurisdictional expansions pursuant to FIRRMA (although not yet effective, pending regulations to be issued by CFIUS), transactions involving foreign parties are significantly more likely to be subject to CFIUS review than they have been in the past. 

Jurisdictional Expansions

New Categories of “Covered Transactions”

FIRRMA expands CFIUS’s jurisdiction to include as “covered transactions” subject to CFIUS review four new types of transactions that would not result in control of a U.S. business by a foreign person: 

1. Real Estate Transactions. The purchase or lease by a foreign person of, or a concession offered to a foreign person with respect to, real estate located in the United States that is a part of an air or maritime port or is in “close proximity” to a U.S. military installation or another United States Government facility or property that is sensitive for reasons relating to national security, could reasonably provide the foreign person with the ability to collect intelligence on activities at such a installation, facility or property, or otherwise could expose national security activities at such an installation, facility or property to the risk of foreign surveillance has been made subject to CFIUS jurisdiction, even if the purchase, lease or concession does not relate to a U.S. business. Real estate transactions involving a single “housing unit” or real estate in “urbanized areas” are excepted, subject to regulations that CFIUS may adopt in consultation with the Department of Defense that may reduce the scope of these exceptions. 
2. Non-controlling Investments in Companies that Deal in Critical Technology, Critical Infrastructure and Personal Data of U.S. Citizens. FIRRMA provides CFIUS with jurisdiction to review any “other investment” by a foreign person in any unaffiliated U.S. business that (i) owns, operates, manufacturers, supplies or services critical infrastructure, (ii) produces, designs, tests, manufactures, fabricates or develops one or more critical technologies, or (iii) maintains or collects sensitive personal data of U.S. citizens that may be exploited in a manner that threatens national security.

   For purposes of FIRRMA, “other investment” means any non-controlling investment (meaning an acquisition of equity interest, including contingent equity interests), direct or indirect and regardless of size, that affords the foreign person (1) access to any material nonpublic technical information relating to critical infrastructure or critical technologies in the possession of the U.S. business; (2) membership or observer rights on the board or equivalent governing body of the U.S. business or the right to nominate an individual to a position on the board of directors or equivalent governing body; or (3) any involvement (other than through voting of shares) in substantive decision-making regarding critical infrastructure, critical technologies or sensitive personal data of U.S. citizens. CFIUS will prescribe regulations providing guidance on the types of transactions that the Committee considers to be “other investments.”

3. Changes in Rights of a Foreign Person with Respect to its Investment in a U.S. Business. Any change in the rights that a foreign person has with respect to a U.S. business in which the foreign person has an investment, if that change could result in foreign control of the U.S. business or an “other investment.”
4. Transactions Structured To Evade CFIUS Review. Any other transaction, transfer, agreement or arrangement the structure of which is designed or intended to evade or circumvent the application of the covered transaction definition, subject to regulations prescribed by the Committee.

Potential Expansion of Target Businesses Subject to CFIUS Jurisdiction

Another potentially significant jurisdictional expansion relates to the definition of “U.S. business.”  FIRRMA defines “U.S. business” to mean “a person engaged in interstate commerce in the United States.”  In contrast, the current definition in CFIUS regulations includes a limiting clause “but only to the extent of its activities in interstate commerce.” Without this limiting clause from the current CFIUS regulations, FIRRMA appears to have the potential to provide CFIUS with jurisdiction to review elements of a transaction affecting an entity that provides goods or services in the United States without limiting that review to the entity’s U.S.-based activities. Depending on the regulations that are promulgated by the Committee under FIRRMA, this definition of “U.S. business” could entail oversight over transactions with much less of a U.S. nexus than is currently the case.

Clarification of “Other Investment” for Investment Fund Investments

FIRRMA clarifies and limits CFIUS’s jurisdiction over investments by U.S.-controlled investment funds that may receive capital contributions from foreign limited partners or the equivalent. Subject to regulations prescribed by the Committee, FIRRMA provides that an indirect investment by a foreign person through an investment fund in a U.S. critical infrastructure, critical technology or personal data business that affords the foreign person (or a designee of the foreign person) membership as a limited partner or equivalent on an advisory board or committee of the fund will not be considered an “other investment” as long as (i) the fund is managed exclusively by a general partner or equivalent that is not a foreign person; (ii) the advisory board does not have the ability to approve, disapprove or otherwise control investment decisions of the fund or decisions made by the general partner or equivalent related to entities in which the fund is invested; (iii) the foreign investor does not otherwise have the ability to control the fund, including the authority to approve, disapprove or otherwise control investment decisions of the fund or decisions made by the general partner or equivalent related to entities in which the fund is invested, or to unilaterally dismiss, prevent the dismissal of, select or determine the compensation of the general partner or equivalent; and (iv) the foreign person does not have access to material nonpublic technical information relating to critical infrastructure or critical technologies in the possession of the U.S. business as a result of its participation on the advisory board or committee.

Accordingly, investments in the types of sensitive businesses identified by FIRRMA by U.S.-controlled investment funds with foreign limited partners will not necessarily be subject to CFIUS review.  These provisions will have potentially significant implications for U.S.-controlled investment funds that receive investments from foreign investors, and both U.S.-controlled funds and foreign investors already invested or who are seeking to invest in such funds will need to understand and consider the implications of these rules with respect to fund governance and other limited partner rights afforded to foreign investors.

Although the clarification of how to treat indirect investment through U.S. investment funds was included to clarify the circumstances in which a limited partner’s governance or other rights in a U.S.-controlled fund could give rise to jurisdiction as an “other investment,” it is not unreasonable to expect that CFIUS may use such indicia by analogy in considering whether investment by a foreign-controlled investment fund whose general partner is located in one foreign country poses a greater threat because of foreign limited partners from one or more other foreign countries than if such limited partners had no such rights. For example, in assessing the potential threat posed by an investment by an investment fund with a general partner located in the United Kingdom or Canada (which would be jurisdictionally covered as a transaction that gives a foreign person control of a U.S. business), CFIUS might apply the four criteria in assessing the significance and potential threats posed by Chinese limited partners in that fund.

Effectiveness of Jurisdictional Expansions

The jurisdictional expansions discussed above are not immediately effective. According to the U.S. Department of Treasury’s FIRRMA FAQs, CFIUS will provide further guidance as to the timing for the effectiveness of these provisions. FIRRMA also authorizes CFIUS to conduct pilot programs to implement any provisions of FIRRMA that are not immediately effective.  The FIRRMA FAQs indicate that the scope and procedures of any such pilot program will be published in the Federal Register.  Although FIRRMA’s jurisdictional expansions will take effect only upon the Committee’s issuance of regulations or the implementation of one or more pilot programs, as a matter of prudence, parties should evaluate potential transactions under the expanded jurisdictional provisions.

Process Reforms

Additional Time for CFIUS Review

Under the prior version of the statute, the CFIUS review process consisted of a 30-day review period, potentially followed by a 45-day investigation period.  Although parties to a transaction may in certain cases withdraw and refile the notice at the end of the investigation period, and thus start a new sequence of review and investigation periods, the core CFIUS review process under the old statute lasted for up to 75 days.

FIRRMA extends the initial review period to 45 days and authorizes CFIUS to extend the subsequent investigation period by an additional 15 days in “extraordinary circumstances,” to be defined by CFIUS regulations. With these modifications, the core CFIUS review process has been extended to 90 days, and the CFIUS review process could take as long as 105 days before taking account for any time related to the pre-filing process and before accounting for any withdrawals and resubmissions of the written notice.

Timing for Review of Draft Filings and Acceptance of Filings

FIRRMA requires that CFIUS provide comments on draft notices submitted by the parties to a transaction in advance of a formal filing within 10 business days, and further requires CFIUS to accept formal filings — and thus start the review period “clock” — within 10 business days following submission. If CFIUS determines that the submission is incomplete, it must explain to the parties why the filing is incomplete. In order for the 10-day deadlines to apply, the parties must stipulate that the transaction is a “covered transaction” subject to CFIUS jurisdiction.

Declarations and Mandatory Declarations

FIRRMA establishes a new form of “light” filing, called a “declaration,” that contains basic information regarding the transaction and generally would  not exceed five pages in length. FIRRMA directs CFIUS to prescribe regulations establishing specific requirements for declarations, and the provisions relating to declarations are not yet effective.

FIRRMA provides that, upon receiving a declaration, CFIUS may request that the parties to the transaction file a written notice, initiate a unilateral review of the transaction, notify the parties in writing that the Committee has completed all action with respect to the transaction or inform the parties that the Committee is unable to complete action with respect to the transaction on the basis of the declaration alone and invite the parties to the transaction to file a written notice with complete responses to all the items that CFIUS expects to be included in a filing. FIRRMA requires the Committee to take action in respect of a declaration within 30 days following receipt. 

FIRRMA provides that a declaration (or, at the election of the parties, a written notice in lieu of a mandatory declaration) is mandatory in respect of certain transactions that would result in the direct or indirect acquisition of a substantial interest in a United States business by a foreign person in which a foreign government has a direct or indirect substantial interest. The transactions at issue include those that involve investment in a U.S. business that is the target of the “other investment” provision described above – U.S. businesses in critical infrastructure, critical technology or with personal data of U.S. citizens that may be exploited in a manner that threatens national security.  FIRRMA authorizes CFIUS to identify through regulations other categories of transactions that involve critical technologies (but not critical infrastructure or sensitive data on U.S. citizens) beyond those that involve a substantial interest in a United States business by a foreign person in which a foreign government has a direct or indirect substantial interest for which declarations will be mandatory.

For purposes of the mandatory declaration, the term “substantial interest” will be defined by CFIUS regulations. In developing those regulations, the Committee is required to consider the means by which a foreign government could influence the actions of the foreign person, including through board membership, ownership interest or shareholder rights. However, FIRRMA specifies that an interest that is excluded from the term “other investment” or that is less than a 10-percent voting interest will not be considered a “substantial interest.” Mandatory declarations also will not be required for investment funds that are structured consistent with the clarification of “other investment” in the investment fund context, as discussed above. FIRRMA also authorizes CFIUS to waive, with respect to a foreign person, the requirement to submit a mandatory declaration if the Committee determines that the foreign person has demonstrated that the investments of the foreign person are not directed by a foreign government and that the foreign person has a history of cooperation with the Committee. This waiver provision could potentially benefit government-sponsored pension funds that have a long history of investment in the United States. 

Under FIRRMA, CFIUS may not require mandatory declarations to be submitted more than 45 days before the completion of the transaction, and FIRRMA provides CFIUS with authority to impose civil penalties on any party that fails to comply with a mandatory declaration requirement.  CFIUS may not request or recommend that a mandatory declaration be withdrawn and refiled, except to permit the parties to correct material errors or omissions.  This means that CFIUS will have to make the decision to do one of the following: (1) request that the parties to the transaction file a written notice; (2) initiate a unilateral review of the transaction; (3) notify the parties in writing that the Committee has completed all action with respect to the transaction; or (4) inform the parties that the Committee is unable to complete action with respect to the transaction on the basis of the declaration alone and invite the parties to the transaction to file a written notice with complete responses to all of the items that CFIUS expects to be included in a filing.  CFIUS is required to make such decision within 30 days after it receives a mandatory declaration, but if CFIUS decides that a written notice is necessary, then a full review and investigation period could be required.

Filing Fee

Under the prior version of the statute, there was no filing fee associated with any notification to CFIUS. FIRRMA authorizes CFIUS to impose a fee of no more than one percent of the value of the transaction or $300,000 (adjusted annually for inflation pursuant to regulations prescribed by the Committee), whichever is less.  CFIUS has not yet taken steps to impose this fee, and will do so by regulation at a later date.

In addition, FIRRMA establishes a fund to be administered by the CFIUS chairperson and authorizes $20 million in appropriations to this fund for each of fiscal years 2019 through 2023 to enable the Committee to perform its functions.

Implications

Parties will need to consider carefully both the statutory and regulatory definitions and examples of key terms such as “critical technology,” “critical infrastructure,” “sensitive personal data” and “U.S. business” to determine whether the nature of the U.S. business brings any particular transaction within CFIUS’s purview. Real estate transactions that previously were not subject to CFIUS review because they did not involve a U.S. business will potentially be subject to CFIUS jurisdiction. Parties to transactions will need to analyze whether a foreign government has a “substantial interest” in any foreign party to the transaction, as well as whether that foreign party is acquiring a substantial interest in a U.S. business involved in one of the specified categories, to determine whether a declaration of the transaction to CFIUS is mandatory.

Investment fund managers will need to consider carefully the implications of the structure of their funds and the rights given to foreign limited partners.  U.S.-based investment fund managers that provide governance and informational rights to foreign limited partners will need to be aware that those rights may give rise to CFIUS jurisdiction in respect of the fund’s investments, so that any acquisition by that fund of U.S. businesses involved in critical infrastructure, critical technology or personal data of U.S. citizens could potentially be subject to CFIUS jurisdiction.  Foreign-based investment fund managers will also need to consider the rights they give to limited partners located in foreign countries that are generally deemed to present greater national security threats, such as China, because those rights could affect how CFIUS views the potential threat posed by a proposed acquisition by that investment fund.

Certain provisions, such as the introduction of declarations as a form of “light” filing or the specification of a time period during which CFIUS must comment on draft notices or accept certain formal notices, may serve to reduce the length of the CFIUS review process for parties to certain transactions. However, FIRRMA’s extension of the initial review period to 45 days and introduction of the possibility that parties’ submission of a declaration may be followed by a request from the Committee for a full notice filing means that in other cases parties will certainly face a longer review process than they would have under prior law.

In addition, since FIRRMA leaves many details to be prescribed by Committee regulations, the full implications of the CFIUS reform affected by FIRRMA will not be known for many months.  However, parties will have substantial opportunities to engage with the Committee throughout the rulemaking process and to provide the Committee with valuable insight into essential aspects of transactions involving foreign investment in the United States.

The law regarding sandbagging (which refers to a buyer that brings a claim for misrepresentation post-closing even though the buyer knew the representation was false before closing)[1] in Delaware seemed clear to many practitioners. Vice Chancellor Laster stated in a 2015 oral ruling that “Delaware is what is affectionately known as a ‘sandbagging’ state.”[2] In addition, then-Vice Chancellor Strine held that a buyer need not establish justifiable reliance in order to bring a breach of contract claim arising out of an acquisition agreement,[3] and given that the reliance element is what creates a problem for a buyer attempting to sandbag, this decision is often interpreted as a pro-sandbagging holding. Additionally, the 2017 ABA Deal Point study seems to confirm that practitioners have this view by finding that 51 percent of deals were silent on the point.[4] After all, many buyers reason that if Delaware is a pro-sandbagging state, why use negotiating capital to get a clause that is unnecessary?

However, this approach is dangerous after the May 24, 2018 Delaware Supreme Court’s decision in Eagle Force Holdings, LLC v. Stanley Campbell.[5] In a footnote, the majority opinion explained that there is a debate about whether a buyer can recover for a breach-of-warranty claim when the buyer knew at signing that the representation was not true. Although the majority observed that most states follow New York’s CBS Inc. v. Ziff-Davis Publishing Co.[6] (which held that traditional reliance is not required, and that the only “reliance” required is that the express warranty is part of the bargain of the parties), the majority did not decide this “interesting issue” because the claims were not before the court. Similarly, the dissent did not determine how this issue should be decided but emphasized Delaware’s anti-sandbagging jurisprudence.[7]

How Did Delaware Law Get Here?

To understand why the law is unclear on the sandbagging issue, it is helpful to discuss the path of the law. Early on, courts did not consider mere representations to be promises. Consequently, a buyer could not sue a seller for a breach of representation in a contract dispute because the representation was effectively not part of the contract. [8] To provide a buyer relief for being lied to, however, courts allowed the buyer to make a tort claim for misrepresentation, and one element of such a claim is reliance. Thus, under the traditional tort-based framework, a buyer must prove that it relied on the misrepresentation. Under the modern view, however, representations are actionable under contract law, and given that reliance is not part of contract law, the buyer need not show reliance.[9] It is this history of the importation of tort law to fill a gap in contract law (which gap, by the way, no longer exists) that has created uncertainty.

As a side note, this history of tort law and contract law is part of the reason acquisition agreements refer to “representations and warranties.” The representation refers to a tort concept and the warranty to a contract concept. As the debate about these near synonyms has been discussed in prior years in this publication, we will not relitigate the issue.[10]

Returning back to Delaware sandbagging case law, in the 1910s the Delaware Superior Court held that reliance was a necessary requirement of a breach-of-warranty claim.[11] This was reaffirmed in 2002.[12] However, in 2005, the Superior Court shifted and held that reliance was not an element of a claim for breach.[13] Shortly thereafter, the Chancery Court came out in favor of sandbagging in the often-cited Cobalt Operating, LLC v. James Crystal Enterprises case.[14] This is one of the cases mentioned in the introduction, but the Cobalt case might not be as strong as it first appears because the contract in Cobalt contained a clause that representations would not be affected by due diligence, and the court found that the Cobalt defendant intentionally obscured its fraud and gave misleading explanations when the plaintiff inquired about inconsistencies that arose in due diligence. These two facts can make it easy for a court to distinguish the case, and in fact, Delaware courts continued to have decisions that were inconsistent regarding sandbagging. The Delaware Supreme Court had not ruled on this issue[15]—that is, until the dicta comments in Eagle Force.

Conclusion

Although the majority and dissent in Eagle Force leave some clues as to how they might rule on the sandbagging issue, it is not productive to speculate about the outcome. Instead, buyers are best advised to include a pro-sandbagging clause (which is commonly referred to as a knowledge savings clause) in the purchase agreement. The following is an example of such a clause:

The post-Closing indemnification rights of the parties pursuant to Article [●] (Indemnification) shall not be affected by any waiver of condition set forth in Article [●] (Conditions to Closing) or any knowledge, obtained from any source at or before the execution hereof or at or before the Closing, of any breach of representation, warranty, covenant or agreement, and the parties shall be deemed to have reasonably relied upon the representation, warranty, covenant and agreement notwithstanding such knowledge.

Eagle Force has put buyers on notice that they might need to update their approach to sandbagging. To be silent is to leave the matter ambiguous.

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content herein does not reflect the views of Sidley Austin LLP.

[1]              The term “sandbagging” dates back to the 19th century when street gangs would craft a homemade weapon by pouring sand into socks. Although the sock looked innocuous enough, when swung at an enemy, the concealed lump of sand could inflict substantial damage. The term has evolved to represent concealing or misrepresenting with the purpose of deceiving another. See Glenn West & Kim Shah, Debunking the Myth of the Sandbagging Buyer, M&A Lawyer, Jan. 2007, at 3.

[2]              See NASDI Holdings v. North Am. Leasing, No. 10540-VCL, slip op. at 57 (Del. Ch. Oct. 23, 2015).

[3]              See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff’d without op., 945 A.2d 594 (Del. 2008).

[4]              See ABA M&A Mkt. Trends Subcomm., Private Target Mergers & Acquisitions Deal Points Study 66 (Jessica C. Pearlman ed., 2017).

[5]              See Eagle Force Holdings, LLC v. Campbell, C.A. No. 10803-VCMR at 47, n.185 (Del. May 24, 2018).

[6]              See CBS Inc. v. Ziff-Davis Publ’g Co., 553 N.E.2d 997 (N.Y. 1990). It is interesting that the majority opinion did not did not discuss the subsequent case law that has significantly narrowed Ziff-Davis’s impact.

[7]              See Eagle Force, No. 10803-VCMR at 10 (Strine, J. & Vaughn, J., dissenting) (“[T]o the extent Kay is seeking damages because Campbell supposedly made promises that were false, there is doubt that he can turn around and sue because what he knew to be false remained so. Venerable Delaware law casts doubt on Kay’s ability to do so . . . .”).

[8]              See West & Shah, supra note 2, at 4–5.

[9]              See Charles K. Whitehead, Sandbagging: Default Rules and Acquisition Agreements, Del. J. Corp. L. 1081, 1084–86.

[10]             See Kenneth A. Adams, A lesson in drafting contracts: What’s up with “representations and warranties”?, Bus. L. Today, Nov.-Dec. 2005; Tina L. Stark, Nonbinding Opinion: Another view on reps and warranties, Bus. L. Today, Jan.–Feb. 2006. Interestingly, the footnote in the majority opinion in Eagle Force cites to Professor Stark’s article (but for a different proposition).

[11]             See Clough v. Cook, 87 A. 1017, 1018 (Del. Ch. 1913); Loper v. Lingo, 97 A. 585, 586 (Del. Super. Ct. 1916). The dissent in Eagle Force cited the Clough case for the proposition that a party who signs a contract with knowledge that a representation is false may not later claim reliance on it. See Eagle Force, No. 10803-VCMR at 10 n.39 (Strine, J. & Vaughn, J., dissenting).

[12]             See Kelly v. McKesson HBOC, Inc., 2002 WL 88939, at *8 (Del. Super. Ct. Jan. 17, 2002) (“According to sound Delaware law, a plaintiff must establish reliance as a prerequisite for a breach of warranty claim.”).

[13]             See Interim Healthcare, Inc. v. Spherion Corp., 884 A.2d 513, 548 (Del. Super. Ct. 2005). The court also noted that “the extent or quality of plaintiffs’ due diligence is not relevant to the determination of whether [defendant] breached its representations and warranties in the Agreement. . . . [P]laintiffs were entitled to rely upon the accuracy of the representation irregardless [sic] of what their due diligence may have or should have revealed.” Id.

[14]             See Cobalt Operating, LLC v. James Crystal Enters., LLC, 2007 WL 2142926, at *28 (Del. Ch. July 20, 2007), aff’d without op., 945 A.2d 594 (Del. 2008).

[15]             The Delaware Supreme Court did affirm Cobalt, but it did so without a written opinion. James Crystal Enters. v. Cobalt Operating, LLC, 945 A.2d 594 (Del. 2008).

In Janus v. AFSCME Council 31, 138 S. Ct. 2448 (2018), the United States Supreme Court recently held that legislation requiring public-sector employees in units represented by public-sector unions to pay “fair share fees” (sometimes referred to as “agency fees”) violates the First Amendment because it compels individuals to subsidize the speech of other private parties. Writing for the majority, Justice Samuel Alito stated, “Neither an agency fee nor any other payment to the union may be deducted from a nonmember’s wages, nor may any other attempt be made to collect such a payment, unless the employee affirmatively consents to pay [the union].” The immediate impact of Janus is that public-sector employees cannot be required to pay for any union activity without their clear and affirmative consent. This article explores the practical considerations of Janus and provides a framework for public employers to follow prospectively.

Life Before Janus

Janus’s roots date back to the Court’s 1977 decision in Abood v. Detroit Board of Education, 97 S. Ct. 1782 (1977), which evaluated the legality of a Michigan statute permitting unions and public-sector employers to agree to an “agency shop” arrangement. In an agency shop, the union is designated as the exclusive representative of all the unit employees, even those who do not join. Individuals who opt out of membership are still required to pay a service fee to the union. The Abood Court held that the payment of some fee by nonmembers was necessary to maintain labor peace as envisioned by federal labor laws and to avoid the risk of “free riders”—employees receiving the benefit of union protections at the expense of dues-paying members. On the other hand, the Abood Court recognized that the First Amendment prohibits the government from forcing contributions for political purposes. The resulting compromise was the so-called fair share fee—a percentage of union dues calculated by subtracting any portion the union expends on political or ideological activities from what the union allocates toward negotiating terms of employment on behalf of employees. Some viewed this percentage as difficult to quantify, and it left a significant gray area as to what exactly qualified as representation versus political/ideological activities. (Since 1977, the Supreme Court had tiptoed around the continuing validity of Abood. In 2012, in Knox v. SEIU, 132 S. Ct. 2277 (2012), Justice Alito noted in dicta that the constitutional justification for public-sector agency fees was “something of an anomaly.” Two years later, in Harris v. Quinn, 134 S. Ct. 2618 (2014), Justice Alito again criticized Abood.)

The Janus Decision

Mark Janus, a child-support specialist for the Illinois Department of Healthcare and Family Services, refused to join the AFSCME Council because he opposed the union’s public-policy positions as well as its stance toward collective bargaining which, in his view, did not recognize Illinois’ fiscal crises. Nevertheless, as permitted by Abood, the AFSCME Council required Janus to pay a fair share fee to the union—over 70 percent of total membership dues. As a result, Janus filed a complaint to challenge the constitutionality of such fees.

When the case reached the Supreme Court, the majority ruled that the First Amendment protected Janus from being mandated to pay such fees, effectively overruling Abood. The Court explained that Abood was based on the faulty assumption that “designation of a union as the exclusive representative of all the employees in a unit and the exaction of agency fees are inextricably linked[.]” Janus, 138 S. Ct. at 2465. In the end, the majority found fair share fees to be unconstitutional because they compel nonmembers to subsidize private speech on matters of substantial public concern.

Janus’s Impact

Practically, public-sector unions across the country anticipate that a significant number of nonmembers will cease their financial support and that current members may resign their membership to take advantage of newly discovered disposable income. To counteract such defections, unions representing public-sector employees are likely to invest in campaigns designed to educate both members and nonmembers about the value of union representation and the negative implications of a free-rider system. The efficacy of these campaigns in light of Janus is an open question.

Several states with high percentages of union density (especially in the public sector) anticipated the outcome in Janus and proactively adopted legislation. For example, in New York and New Jersey, new legislation gives unions access to new employees’ personal contact information. These states also allow unions the right to meet with new hires during work hours. Further, the New York legislation makes clear that unions cannot be forced to provide full membership benefits to nonmembers. In California, Governor Brown signed Senate Bill 866 regulating how public employers and unions manage membership dues and fees, and how public employers communicate with employees about their rights relating to union membership. Specifically, the California law requires public employers to refer employees with questions or requests concerning fees or dues to the union. It also mandates that dues or fees be deducted from payroll once the union notifies the employer of an employee’s valid authorization.

Other states may consider a more tailored alternative to agency fees, which would prevent free ridership while imposing a lesser burden on First Amendment rights. (See, e.g., Cal. Govt. Code Ann. § 3546.3 (West 2010); cf. Ill. Comp. Stat., ch. 5, § 315/6(g) (2016). These California and Illinois statutes allow public employees with religious objections to opt out of agency fees while permitting the union to charge those employees for particular services.) Such laws could provide that, if an employee with an objection to paying an agency fee “requests the [union] to use the grievance procedure or arbitration procedure on the employee’s behalf, the [union] is authorized to charge the employee for the reasonable cost of using such procedure.” Janus, 138 S. Ct. at 2469, n.6.

Practical Guidance

The Janus mandate is clear: public-sector unions cannot demand fair share fees, and public-sector employers cannot collect such fees absent clear and affirmative consent. However, the practical impact of Janus raises a myriad of questions that public employers must address now. For example, how should employers communicate the impact of Janus to employees? What type of consent is required to withhold dues or fees from employees? Can a public employer seek indemnity from the union for any claims made by employees as a result of the payroll deductions? Is there a duty to bargain over the impact of Janus? How these questions are answered will vary by locality.

Public employers may wish to affirmatively communicate with employees about the impact of Janus. However, before doing so, public employers should become familiar with recently enacted legislation that may govern such communications. For example, the California law discussed above places restrictions on “mass communications” to employees. Any mass communication sent to employees or applicants concerning their rights to join or support an employee organization, or refrain from joining or supporting an employee organization, require the employer to meet and confer with the union.

In order to prepare for a possible influx of employees seeking to cease financially supporting a union, public employers should also review applicable collective bargaining agreements and dues authorization forms on file. If such authorizations exist, employers may wish to question whether the authorizations are “clear and affirmative” as required by Janus, 138 S. Ct. at 2486. If authorizations are missing, employers may consider reaching out to the union to verify that a valid authorization exists, but again, state statutes may be implicated when an employer seeks to verify dues authorization information. For example, under the new California law, a public employer must rely on the information provided by the union concerning such authorizations. As a counterbalance, California public-sector unions must indemnify the employer for any claims made by employees that payroll deductions were improperly made. Similar indemnity legislation may follow in other states.

Since agency fee provisions are but one part of an overall collective bargaining agreement, public employers must carefully review such agreements for any contract language that requires agency (or service fee) deductions because Janus now renders such language unlawful. This issue is further complicated if the applicable collective bargaining agreement does not contain a severability clause. Additionally, depending upon the jurisdiction, unions may seek to negotiate over the “impact” of Janus. Many states’ public-sector labor laws require “impact bargaining,” referring to negotiations over the impact of management rights decisions on union employees. However, public employers may argue that negotiations are not required because this issue does not directly relate to employees’ terms and conditions of employment but rather is an intra-union matter.

Conclusion

Although the full impact of the Janus decision will play out over the course of years, public employers must grapple with the immediate impact of Janus and resulting legislation today. These practical considerations are intended to serve as a general guide to public employers to minimize disruption in the workplace during the post-Janus transition.

On August 17, 2018, the SEC adopted final amendments relating to an ambitious housekeeping effort, “Disclosure Update and Simplification,” a component of the SEC’s disclosure effectiveness project. The final amendments address certain disclosure requirements that have become redundant, duplicative, overlapping, outdated, or superseded in light of other SEC disclosure requirements, US GAAP or “changes in the information environment.” The “demonstration version” of the final amendments provides a blacklined version displaying the changes. The final rules become effective 30 days after publication in the Federal Register, and the staff has indicated that it will review the impact of the amendments within five years thereafter.

The final amendments eliminate entirely a number of provisions that are completely duplicative, as well as a variety of references to obsolete terms such as “pooling-of-interests accounting” and “extraordinary items.” In another nod to modernity, the SEC removed the requirement to identify the SEC’s Public Reference Room and disclose its physical location and phone number; instead, the SEC will retain the requirement to disclose the SEC’s internet address and require all issuers to disclose their internet addresses if they have one. SEC disclosure requirements that overlap with GAAP, IFRS, or other SEC disclosure requirements have, in some instances, been deleted and, in other instances, where the requirement involved incremental material information, been integrated into other requirements. In some cases where the disclosure requirements overlap with GAAP but require material incremental information, the SEC retained the requirement, but referred the items to FASB for potential incorporation into GAAP in the future.

For the most part, the changes are not particularly earth-shaking; however, where the amendments result in relocation of disclosure into the financial statements, the effect can be burdensome in that it subjects the new disclosure to audit or interim review and audit of internal control over financial reporting, which could create potential verification and auditability issues. In addition, XBRL tagging requirements apply to information in the financial statements. Moreover, because the safe harbor for forward-looking information under the Private Securities Litigation Reform Act of 1995 does not apply to financial statements, potential liability concerns are introduced. In this regard, relocation of disclosure into the financial statements, together with the absence of the PSLRA safe harbor protection, may make issuers warier about supplementing required disclosures in the financial statements with forward-looking information. However, the SEC noted that it did not adopt any requirements to disclose forward-looking information in the financial statements, and further observed that issuers retain the option of providing forward-looking information outside of the financial statements (and, in some cases, are required to provide that information). Of course, relocating disclosures outside the financial statements will have the opposite effect, no longer subjecting the information to requirements for audit, review, or XBRL and providing the potential for PSLRA protection. Other changes may simply affect the relative prominence of the disclosure or impose or remove a bright-line disclosure threshold.

Some Notable Changes

To convey the flavor of the changes, below are selected changes affecting Regulation S-K. Note, however, that many of the changes effected by the amendments relate to Regulation S-X and the financial statements.

Item 101—Description of Business

Segments and geographic information. In light of existing GAAP and Item 303(b) disclosure requirements, the amendments eliminate the mandates in Item 101 to provide segment financial information and financial information by geographic area. The current rule explicitly permits issuers to avoid duplication by cross-referencing to the applicable notes to the financial statements, and that is how most companies have historically addressed this requirement. Now, companies will not have to bother with that cross-reference.

Foreign operations. Similarly, the SEC eliminated the requirements to disclose under Item 101 material risks associated with an issuer’s foreign operations and any segment’s dependence on foreign operations. Those matters, the SEC concluded, are more appropriately disclosed under “Risk Factors” and, where appropriate, in MD&A. To make that point explicit, the SEC has added a specific reference to “geographic areas” to the MD&A requirement to disclose trends and uncertainties by segment.

R&D. Similarly, because the information is comparable to information already required by GAAP, the SEC has eliminated the mandate to disclose under Item 101 the amount spent on R&D activities for all years presented.

Major customers; product revenue. However, the SEC elected to retain some of the overlapping provisions that require disclosure of information incremental to GAAP and to instead refer them to FASB for potential incorporation into GAAP. For example, both GAAP and Item 101 require disclosures about major customers: Regulation S-K requires disclosure if loss of one or a few customers would have a material adverse effect on a segment, while GAAP requires certain disclosures for each customer that accounts for 10 percent or more of total revenue. In addition, Regulation S-K requires disclosure of the name of any customer that represents 10 percent or more of revenues and the loss of which would have a material adverse effect, while  GAAP does not. Similarly, both GAAP and Regulation S-K require disclosure regarding revenue from products and services; however, the Regulation S-K mandate has a 10-percent threshold, while GAAP requires disclosure for each product or service, or group of similar products and services, unless impracticable. Depending on FASB’s decision regarding integration of this information into the applicable GAAP requirement, modifications could result in PSLRA safe harbor and other financial statement disclosure issues, as well as issues arising out of the elimination or inclusion of bright-line disclosure thresholds.

Item 201—Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters

Market prices. The SEC has updated the market price disclosure requirements: instead of requiring disclosure of the high and low sales prices and sales price as of the latest practicable date—which are readily available for free on numerous websites on a daily basis and likely more up to date—Item 201(a)(1) is amended to eliminate the detailed disclosure requirement to provide sale or bid prices for most issuers with common equity traded in an established public trading market and replaced with disclosure of the trading symbol. More specifically:

• Issuers with one or more classes of common equity will be required to identify the principal S. markets where each class is traded and the corresponding trading symbols used by the markets for each class of common equity. Foreign issuers will also be required to identify the principal foreign public trading markets, if any, and the trading symbols, for each class of their common equity.
• Issuers with common equity that is not traded on an exchange will be required to indicate, as applicable, that any over-the-counter market quotations in these trading systems reflect inter-dealer prices without retail mark- up, mark-down, or commission and may not necessarily represent actual
• Issuers with no class of common equity traded in an established public trading market will be required to state that fact and disclose the range of high and low bid information, if applicable, for each full quarter within the last two fiscal years and any subsequent interim In addition, these issuers must disclose the source and explain the nature of the quotations.

Dividends. The amendments also streamline the various redundant and overlapping requirements in Regulations S-X and S-K to discuss dividends. The SEC is eliminating the requirement in Item 201 to disclose restrictions that currently or are likely to materially limit the company’s ability to pay dividends on its common equity; instead, companies will be required to provide disclosure of material restrictions on dividends only in the notes to the financial statements under Regulation S-X. Likewise, the amendments eliminate the requirement in Item 201 to disclose the frequency and amount of cash dividends declared for the two most recent fiscal years and any subsequent interim period; rather, the amendments will mandate that Rule 3-04 of Regulation S-X, which currently requires financial statement disclosure of the amount of dividends per share and in the aggregate, be applied to interim periods.

Convertible/exercisable securities. In light of the broader GAAP requirement to disclose the terms of significant contracts to issue additional shares and other reasonably similar information, the SEC has eliminated the Item 201 requirement to disclose on Form S-1 or Form 10 the amount of common equity subject to outstanding options, warrants, or convertible securities when the class of common equity has no established U.S. public trading market.

Equity compensation plan table. Another overlapping provision that was proposed to be eliminated is instead being retained and referred to FASB for potential incorporation into GAAP: the SEC decided not to eliminate the mandate in Item 201(d) to provide tabular disclosure regarding existing equity compensation plans approved and not approved by shareholders. This information is currently required in a number of different forms, including Forms 10-K and proxy statements. In the proposal, the SEC had suggested elimination of the provision because it overlapped with a similar GAAP requirement and because the SEC believed that drawing the distinction between plans approved and not approved by shareholders was no longer useful to investors because the major exchanges now require, with limited exceptions, plan approvals by shareholders. However, relocating the disclosure to the financial statement notes would raise potential liability issues in the absence of PSLRA protection and would mean that the disclosure would no longer appear alongside information about equity compensation plans subject to shareholder action. At the end of the day, the SEC decided to retain and refer to FASB the overlapping requirement, recognizing the concerns expressed by commenters that GAAP does not explicitly require certain information that could be material to investors, such as the formula for calculating the number of securities available for issuance under the applicable plan. Note, however, that, although the final rules currently retain Item 201(d), referring it to FASB, they surprisingly still eliminate the provisions in Schedule 14A (proxy statements) and Form 10-K that currently mandate the inclusion of Item 201(d) disclosure in those documents. As a result, although item 201(d) disclosure would continue to be required in Form S-1 and Form 10, unless the staff indicates otherwise, under the new amendments, Item 201(d) disclosure would not be required in proxy statements or Forms 10-K. In informal discussions with the staff, we have been advised that the staff is aware of the issue and is considering it.

Item 303—Management’s Discussion and Analysis of Financial Condition and Results of Operations

Seasonality. The amendments eliminate Instruction 5 to Item 303(b) regarding seasonality because it required disclosures that convey reasonably similar information to that required under GAAP and the remainder of Item 303.

Item 503—Prospectus Summary, Risk Factors, and Ratio of Earnings to Fixed Charges

Ratio of earnings to fixed charges. The amendments eliminate the requirement in Item 503(d) to disclose the historical and pro forma ratio of earnings to fixed charges (and ratio of combined fixed charges and preference dividends to earnings) in connection with the registration of debt securities and preference equity securities. The SEC observed that now a “variety of analytical tools are available to investors that may accomplish a similar objective as the ratio of earnings to fixed charges.” In addition, the SEC noted, debt investors often negotiate covenants requiring issuers to provide more relevant financial information.

Item 601—Exhibits

Earnings per share. The final amendments eliminate Item 601(b)(11), which requires a statement showing the calculation of per-share earnings (unless the computation can be determined from information already in the report) in annual filings. According to the SEC, that requirement is duplicative of information required under GAAP, Regulation S-X, and IFRS.

Ratio of earnings to fixed charges. In connection with the elimination of Item 503(d), the related Item 601(b)(12) exhibit filing requirement has been eliminated.

Reports to shareholders. Various reports to security holders, required to be filed as exhibits under Items 601(b)(19) and (22), are also eliminated in light of, in the former case, other exhibit provisions or, in the latter case, the requirement to disclose shareholder voting results in a Form 8- K.

On the Horizon

With regard to those incremental disclosure requirements that were referred to FASB for consideration of whether they should be incorporated into GAAP, the SEC requested that FASB determine whether to add these items to its agenda within 18 months after publication of the adopting release in the Federal Register. In a statement to Bloomberg BNA, FASB indicated that it was “reviewing the SEC’s recommendations, and that board members will discuss the request at an upcoming public meeting.” Accordingly, depending on the position ultimately taken by FASB, financial reporting requirements could become more burdensome for all companies—and especially for smaller reporting companies—if FASB determines to incorporate these incremental disclosures into GAAP.

In addition, the SEC indicated that it planned to continue to study the question of the potential integration of the mandate under GAAP to disclose loss contingencies and the requirement under Item 103 of Regulation S-K to disclose certain legal proceedings, which are one type of loss contingency. Item 103 includes a bright line disclosure threshold in some cases of 10 percent of the issuer’s consolidated current assets, while GAAP provides a more general materiality threshold. However, the overlap has historically led many companies to either repeat the disclosures or cross-reference to them. In the proposing release, the SEC had considered referring the issue to FASB for potential incorporation into GAAP. As described by the SEC in the proposing release, incorporation of Item 103 requirements into GAAP would result in more instances of disclosure of the possible range of loss; more disclosure that is subject to audit or review, internal control, and XBRL requirements; more disclosure of prescribed facts (such as the court or agency, the date instituted, the principal parties involved, the alleged factual basis of the proceeding, and the relief sought); and a more general materiality threshold in connection with environmental legal proceedings (instead of the bright-line thresholds in Regulation S-K). It would also give rise to PSLRA safe-harbor protection issues and other financial statement concerns. The SEC observed in the adopting release that many commenters opposed the integration on a variety of bases, including the possible need to revisit the ABA policy statement regarding lawyers’ responses to auditors’ requests for information. Some commenters supported the integration, noting the repetition in many filings, and some recommended that the SEC conduct more analysis and outreach. Ultimately, the SEC apparently took that advice and determined to retain the current requirements and study the issue further.

Recently, the Securities and Exchange Commission (SEC) adopted amendments to the smaller reporting company (SRC) definition to increase the thresholds for eligibility and to adopt certain other changes. Under the new SRC definition, a company with less than $250 million of public float will be eligible to provide scaled disclosures. Companies with less than $100 million in annual revenues and either no public float or a public float that is less than $700 million will also be eligible to provide scaled disclosures. The SEC made no revisions to the actual scaled disclosure requirements available to SRCs. The revised SRC qualification rules are effective on September 10, 2018. 

What Is An SRC and What Did the SEC Change?

The SEC historically has recognized that a single-size regulatory structure for public companies does not fit all. As a result, the SEC has adopted a number of rules that, in effect, have created a graduated disclosure regime for public companies from accelerated filing requirements for larger companies to reduced disclosure requirements for emerging growth companies and SRCs. The SEC expects about 1,000 companies to qualify as an SRC as a result of the revised definition and to possibly take advantage of the new rule changes. Do you represent companies eligible to take advantage of these new changes, and if so should they take advantage of these new changes? What occurs if a company is initially not eligible, but becomes eligible at a later time? What exactly is “scaled disclosure,” and with which of the many SEC rules does a SRC need not comply? This article explores these and other related topics. 

The SEC’s new thresholds for determining SRC status are based on (1) having a public float of $250 million, or (2) a revenue test which also includes a public float component. Once a company determines that it qualifies as an SRC, it will remain an SRC until it exceeds the initial qualification thresholds. The new rules provide three paths to becoming an SRC: one for companies doing an initial public offering and two for existing public companies—a transition rule for this year using the IPO thresholds and, for companies that failed to meet the initial thresholds, the ability to become an SRC if it meets lower revenue and market cap thresholds. 

Initial Qualification 

The following table summarizes the amendments to the SRC thresholds for companies making an initial determination under the revised rules, or a current SRC confirming its continued compliance. A company must meet only one of the two thresholds. 

What If a Company Is Already Public?

Transition Rule for Existing Public Companies 

For the first fiscal year after September 10, 2018, existing public companies may qualify by applying the new initial qualification thresholds (summarized above) rather than the lower, subsequent qualification thresholds (summarized below). A calendar year company will test its status based on its revenues for the year ended December 31, 2017, and its public float as of June 29, 2018. 

What If a Company Is Initially Not Eligible, But Becomes Eligible At a Later Time?

Subsequent Qualification 

If a public company determines that it does not qualify for SRC status because it met neither of the foregoing thresholds, it will remain unqualified unless, when making a subsequent annual determination, it meets one or more lower qualification thresholds. The subsequent qualification thresholds, set forth in the table below, are set at 80 percent of the initial qualification thresholds. Stated differently, this test is for issuers that are currently required to file reports under sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. 

The SEC provided the following example in its guidance: 

Example: A company has a December 31 fiscal year end. Its public float as of June 28, 2019 was $710 million and its annual revenues for the fiscal year ended December 31, 2018 were $90 million. It therefore does not qualify as a SRC. At the next determination date (June 30, 2020), it will remain unqualified for SRC status unless it determines that its public float as of June 30, 2020 was less than $560 million and its annual revenues for the fiscal year ended December 31, 2019 remained less than $100 million. 

What Is “Scaled Disclosure” And With Which Of The Many SEC Rules Does An SRC Need Not Comply?

The advantage of being an SRC is that such a company can comply with certain SEC rules and regulations that are less onerous. An SRC can pick and choose between scaled or nonscaled, financial and nonfinancial disclosure requirements on an item-by-item basis. For a side-by-side comparison of the SRC rules and rules applicable to non-SRCs, see Appendix A. 

There are specific rules regarding entering and exiting the SRC reporting regime, and most companies solicit expert advice regarding compliance with such rules. A larger reporting company that determines it qualifies to be an SRC as of the last business day of its most recently completed, second fiscal quarter is permitted to file as an SRC in its quarterly report for such quarter. When a company no longer qualifies as an SRC as of the end of its most recently completed, second fiscal quarter, it can continue to use the scaled disclosure accommodations available to SRCs through its subsequent annual report Form 10-K. The filing deadline for the Form 10-K will be based on the company’s filing status as of the end of the fiscal year covered by the Form 10-K. 

Is It Always Better To Be An SRC?

No. SRCs are subject to additional disclosure requirements with respect to transactions with related persons, promoters, and certain control persons under Regulation S-K, Item 404. However, rather than the $120,000 threshold under Item 404, SRCs are subject to a threshold that is the lesser of $120,000 or one percent of total assets. The resulting disclosure must address the two preceding years. In addition, SRCs are also subject to additional Item 404 disclosure requirements regarding any underwriting compensation received by their corporate parent or any related persons. This Item 404 disclosure is mandatory for all companies qualifying as an SRC, regardless of whether it elects to take advantage of the scaled disclosure accommodations for SRCs. 

Must SRCs File Auditors’ Attestation Reports Under Section 404(B) Of the Sarbanes-Oxley Act I?

Sometimes. Only “nonaccelerated filers” and “emerging-growth companies” are exempt from the requirement to provide an auditors’ attestation report. As a result, it is possible that a company could qualify as an SRC and be eligible to provide scaled disclosure, but at the same time meet the definition as an accelerated filer required to provide an auditors’ attestation report. Note that SEC Chairman Jay Clayton has directed SEC staff to exempt some companies from the Sarbanes-Oxley Act Section 404(b) auditors’ attestation report. 

Pointers:

• Companies that have completed an initial public offering in the last five years will soon lose their emerging growth company eligibility due to the passage of time. Qualifying for SRC status will enable them to take advantage of the scaled disclosure regime. 
• There will be a greater number of companies that qualify as both an SRC and an accelerated filer, and will be required to check both boxes on the cover page. 
• Companies should keep in mind the status of their competitors and whether qualifying as an SRC may negatively impact market perception of the company. Given the complexity of the federal securities laws, it is prudent to consider some of these issues sufficiently in advance. In addition, companies should keep in mind their long-term capital raising plans as the market practices develop. 
• Given the rampant use of stock buy-backs, a company could plan its entry into the SRC regime based on its revenues and public float. 
• It is possible for a company not to have a public float. This could occur if a company does not have any public common equity outstanding, or no market price for its common equity exists. 
• If you are a tech company, or a pre-clinical life sciences company, with no revenue, it is highly likely that you will qualify as an SRC. 

Appendix A 

A recent decision by the Louisiana Court of Appeals considered the effect of the seriatim deaths of several members of an LLC and, ultimately, whether an action for judicial dissolution initiated by a member who subsequently passed away could continue. In this instance, the court found that the action for judicial dissolution of the LLC could continue.  Schauf v Schauf, No. 51, 919-CA, __ So.3d __, 2018 WL 1937068 (La. App. 2d Cir. Apr. 25, 2018).

Angela Schauf organized the Schauf Family LLC in 2001, keeping 50 percent of the ownership for herself and distributing to each of her four children a 12.5-percent interest. Those four children were Peter, Paul, Mary, and Kathryn. Angela and all of the children executed an operating agreement. The LLC’s only asset was farmland that was leased out. Angela passed away, and her interest in the LLC was divided among the four children, resulting in each of them becoming a 25-percent member. Then, each of Peter and Kathryn passed away, leaving their interests in the LLC to their respective spouses, Jo Ann and Michael.

Thereafter, disagreements arose with respect to the LLC, and each of Jo Ann (assignee of Peter) and Michael (assignee of Kathryn), as well as Mary, an original member, sought to dissolve the LLC, sell its assets, and distribute the proceeds. Paul objected to any dissolution and also rejected the proposal that he buy out the other members. Nonetheless, everyone except Paul voted to dissolve the LLC and appoint Jo Ann as its liquidator.

Thereafter, Paul filed suit, asking for a ruling that the appointment of the liquidator and the vote to dissolve the LLC were null and void. Mary then passed away, and a motion was filed to substitute Jo Ann, Mary’s executrix, in the lawsuit. In turn, the trial court granted Paul’s application for summary judgment, in which the vote to liquidate and the appointment of Jo Ann as the LLC’s liquidator was declared void. Conversely, the defendants’ motion for summary judgment was denied on the basis that they had no authority to dissolve the LLC and liquidate its assets. The defendants filed this appeal.

The court’s opinion begins with a review of the status of the estate of a deceased member under the Louisiana LLC Act. Specifically, the estate does not become a member (absent a contrary provision in either the articles or operating agreement).

Thus, an LLC’s articles of organization or a written operating agreement could, but have not in this case, provide that a person who inherits a decedent member’s interest in the LLC would become a member of the LLC or would have certain rights that are provided only to members.

From there, the court offered some observations as to the status of a decedent member’s estate vis-a-vis the LLC, namely:

The rule treating a decedent member’s legal representative as an assignee of the decedent’s interest may be problematic. As an assignee of the decedent member’s interest, the decedent’s legal representative is entitled only to receive distributions from the LLC as authorized by the LLC’s operating agreement or by the members, to share in the LLC’s profits and losses, and to receive allocations of the LLC’s items of income, gain, loss, deduction, and credit. A decedent member’s legal representative may not become a member of the LLC or exercise any of the rights or powers of a member unless the LLC’s articles of organization or a written operating agreement provides otherwise or the legal representative is admitted as a member of the LLC. Thus, the legal representative of a decedent member may not participate in the management of the LLC, vote on the LLC’s affairs, or inspect the LLC’s records unless the LLC’s articles of organization or an operating agreement specifically accords such management rights to the decedent’s legal representative or the legal representative is admitted as a member of the LLC. Without the right to vote or inspect records, a decedent member’s legal representative will have little ability to protect the interests of the decedent’s estate or heirs with respect to the decedent’s interest in the LLC. Id. at *6–*7.

Still, the court noted that an action for judicial dissolution may be brought by any member on the grounds that it “is not reasonably practicable to carry on the business of the LLC in conformity with its articles of organization and operating agreement.” Id. at *3, quoting La. R. S. 12:1335. The court went on to find that Mary had been a member of the LLC at the time the petition for judicial dissolution was filed, that “[h]er death did not terminate the dissolution process once it had been initiated.” and that JoAnn, as Mary’s executrix, could continue the dissolution action. Id. at *8.

Almost in passing, the court rejected the suggestion that because the articles of organization provided that the LLC would dissolve after 25 years, it could not be dissolved prior to that time.

If this decision is restricted to its facts—namely, an action for judicial dissolution—it is an entirely reasonable outcome. At the time the action for judicial dissolution was filed, three of the four persons having a derivative economic interest in the LLC’s assets no longer wish to be in business together. Likewise, one-half of the members did not want to be in business with the other half. It would be dangerous, however, to extend this decision beyond the context of an action for judicial dissolution. If, in contrast, the suit were to have involved a derivative action or a request to inspect documents by a member who then passes away, different policy concerns focused upon the LLC’s internal management would arise.

Among the most important recent developments in Delaware corporate law is the establishment (or re-establishment) of the potentially case-dispositive impact of an affirmative stockholder vote in M&A litigation. The Supreme Court of Delaware’s 2015 decision in Corwin v. KKR Financial Holdings LLC held that a fully informed vote in favor of a transaction by disinterested stockholders invokes the application of the business judgment standard of review. Given that application of the deferential business judgment standard of review renders the challenged transaction almost certainly immune from further judicial scrutiny, it is difficult to overstate Corwin’s impact. Few cases survive Corwin’s application, an unsurprising result given that a faithful application of the doctrine places a significant burden on a stockholder plaintiff to allege, without the aid of discovery, a material omission or misstatement in connection with a stockholder vote. Due to this trend, the Delaware Supreme Court’s decision in Morrison v. Berry, which reversed a Court of Chancery decision dismissing a merger challenge based on Corwin, presents an important step in the continued development of the Corwin doctrine. As discussed below, it is apparent that Delaware’s high court expects the Court of Chancery to apply Corwin in a careful, searching manner that is consistent with the plaintiff-friendly motion to dismiss standard. Indeed, Morrison is the second of two recent Delaware Supreme Court cases (the first being Appel v. Berkman) that stress the careful application of Corwin.

The Corwin Decisions

Stockholders of KKR Financial Holdings LLC (KKR Financial) challenged its acquisition by KKR & Co., L.P. (KKR), alleging breaches of fiduciary duty against KKR, as controlling stockholder, and KKR Financial’s board. In opposing the defendants’ motion to dismiss, the plaintiffs argued that the entire fairness standard of review should apply because KKR was allegedly a controlling stockholder of KKR Financial and because, with respect to the claim against KKR Financial’s board, the complaint contained sufficient allegations to rebut the business judgment standard of review.

The Court of Chancery granted the defendants’ motion in full. Regarding plaintiffs’ claim against KKR, the court held that KKR was not a controlling stockholder and therefore owed no fiduciary duties to KKR Financial or its stockholders. As to the claims against KKR Financial’s board, the court first held that the complaint failed to allege facts sufficient to rebut the business judgment rule. Although the court could have ended its decision there, it went on to hold that, even if the complaint had adequately alleged such facts, “business judgment review would still apply because the merger was approved by a majority of disinterested stockholders in a fully-informed vote.” The Supreme Court of Delaware affirmed, likewise holding that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.”

Fully Informed Stockholder Vote

Given that the plaintiffs in Corwin did not allege that the merger-related disclosures were deficient or contest the defendants’ argument that the business judgment rule was invoked by virtue of the affirmative stockholder vote, the Corwin decisions did not discuss what constitutes a “fully informed” stockholder vote sufficient to invoke the business judgment standard of review. In subsequent decisions by the Court of Chancery, the court has looked to the existing standards under Delaware law in the context of disclosure-based fiduciary duty claims regarding what is or is not material to the stockholders’ decision-making. Where a plaintiff adequately alleges that the merger disclosures were materially incomplete or misleading, the court has found that the stockholder vote was not fully informed.

Morrison v. Berry

The action relates to the 2016 acquisition of The Fresh Market (the Company) by Apollo Global Management LLC (Apollo) through a tender offer. Apollo submitted an unsolicited offer to acquire the Company in October 2015, noting that it had discussed the proposal with Ray Berry, the Company’s founder and a member of the board who, together with his son Brett, owned 9.8 percent of the Company’s outstanding stock. After a five-month process, a special committee of the board and the board recommended a transaction with Apollo that involved a tender offer and an equity rollover by Ray and Brett Berry. The tender offer closed in April 2016 with over 68 percent of outstanding shares validly tendered.

Following the announcement of the tender offer, a stockholder of the Company demanded books and records under section 220 of the Delaware General Corporation Law, through which she received “several key documents,” including board minutes and e-mails between Ray Berry’s counsel and Company counsel. The stockholder then filed suit alleging breaches of fiduciary duty against the board and a claim for aiding and abetting breaches of fiduciary duty against Brett Berry. The defendants moved to dismiss under Corwin, which had been applied to tender offers in an earlier Court of Chancery decision captioned In re Volcano Corp. Stockholder Litigation. The stockholder plaintiff argued that Corwin did not apply because the Company failed to disclose all material facts in its Schedule 14D-9; therefore, the stockholders’ decision to accept the tender offer was not fully informed. In a short letter opinion, the Court of Chancery granted the motion to dismiss, ruling that the alleged disclosure issues were immaterial and that the action was “an exemplary case of the utility of th[e] ratification doctrine, as set forth in Corwin and Volcano.”

On appeal, the Delaware Supreme Court reversed, finding that the stockholder plaintiff alleged four disclosure deficiencies that rendered the 14D-9 materially incomplete and misleading.

First, the Supreme Court concluded that the complaint adequately alleged that the 14D-9 omitted material information about Ray Berry’s agreement with Apollo and his representations to the board about the agreement. After withdrawing its initial offer, Apollo renewed its offer on November 25, 2015. A November 28, 2015 e-mail from Berry’s counsel to Company counsel read that Berry had one conversation with Apollo in the interim, during which “he agreed, as he did in October” to roll over his equity if Apollo reached an agreement with the Company. The 14D-9 did not include any reference to an agreement between Berry and Apollo in October. Whereas the Court of Chancery determined that this information was not material because Berry’s “position as of the time of the auction process and go-shop—that is, at the time material to stockholders—was adequately disclosed,” the Supreme Court determined that this information was material, especially in light of the 14D-9’s disclosure that Berry stated during an October 15 board meeting that he had not committed to a transaction with Apollo. The Supreme Court held that a reasonable stockholder would want to know both about Berry’s “level of commitment” to Apollo in October and that Berry was not forthcoming with the board about that commitment.

Second, the Supreme Court held that the 14D-9 was materially misleading because it included statements that Berry was open to considering other bidders and rolling over his equity in such transactions. The minutes from the board’s October 15 board meeting indicated, however, that Berry only committed to rolling over his equity if he was confident in the purchaser’s experience in the retail food industry, and he stated that Apollo was “uniquely qualified” in that respect. Without specifically addressing this alleged disclosure deficiency, the Court of Chancery held that Berry’s involvement with and commitment to Apollo was adequately disclosed. In contrast, the Supreme Court reasoned that stockholders would want to know facts suggesting that Berry preferred Apollo because these facts concern “the openness of the sale process.”

Third, the Supreme Court focused on statements in the November 28 e-mail from Berry’s counsel to Company counsel that Berry believed the board should pursue a sale of the Company “at this time,” and that he would sell his shares if the board failed to act. The Court of Chancery concluded that the omission of these facts from the 14D-9 was not material because “it would not have made investors less likely to tender.” The Supreme Court emphasized that the materiality standard considers whether there is a substantial likelihood that a reasonable stockholder would have considered the omitted fact important—not whether it would have caused the stockholder to change his or her vote. To this end, the Supreme Court held that stockholders “would want to know the rationale that Ray Berry gave the Board in encouraging it to pursue the sale, as well as his communication of his intent to sell his shares if such a transaction were not consummated.” In so reasoning, the Supreme Court cited to the decision it issued earlier this year in Appel v. Berkman, which held that the Schedule 14D-9 issued by Diamond Resorts International was materially misleading because it omitted information about why the company’s founder, chairman, and largest stockholder abstained from voting on proceeding with merger discussions. The company’s founder abstained because he thought mismanagement of the company had depressed the sale price and it was the wrong time to sell the company—facts the Supreme Court concluded would have been of interest to stockholders. Likewise, in Morrison, the Supreme Court held that stockholders would have been interested to know Berry’s rationale for pursuing the Apollo transaction.

Finally, the Supreme Court held that the 14D-9 was materially misleading in that it stated the Company created a special committee in October 2015 because it “could become the subject of shareholder pressure,” when in fact the contemporaneous board minutes reflected that the Company had already encountered “a significant amount” of stockholder pressure. The Supreme Court reasoned that, because the Company chose to address why the special committee was created, “stockholders were entitled to know the depth and breadth of the pressure confronting the Company” and that “it already existed.”

Because the 14D-9 was materially incomplete and misleading, the Supreme Court concluded that the stockholders’ decision to tender their shares was not fully informed, and the business judgment standard did not apply under Corwin. In so holding, the court warned directors and the attorneys who advise them to avoid “partial and elliptical disclosures,” which “cannot facilitate the protection of the business judgment rule under the Corwin doctrine.”

Takeaways

• Morrison demonstrates the Supreme Court’s willingness to closely scrutinize a company’s contemporaneous documents to see if they support the facts disclosed to stockholders. The court’s apparent willingness to so scrutinize the underlying record appears motivated by its recognition that “[c]areful application of Corwin is important due to its potentially case-dispositive impact.”
• In light of the court’s willingness to carefully examine the underlying record, Morrison reminds practitioners of the importance of full and accurate disclosures. This is especially so considering stockholder plaintiffs’ growing reliance on section 220 of the Delaware General Corporation Law as a means of avoiding dismissal by showing discrepancies between the record and the disclosures.
• Particular attention should be given to disclosures relating to the motivations and analysis of key board members and stockholders, given the Supreme Court’s decisions in Morrison and Appel.

The online retail marketplace bedevils major brand owners. It provides a vast, new market channel; it destroys brand owners’ exclusive channels. Amazon.com is not only a major force in the former but also the prime mover in the second. Take, for example, Versace’s “Bright Crystal” eau . Multiple sellers are linked to the product page on Amazon, offering the same, new product, often at reduced prices which may compromise Versace’s authorized dealer network’s profitability and stability.

Trademark infringement is the principal weapon brand owners have in combating unauthorized dealers. But there is nothing improper about selling genuine product by an unauthorized dealer, per se. The first sale doctrine in both trademark and copyright law bars the brand owner from controlling the downstream sales. The first sale doctrine provides that one who purchases a branded item generally has a right to resell that item in an unchanged state.[1]  But there’s an exception.

Trademark Infringement and “Genuine” Goods

 The first sale doctrine does not protect alleged infringers that sell trademarked goods that are “materially different” than those sold by the trademark owner or its authorized dealers. This is the case at least where there is a difference in the product, packaging, contents or warranties. The existence of a material difference between authorized and unauthorized goods sold under the same trademark creates “confusion over the source of the product and result in loss of [the trademark owner’s] good will.”[2] In other words, materially different goods sold by an unauthorized seller are not considered “genuine” because they are “confusingly different.”

 What is a “material difference”? It is virtually any physical or non-physical difference (however subtle) that exists between the authorized goods and unauthorized goods that a consumer would likely consider it relevant when purchasing the product. As one court put it, “it is by subtle differences that consumers are most easily confused,” and therefore “the threshold of materiality must be kept low enough to take account of potentially confusing differences—differences that are not blatant enough to make it obvious to the average consumer that the origin of the product differs from his or her expectations.”[3] Thus, for example, material differences could include differences in battery life between authorized and unauthorized batteries or alterations to packages or reference numbers and codes, or differences in warranty protection.[4]

From a brand owners’ enforcement perspective, the primary concern is trademark enforcement. However, copyright infringement can arise from lifting the brand owner’s copy or images. Other weapons at hand for brand owners include non-intellectual property rights, such as breach of contract, restrictions violating anti-trust principles, misleading statements regarding being “authorized”[5] and state warranty statutes.[6]

Doing Something: Takedowns and Suits Against the Infringer 

Armed with these weapons, one could sue the infringer or demand a takedown. However, Amazon is notorious for not honoring unauthorized dealer takedown requests: it distinguishes such issues from more traditional trademark infringement or counterfeit sales. “Asking Amazon to help police your brand will fall on deaf ears, even if you have protective assets like a patent or trademark. Amazon does not view unauthorized sellers (i.e. anyone but you and your authorized distributors) as policy violators.”[7] The Digital Millennium Copyright Act (DMCA) is of limited use, since the “primary” and more lasting offense is trademark. Moreover, as is typical on Amazon Marketplace, the true name and location of the third-party seller is usually cloaked, with only a fictitious alias to pursue.  Suing the seller thus becomes problematic.

Taking on Amazon:  A Problem with “Consent”

So what about suing Amazon as the enabler? Unfortunately for the brand owner, often it knowingly or unknowingly consented to Amazon’s practice, in its own initial listing of goods.  By doing so, Amazon claims the right to keep the product detail page on its site, even if the brand owner wishes to cease sales. Amazon goes on to claim unfettered sublicensing rights: “Additionally, when you add your copyrighted image to a detail page, you grant Amazon and its affiliates a non-exclusive, worldwide, royalty-free, perpetual, irrevocable right to exercise all rights of publicity over the material. . . . Other sellers can list their items for sale against pages that you have created or added your copyrighted images to.”[8] Amazon routinely refuses to provide information to brand owners of the identity of third-party sellers.

Assuming brand owners listed their products with Amazon, their enforcement path becomes troubled. Challenging the “consent” provisions is one of contract law.  Three questions immediately arise:

(1) Was there effective consent? Perhaps “browsewrap” issues apply to assumed electronic consent. 

(2) Is the agreement unenforceable and voidable by its terms? In other words, are the applicable provisions “unconscionable” or an “unfair business practice” under applicable state law? 

(3) Further, even if the agreement is otherwise enforceable, has it been rendered unenforceable by Amazon’s practice? One could argue that Amazon’s practice, in refusing to reveal the identity of third-party sellers to the brand owner on request, breaches the implied covenant of good faith and fair dealing. It arguably deprives the brand owner of the benefit of the bargain it supposedly expected in listing with Amazon in the first place. By the same token, the mutual understanding of the brand owner and Amazon that Amazon would act “responsibly” in sublicensing is an implied-in-fact condition that often is not being met.

These are not easy issues to address, but they are necessary. For the company with enough at stake, there is some interesting law to be made. Each is highly fact-specific, and some case law exists to support either side of the controversy on each point. The answer in any given case is, well, it depends.

[1] See, e.g., Dan-Foam A/S v. Brand Named Beds, LLC, 500 F.Supp.2d 296, 317 (S.D.N.Y. 2007).  

[2] Original Appalachian Artworks, Inc. v. Granada Electronics, Inc., 816 F.2d 68, 73 (2d Cir. N.Y. 1987). 

[3] Societe Des Produits Nestle, S.A. v. Casa Helvetia, Inc., 982 F.2d 633, 641 (1st Cir. 1992).

[4] Duracell, Inc. v. Global Imports, Inc., 12 U.S.P.Q.2d 1651 (S.D.N.Y. 1989)); Davidoff & Cie, S.A. v. PLD Int’l Corp., 263 F.3d 1297 (11th Cir. 2001); Fender Musical Instr. Corp. v. Unlimited Music Center, Inc., 35 U.S.P.Q.2d 1053 (D.Conn. 1995.

[5] 15 U.S.C. § 1125(a)(1).

[6] California Civil Code Sections 1797.8 et seq. require retail sellers offering unauthorized, imported consumer goods that normally have express, written warranties to post/affix conspicuously certain disclosures.

[7] www.bobsledmarketing.com/blog/protect-your-brand-on-amazon

[8] https://www.amazon.com/report/infringement

In the time before the internet made breaking news available 24/7/365, the most important breaking news came via the three television networks. When important (usually bad) news broke, each of the networks would suspend regular broadcasts with a special “up to the minute” report, and would introduce the report with the phrase, “We interrupt this program to bring you…”

This column interrupts our coverage of LLC-related remedies to discuss an important and interesting decision of the Iowa business court. The case, which Professor Matt Dore of Drake Law School recently brought to my attention, is REG Washington, LLC v. Iowa Renewable Energy LLC, Equity No. EQCE128952 (Iowa District Court for Scott County, Sept. 27, 2017) (REG v. IRE). What makes the case noteworthy is its discussion of transfer restrictions applicable to ownership interests in a limited liability company, and more particularly transfer restrictions applicable to so-called transferable interests, i.e., economic rights. Relevant precedent in the LLC context is somewhere between scant and nonexistent, so the case provides a useful first word on the subject. (Most cases considering transfer restrictions in limited liability companies or partnerships do so in the context of a right of first refusal (ROFR). See, e.g., Robertson v. Murphy, 510 So. 2d 180, 182–83 (Ala. 1987) (upholding ROFR under partnership agreement); RTS Landfill, Inc. v. Appalachian Waste Sys., LLC, 598 S.E.2d 798 (Ga. Ct. App. 2004) (rejecting a ROFR pertaining to LLC interests because the right was permanent in duration and purported to permit the purchase at $500,000 less than any third-party offer)). Moreover, the decision’s analysis centers around the “pick your partner” principle and expressly rejects any analogy to corporate law cases addressing stock transfer restrictions.

REG v. IRE involved an Iowa limited liability company, Iowa Renewable Energy, LLC (IRE), which “operates a bio-diesel production facility in Washington, Iowa,” and REG Washington, LLC (REG), “a producer of bio-based fuel and renewable chemicals located in Ames, Iowa.” The litigation arose out of two tender offers REG made for ownership interests in IRE.

Given that the IRE operating agreement has strict transfer restrictions, understanding the case begins with understanding the relevant provisions of the operating agreement. The IRE operating agreement refers to “Membership Interests” as comprising “two distinct interests in the company: ‘Membership Economic Interest’ and ‘Membership Voting Interest,’” and provides that “[t]he Membership Economic Interest of a Member is quantified by the Unit of measurement referred to herein as ‘Units.’” Through its tender offers, REG sought to purchase up to “49% of IRE’s Class A units and 49% of IRE’s Class B units.”

Section 9.1 of the IRE operating agreement contained a strict limitation on transfers: “Except for Permitted Transfers [not relevant to the case], no Member shall transfer all or any part of its Units, voluntarily or involuntarily, or by operation or process of law or equity, unless and until the Directors have approved the Transfer in writing, which approval may be withheld in the Directors’ sole discretion.” The operating agreement further provided that any purported transfer made without the directors’ approval was void. Although the operating agreement did not appear to quantify member voting interest in terms of units, the court held Section 9.1 applicable to both of the “two distinct interests.”

In any event, the focus of the case is on the operating agreement’s control over the transfer of economic rights. Despite its knowledge of the operating agreement’s transfer restriction, pursuant to its second offer, REG paid cash to 28 IRE members for, in the aggregate, 1,895 units, accompanied by signed proxies and powers of attorney. The IRE directors exercised their “sole discretion” and declined to give effect to the purported purchases. REG then brought suit “in equity seeking a writ of mandamus or, in the alternative, an injunction against Defendants Iowa Renewable Energy, LLC” and several individual defendants.

Like all LLC statutes, the Iowa act prohibits transfers of governance rights and complete membership interests unless authorized by the operating agreement or consented to by all the members. However, the “default setting” on economic rights is the opposite; unless the operating agreement provides otherwise, “a transfer, in whole or in part” of “a transferable interest . . . is permissible.” Iowa Code Ann. § 489.502(1)(a).

The Iowa LLC statute is based on ULLCA (2006). Like all other LLC statutes (including ULLCA (1996) and ULLCA (2013)), ULLCA (2006) gives no direct, express guidance on the extent to which an operating agreement may restrict the transferability of economic rights. However, all uniform LLC acts (including Iowa’s) provide a centralized list of “thou shall nots” that limit the power of an operating agreement. Restricting the transfer of transferable interests is not on the “thou shalt not” list. Moreover, Iowa Code Ann. § 489.502(6) provides categorically and without exception that “[a] transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement or another agreement to which the transferor is a party is ineffective as to a person having notice of the restriction at the time of transfer.”

In the corporate realm, where shares are freely transferable absent a contrary agreement, both case and statutory law impose some sort of reasonableness requirement on stock transfer restrictions. See, e.g., Iowa Code Ann. § 490.627(3) (stating that “[a] restriction on the transfer or registration of transfer of shares is authorized . . . [t]o maintain the corporation’s status when it is dependent on the number or identity of its shareholders[,] [t]o preserve exemptions under federal or state securities law[, and] [f]or any other reasonable purpose”) (derived from Mod. Bus. Corp. Act § 6.27; Elson v. Schmidt, 140 Neb. 646, 650–51, 1 N.W.2d 314, 316 (1941) (upholding a stock transfer limitation “[a]fter a careful reading of the authorities” because the limitation “is a reasonable restriction”).

In assessing the reasonableness of stock transfer restrictions (and thereby departing from a laissez faire or “freedom of contract” approach), courts have often written of the law’s hostility toward “restraints on alienation.” In REG v. IRE, REG invited the court to embrace that hostility, “argu[ing] that a transfer restriction is subject to a ‘reasonableness’ standard that some courts apply to transfers of corporate stock.”

The court rejected the invitation. Noting that “REG routinely cites corporate law cases to support its allegations that the Operating Agreement’s restrictions on transfers of Membership Interest are improper,” the court held that, “[w]hile analogies to corporate law may be appropriate in certain situations, the transferability of membership interest in an LLC entity is not one of them.” Quoting the official comments to ULLCA (2006) at section 502, the court emphasized the contractual nature of an LLC and explained:

Re-ULLCA counsels that the intention of the contracting parties must be controlling: “Unless the operating agreement otherwise provides, a member acting without the consent of all other members lacks both the power and the right to: (i) bestow membership on a non-member; or (ii) transfer to a non-member anything other than some or all of the member’s transferable interest.” Rev. Unif. Ltd. Liability Co. Act § 502 introductory cmt. (2006) (internal citations omitted). Here, IRE has provided otherwise. The Member parties contracting to form IRE specifically limited their ability to transfer any aspect of Membership Interest under the Operating Agreement by requiring approval by the Board of Directors.

Having rejected any reasonableness standard, the court had neither need nor occasion to consider the reasonableness of section 9.1 of the IRE operating agreement.

There is much to be said for the court’s holding. After all, in sharp contrast to the corporate construct, the LLC construct hardwires restraints on alienation into the entity-creating statute; all LLC statutes restrict the transfer of governance rights. See, e.g., ULLCA (2013) § 501, cmt. (“Absent a contrary provision in the operating agreement or the consent of the members, a “transferable [i.e., economic] interest” is the only interest in an LLC which can be transferred to a person who is not already a member.”) Moreover, many (perhaps most) LLC statutes also provide that as a default rule, a member’s dissociation strips away the dissociating person’s governance rights and locks the person in as a mere transferee of its own economic rights. See, e.g., ULLCA (2013) § 603(3) (providing that, upon a person’s dissociation, “any transferable interest owned by the person in the person’s capacity as a member immediately before dissociation is owned by the person solely as a transferee.”). Certainly, the typical limited liability company is the wrong place to be if one seeks free transferability of any aspect of one’s ownership interest.

On the other hand, however, how threatening is the transfer of economic rights to the pick-your-partner principle? LLC statutes provide transferees no entrée to (much less influence over) a limited liability company’s activities and affairs, see, e.g., ULLCA (2013) § 502(a)(3)(A), no right to participate in management, no general right to access to company financial information, and precious little access even to information directly relevant to the transferee’s interest, see, e.g., ULCCA (2013) §§ 502(a)(3)(B), 502(c) (providing that a transferee has no “access to records or other information concerning the company’s activities and affairs,” except that “[i]n a dissolution and winding up of a limited liability company, a transferee is entitled to an account of the company’s transactions only from the date of dissolution”).

However, in contrast to this general proposition, REG v. IRE involved at least two sets of circumstances that would have justified the application of a “sole discretion” standard. First, it is by no means certain that REG was seeking to obtain only economic rights. By acquiring proxies and powers of attorneys from its transferors as well as economic rights, in effect REG sought the transfer of governance rights. If so, the pick-your-partner principle was centrally at issue, and enforcing the restriction was indubitably necessary. Before the check-the-box regulations, practitioners and some academics worried that giving proxy rights to persons that were neither fellow members nor managers of the company created the corporate characteristic of free transferability of interests. At least one LLC statute addressed the concern directly. See Minn. Stat. § 322B.363(8) (“A member may not grant any proxy to any person who is an assignee of any member’s financial rights and who is not also a member.”).

Second, leaving the proxy argument entirely aside, the IRE operating agreement contains an unusual definition of economic rights. The agreement defines a “Membership Economic Interest” to include not only “the right to receive distributions of the Company’s assets,” but also (for some undiscussed reason) “the right to information concerning the business and affairs of the Company,” thereby providing unusual and potentially disruptive access rights to those who own merely member economic interests.

The court made neither of these points. Instead, it hitched its wagon to the pure, unvarnished pick-your-partner principle:

While analogies to corporate law may be appropriate in certain situations, the transferability of membership interest in an LLC entity is not one of them. Contrasted with other principles of incorporated business organizations, “[o]ne of the most fundamental characteristics of LLC law is its fidelity to the ‘pick your partner’ principle.”

It is not clear that the court chose the correct wagon, given the paradigmatic circumstances that gave rise to the principle. Under the first uniform partnership act promulgated in 1914 almost a century before the advent of the limited liability company:

1. general partnerships were closely held, i.e., only a few partners;
2. each partner had the inescapable power to bind the partnership (“statutory apparent authority”);
3. a partner’s power to bind the partnership was also the power to encumber the personal assets of the partners because each partner was personally liable for the partnership’s debts; and
4. the departure of even one partner from the enterprise dissolved the legal relationship of partnership.

Almost all limited liability companies are closely held, but statutory apparent authority for members is not ubiquitous, i.e., not in any manager-managed company and not at all under some LLC statutes. See ULLCA (2006 & 2013) § 301(a) (“A member is not an agent of a limited liability company solely by reason of being a member.”). As for member liability for the entity’s debts, limited liability is of course a hallmark of the limited liability company, and the dissociation-dissolution link is a thing of the past for virtually all (if not all) LLC statutes. Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies: Tax & Business Law ¶ 1.01[3][e] (Warren Gorham & Lamont, 1994; Supp. 2018-1) (LLC characteristics after “check-the-box”).

An almost 25-year-old Louisiana appeals shows the above-described paradigm in action. The case, LeBreton v. Allain-LeBreton Co., 631 So. 2d 662, 664 (La. Ct. App.), writ denied, 637 So. 2d 159 (La. 1994), involved restrictions on the transfer of partner interests in a non-LLP general partnership. The party challenging the transfers argued for the corporate jurisprudence. The court rejected the argument, explaining as follows.

Every partner in a partnership is liable for the debts of the partnership, absent contrary agreement. Attempts to limit the ability of a partner to bind the partnership are invalid against a good faith party. Thus, because any partner may obligate the partnership and therefore, his partners, it would seem appropriate that there would be a presumption against transferability of interests in a partnership.

Unlike the circumstances in LeBreton, in the context of limited liability companies, only the closely held characteristic remains to justify applying the pick-your-partner principle to restrictions on the transfer of economic rights. In addition, as REG v. IRE itself exemplifies, even that characteristic has exceptions. According to the court, “IRE has issued over 26,000 units, which are held by approximately 600 unitholders.” Doubtlessly, the persons managing the limited liability company owed fiduciary duties to the company and in some circumstances to the unit holders, but a “community” of 600 is far from the paradigmatic closely held business in which personal, mutual relations of trust and confidence are expected and salutary. Note also that, at least for as long as uniform partnership acts have existed (since 1914), partnership law has protected the pick-your-partner principle while accepting economic interests as freely transferable.

Why then should LLC law invoke the mantra of pick your partner to make transfer restrictions on LLC transferable interests immune from judicial scrutiny? Yet, on information and belief, transfer restrictions like those in the IRE operating agreement are far from rare. Given the scarcity of precedent, REG v. IRE provides useful first words on the subject, but given the issues raised in this column, hardly the last.

Article 9 of the Uniform Commercial Code also bears on this issue. UCC sections 9-406 and 9-408 have overridden some transfer restrictions often included in partnership and operating agreements. In May and July 2018, the ALI and the ULC adopted amendments to sections 9-406 and 9-408, placing transfer restrictions on ownership interests in limited liability companies and partnerships outside the sections’ reach. For a discussion of the override issue and the new exception, see LLC and Partnership Transfer Restrictions Excluded from Article 9 Overrides, soon to be published in Business Law Today.