The Eleventh Circuit Court of Appeals recently affirmed a decision on appeal from the United States District Court for the Middle District of Florida (which also affirmed the bankruptcy court’s decision), with notable implications for Chapter 15 cases.[1] The central question at issue was whether 11 U.S.C. § 109(a), which governs who may be a debtor under title 11, applies to cases brought under Chapter 15 of the Bankruptcy Code. Despite the Bankruptcy Code’s plain text stating that section 109(a) (as well as all of Chapter 1) applies to Chapter 15 cases, the Eleventh Circuit found itself bound by precedent in In re Goerg, 844 F. 2d 1561 (11th Cir. 1985), wherein the Eleventh Circuit held that the Bankruptcy Code’s debtor eligibility language does not apply to cases ancillary to a foreign proceeding. Thus, the Eleventh Circuit held that the debtor eligibility requirements in section 109(a) do not apply to Chapter 15 cases and affirmed the lower courts’ decisions.
Chapter 15 Generally
Chapter 15 of the Bankruptcy Code is designed to help the U.S. recognize foreign insolvency proceedings and increase international cooperation among insolvency courts to effectively address cross-border insolvency issues. Chapter 15 was enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) in 2005 and repealed its predecessor, section 304 of the Bankruptcy Code. Chapter 15 codifies the Model Law on Cross-Border Insolvency in substantially the same way it was written by the United Nations Commission on International Trade Law. It provides for recognition of a foreign insolvency proceeding before a U.S. bankruptcy court can provide automatic, provisional, or permissive relief.
Factual Background
In 2015, the appellant, Talal Qais Abdulmunem Al Zawawi and his wife, Leila Hammoud, moved to the United Kingdom with their children. In 2017, Hammoud petitioned for dissolution of marriage. In March 2019, Hammoud obtained a divorce decree and a judgment in her favor for £24,075,000 from a U.K. court. In April 2019, the U.K. court issued a worldwide freezing order against Al Zawawi, enjoining him from disposing any of his assets until the judgment was paid in full. Roughly one year later, Hammoud petitioned the U.K. court to place Al Zawawi in involuntary bankruptcy, alleging that he had failed to make payments on the March 2019 judgment. On June 29, 2020, Al Zawawi was adjudged bankrupt, and the court appointed Colin Diss, Hannah Davie, and Michael Leeds as joint trustees (the “Foreign Representatives”).
On March 24, 2021, the Foreign Representatives filed a Chapter 15 Petition for Recognition of a Foreign Proceeding in the U.S. Bankruptcy Court for the Middle District of Florida, which, if granted, would subject Al Zawawi’s U.S. assets to the automatic stay and open the door to discovery and other relief relating to those assets. The Foreign Representatives argued that the requirements of section 1517 were met and therefore an order granting recognition was warranted. Al Zawawi did not dispute whether the petition satisfied section 1517. He argued, however, that the case should be dismissed on the basis that he was not eligible to be a debtor under section 109(a) because he did not reside or have a domicile, place of business, or any property in the U.S.
The bankruptcy court granted recognition, determining that section 109(a) does not apply to Chapter 15 cases and that, even if section 109(a) did apply, Al Zawawi had property interests in the U.S. Al Zawawi appealed the bankruptcy court’s decision, and the district court affirmed without addressing the alternative finding that Al Zawawi nonetheless had property in the U.S. Al Zawawi again appealed, this time to the Eleventh Circuit Court of Appeals.
Eleventh Circuit’s In re Goerg Decision Binds It to Interpretation Differing from Plain Text
The Eleventh Circuit first addresses the central issue by confronting the plain text of section 103(a), which states that “this chapter, sections 307, 362(o), 555 through 557, and 559 through 562 apply in a case under chapter 15.”[2] “This chapter,” as used in section 103(a), refers to Chapter 1 of the Bankruptcy Code, which includes section 109(a) and the eligibility requirements listed therein. However, unlike other circuits that have held the above plain language settles this issue, the Eleventh Circuit is bound by prior precedent wherein it held otherwise: In re Goerg.
In In re Goerg, the Eleventh Circuit dealt with the question of whether a hypothetical debtor in a case brought under Chapter 15’s predecessor—section 304, titled “Cases ancillary to foreign proceedings”—must fall within Chapter 1’s definition of a “debtor.” The court ultimately said no. In coming to that decision, the Eleventh Circuit had to wrestle with the Bankruptcy Code’s anomalous definitions of “debtor” and “foreign proceeding,” wherein a debtor was defined as a person with a bankruptcy case under title 11, and a foreign proceeding was defined as a proceeding concerning such a debtor but need not even be a bankruptcy proceeding. To resolve the anomaly, the Goerg court adopted the view the term “debtor,” as used in the section 304 context, incorporates the definition of “debtor” used by the foreign proceeding forum. Using this view, the bankruptcy court could entertain the section 304 petition so long as the debtor qualified for relief under applicable foreign law and the foreign proceeding was for the purpose of liquidating an estate; adjusting debts by composition, extension, or discharge; or effecting a reorganization—the definition of “foreign proceeding” under the Bankruptcy Code. In choosing this option, the court relied on section 304’s purpose to prevent piecemeal litigation as to a debtor’s assets in the U.S. and to generally help further the efficiency of foreign insolvency proceedings involving worldwide assets. In light of that understanding, the Eleventh Circuit in Goerg held that the debtor in an ancillary assistance case under section 304 need only be subject to a foreign proceeding (as defined in the Bankruptcy Code) and that debtor eligibility under the Bankruptcy Code was not a prerequisite to section 304 ancillary assistance.
Ultimately, since the Bankruptcy Code’s current definitions of “debtor” and “foreign proceeding” still present a similar anomaly for Chapter 15 as they did for section 304, Goerg counseled the Al Zawawi court to consider the purpose of Chapter 15 (as it did with section 304) in holding that debtor eligibility under Chapter 1 is not a prerequisite for the recognition of a foreign proceeding under Chapter 15. While there are differences between the former section 304 and its successor Chapter 15 (e.g., section 304 did not entitle debtors to the automatic stay), the purposes of section 304 and Chapter 15 are the same. Both aim to provide effective mechanisms for dealing with cases of cross-border insolvency. Based on that purpose, the Eleventh Circuit in Goerg determined that a debtor in a case ancillary to a foreign proceeding need only be properly subject, under applicable foreign law, to a “foreign proceeding” as defined by the Bankruptcy Code. In In re Al Zawawi, the Eleventh Circuit followed that logic and held that based on the current definition of “foreign proceeding” in section 101(23), debtor eligibility under section 109(a) is not required to grant recognition of a foreign proceeding under Chapter 15. Al Zawawi was properly subject to a “foreign proceeding,” and the requirements for recognition under section 1517 were met; thus, the bankruptcy court’s order granting recognition was affirmed.
Takeaway
The Eleventh Circuit’s decision in In re Al Zawawi opens the door for bankruptcy courts in Alabama, Florida, and Georgia to recognize foreign proceedings so long as the debtor is properly subject to a foreign proceeding, which may lead to an influx of similar cases. The decision[3] may also set the stage for the Supreme Court to weigh in, given the circuit split with the Second Circuit and the juxtaposition of the court’s reasoning with the plain text of the Bankruptcy Code.
In re Al Zawawi, No. 22-11024, 2024 WL 1423871 (11th Cir. Apr. 3, 2024). ↑
Among the factors in the devolution of the law from a learned profession to a trade is competition amongst an ever-growing pool of lawyers for an ever-shrinking pool of clients. Particularly in “eat what you kill” economic circumstances, there is tremendous pressure to generate client revenues. Law firms emphasize marketing more than ever before. So when a client prospect comes to you, and all that marketing and reputation seems to be paying off at last, you have every incentive to explore the prospect’s needs and persuade that person that you are the right person to handle the matter. Right?
Not so fast.
Recent ABA Formal Opinion 510 provides worthwhile guidance on some uncertainties in Model Rule 1.18 regarding conflicts of interest related to client prospects. Before considering the uncertainties, however, let’s first consider the rule.
A Brief Tour of Model Rule 1.18
Model Rule 1.18 begins in paragraph (a) by defining a term (not found in the Terminology section)—prospective client—simply as a person who consults a lawyer “about the possibility of forming a client-lawyer relationship with respect to a matter.” The definition is not triggered, according to Comment 2 to Model Rule 1.18, where someone “provides information to a lawyer in response to advertising that merely describes the lawyer’s education, experience, areas of practice, and contact information, or provides legal information of general interest.” The comment regards such information as having been communicated “without any reasonable expectation that the lawyer is willing to discuss the possibility of forming a client-lawyer relationship.”
Be aware, however, that not all legal ethics rules are identical, which underscores the importance for lawyers of always checking the rules in each jurisdiction in which they are admitted to practice. New York’s version of this rule, for example, contains an additional paragraph (e)—not found in the Model Rule—articulating two exceptions to the term prospective client: It does not include anyone who “(1) communicates information unilaterally to a lawyer, without any reasonable expectation that the lawyer is willing to discuss the possibility of forming a client-lawyer relationship; or (2) communicates with a lawyer for the purpose of disqualifying the lawyer from handling a materially adverse representation on the same or a substantially related matter.”[1] These exceptions in the blackletter of the New York rule track guidance in the Model Rule’s Comment [2].
Paragraph (b) of Model Rule 1.18 provides that the lawyer may not use or reveal information learned from a prospective client, even where no client-lawyer relationship ever materialized. In other words, information is protected when imparted by the “client that never was.”[2] Notice that this prohibition is unqualified and applies to any information, not just information that could be harmful to the prospective client. There is, however, an exception encompassing information of the same sort that Model Rule 1.9 would allow to be used or revealed in the case of a former client.[3]
That exception is admittedly rather opaque. First of all, Rule 1.9(c), which deals with use or revelation of information, applies only to information “relating to the representation,” which does not track well as an exception to a rule, like Rule 1.18, that applies only when there never was any representation. Be that as it may, Rule 1.9(c) does provide an exemption, “except as these Rules may permit or require,” which would encompass, for example, exceptions to confidentiality in Rule 1.6(b). In addition, Rule 1.9(c)(1) carves out using information that is “generally known,” but there is no comparable carve-out for revealing such information in Rule 1.9(c)(2).
Paragraph (c) of Rule 1.18 then contains two ukases. First, it prohibits a lawyer subject to paragraph (b) from representing a client with interests materially adverse to those of a prospective client in the same or a substantially related matter if the lawyer received information from the prospective client that could be “significantly harmful” to that person in the matter.[4] Second, such disqualification is imputed to other lawyers in a firm with which the disqualified lawyer is associated.
Both of these are subject to exceptions provided in paragraph (d), which is the focus of Formal Op. 510. These exceptions will permit a representation adverse to the prospective client if their elements are satisfied.
The first exception is informed consent confirmed in writing under paragraph (d)(1), and that consent must come from both the affected client and the prospective client. Such mutual consent will likely be rather rare—probably mere wishful thinking on the part of the drafters.[5]
The second exception, under (d)(2), is more likely but involves several steps, all of which must be scrupulously performed. The lawyer consulted by the prospective client (A) must have taken “reasonable measures to avoid exposure to more disqualifying information than was reasonably necessary to determine whether to represent the prospective client”; (B) must have been timely screened from any participation in the representation; and (C) can receive no part of the fee. In addition, the prospective client must promptly be given written notification.
Formal Op. 510
Formal Op. 510 focuses on imputation under Rule 1.18(d)(2), which will be required unless the lawyer “took reasonable measures to avoid exposure to more disqualifying information than was reasonably necessary to determine whether to represent the prospective client . . .” (emphases added). The opinion observes that there has heretofore been little guidance on these phrases.
What information is “reasonably necessary”?
Despite the laudable efforts of Formal Op. 510 to provide that guidance, Rule 1.18(d) will inevitably remain something of a gray area. As the opinion acknowledges, “It is easier to show that the lawyer’s conduct was intended to serve a legitimate purpose than to show that it was necessary to serve that purpose.”
To begin with, it is clear that many a lawyer will seek to elicit lots of information from a prospective client, perhaps to impress the client with the lawyer’s acumen and experience in order to get new business. None of that is unusual or unethical. Eliciting information to facilitate self-promotion or touting the law firm’s abilities does, however, run the risk of obtaining information that is potentially disqualifying down the road. An example given in Formal Op. 510 involved lawyers who had pitched a prospective client without making efforts to limit their inquiry beyond what was “reasonably necessary” and subsequently moved to another law firm, which ended up being disqualified.[6]
Formal Op. 510 identifies as “reasonably necessary” information relating to a lawyer’s professional responsibilities, including whether:
there is a conflict of interest (see Model Rule 1.7et seq.);
the legal work is something the lawyer can perform competently (see Model Rule 1.1);
the prospective client’s goals will abuse the judicial process or are frivolous (cf.Model Rule 3.1); and
the prospective client may be seeking a lawyer’s assistance in perpetrating a crime or fraud (see Model Rules 1.2(d) and 1.16(a)(4)).[7]
The opinion also counts as “reasonably necessary” information pertinent to the business decision whether to take on the client, which would incorporate assessments of the duration and quantum of work required, potential revenues and likelihood of getting paid,[8] professional reputation aspects, consonance with law firm policies, etc.
“Reasonable measures” to limit information to the “reasonably necessary”
Whether a lawyer, during initial conversations with a prospective client, can successfully limit the scope of their interaction so as to avoid getting information beyond what is “reasonably necessary” is uncertain. Certainly, it is worth a try. Limiting the information intake to just what is necessary to perform a conflicts check is possible, but that does not satisfy the other professional responsibilities mentioned above.
Formal Op. 510 suggests that lawyers provide a warning that they’ve not yet agreed to take on the matter and information should be limited only to what’s necessary for the lawyer to determine whether to move forward. Such an approach, even if it could be effective with a garrulous prospective client, could well prove awkward at the outset of a potential lawyer-client relationship. Moreover, as a practical matter, that inefficacy and that awkwardness could be magnified where the conversation is not in person but is conducted by telephone or over an online communications platform.
The opinion’s discussion of this issue is a well-motivated attempt to provide guidance, but unavoidably it displays an “Alice in Wonderland” quality. It seems unrealistic to believe that a lawyer can curtail the information flow when the details of the transaction or litigation are an indispensable part of the lawyer’s calculus—even if not, when viewed with the benefit of hindsight, “reasonably necessary” within the meaning of the Rule—in determining whether to take on the engagement.
Furthermore, the opinion does not touch on how to avoid misunderstandings or disputes about what was and was not communicated by the prospective client. It would seem prudent for the lawyer to ask the client’s consent (if in a jurisdiction where consent is required) to record the conversation; alternatively, someone else from the firm should be there to take copious notes of the discussion.
On the “timely screening” requirement, Formal Op. 510 deems it unnecessary in the ordinary course to commence the screen of the lawyer who dealt with the client that never was, unless and until “the law firm becomes aware of information that there is a potential conflict. The alternative of erecting an appropriate screen for each potential client would be an unnecessary and unreasonable burden and is not required by Rule 1.18.”
Remember to Check Your Own Rules
Formal Op. 510 interprets the Model Rules, but these are not the law anywhere unless they have been adopted in haec verba by the relevant jurisdiction. Many states (e.g., Ohio, Massachusetts) have adopted Model Rule 1.18 essentially verbatim, but not all have. We have already identified one state variation in New York’s definition of “prospective client.” Some other variations:
Whereas Model Rule 1.18(c) addresses only information from the prospective client that, if used when representing a person with interests adverse to the prospective client in the same or a substantially related matter, “could be significantly harmful to that person” (emphasis added), Florida’s version seems broader in that it applies to information that “could be used to the disadvantage of that person.”
D.C.’s version doesn’t mention any degree of harm and applies not to mere “information” but to a “confidence or secret” received from the prospective client. Those words are defined (not in the Terminology section but in D.C.’s Rule 1.6): “‘Confidence’ refers to information protected by the attorney-client privilege under applicable law, and ‘secret’ refers to other information gained in the professional relationship that the client has requested be held inviolate, or the disclosure of which would be embarrassing, or would be likely to be detrimental, to the client.”[9]
Illinois’s version of Rule 1.18(d)(2) does not require written notice (prompt or otherwise) to the prospective client.
In California’s version, a “prospective client” expressly includes a person’s authorized representative, and the substance of the definition arguably sweeps more broadly than forming a lawyer-client relationship, as it refers to someone who “consults a lawyer for the purpose of retaining the lawyer or securing legal service or advice from the lawyer in the lawyer’s professional capacity . . . .”
N.Y. Comp. Codes R. & Regs. tit. 22, § 1200.1.18(e) (2024). Cf.Restatement (Third) of the Law Governing Lawyers § 15 cmt. c (“[A] tribunal may consider whether the prospective client disclosed confidential information to the lawyer for the purpose of preventing the lawyer or the lawyer’s firm from representing an adverse party rather than in a good-faith endeavor to determine whether to retain the lawyer.”). ↑
With apologies to Ewen Montagu, The Man Who Never Was (1954), and the 1956 film adaptation of the same name starring Clifton Webb. ↑
With regard to information not exempted under Model Rule 1.9, note that Comment [3] thereof explains that the question is whether confidential information could have been shared, not whether confidences were in fact shared. Accord Analytica Inc. v. NPD Research, 708 F.2d 1263, 1266 (7th Cir. 1983). ↑
An earlier ABA ethics opinion concluded that whether information learned by the lawyer could be significantly harmful is a fact-based inquiry depending on a variety of circumstances, including the length of the consultation and the nature of the topics discussed. SeeABA Formal Op. 492 (June 9, 2020). That topic is also, of course, addressed in Model R. 1.18 cmts. [1]–[2]. ↑
Ethics issues relating to seeking to increase the likelihood by getting written consent in advance are beyond the scope of this discussion. ↑
The opinion mentions in passing, at 6 n.11, but does not dwell on, the enhanced due diligence the ABA has recently sought to impose on lawyers to prevent money laundering and the financing of terrorism under Model Rule 1.16 and its Comment [2]; those categories should assuredly be part of what is “reasonably necessary” for purposes of Rule 1.18(d). ↑
Formal Op. 510 cites as an example Vaccine Ctr., LLC v. Glaxosmithkline LLC, No. 2:12-cv-01849-JCM-NJK, 2013 BL 414523, 2013 U.S. Dist. LEXIS 60046, *4–5 (D. Nev. Apr. 25, 2013) (finding that a lawyer sufficiently limited exposure to disqualifying information where the lawyer requested information necessary to assess whether a contingency matter would be economically feasible, even though such a determination “requires a thorough analysis and understanding of liability and damages issues because the attorney must weigh the significant amount of money and time that will be invested in representing the plaintiff with the ultimate likelihood of prevailing and recovering damages”). ↑
See alsoD.C. Bar Op. 374 (2018) (information from prospective client is protected from disclosure to the same extent as client information is protected by D.C. Rule 1.6). ↑
Recently, the Bureau of Consumer Financial Protection (the “Bureau” or the “CFPB”) survived an appropriations-based challenge to its funding mechanism. In a challenge brought by Consumer Financial Services of America based on the appropriations clause of the Constitution,[1] the Fifth Circuit in 2022 had invalidated that mechanism, but in a decision issued on May 16, 2024, the U.S. Supreme Court reversed.[2]
No stranger to existential constitutional challenges, the Bureau fared less well in the 2016 Supreme Court decision in the Seila Law case. There, a divided Court held that the Bureau was unconstitutionally constituted. Writing for the majority on the structural issue, Chief Justice Roberts concluded that the combination of a single agency director and termination only for “inefficiency, neglect of duty, or malfeasance” violated Article II of the U.S. Constitution.[3] Although the Constitution says nothing about removal of executive officials, the majority reasoned that presidents cannot discharge the duty to “take care” unless they have the ability to remove appointees for any reason or none. The requirement of removal for cause “clashe[d] with constitutional structure by concentrating power in a unilateral actor insulated from Presidential control.”[4]
Background
In the omnibus 2010 Dodd-Frank legislation, Congress addressed by problem of weak consumer financial protection at the federal level by relieving the federal prudential banking regulators of jurisdiction over federal consumer financial protection laws and transferring authority for administering those laws to the CFPB, then newly created as an independent bureau within the Federal Reserve System to regulate consumer financial products and services. That regulation included not just the authority to promulgate its own rules—covering the entire consumer financial services market and all consumer financial services providers—but also the power to enforce certain rules issued by the Federal Trade Commission (including rules regarding telemarketing sales and cooling-off periods for sales made at homes); to implement Dodd-Frank’s prohibition on unfair, deceptive, and abusive acts and practices in consumer financial services; and to supervise certain nonbank firms offering consumer financial products and services (including authority to examine and require reports from entities including mortgage bankers, brokers, and servicers; private student lenders; payday lenders; “larger participants” in the markets for other consumer financial products and services; and other covered entities determined to pose risk to consumers). In addition, the Bureau is empowered to enforce federal consumer financial laws against nonbank entities and enjoys the authority to conduct investigations, issue subpoenas and civil investigative demands, initiate administrative adjudications, assess civil money penalties (as well as seek restitution and disgorgement), and prosecute civil actions in federal court.
Congress also gave the Bureau authority to supervise certain depository institutions that historically had been supervised by other regulators for compliance with consumer financial protections. Specifically, the Bureau is responsible for supervising depository institutions with total assets of over $10 billion, and their affiliates, for compliance with federal consumer financial laws. The Bureau coordinates that supervision with other federal and state bank regulators, who retain supervisory authority over those same entities for safety and soundness, among other things. The CFPB’s supervisory authority encompasses the power to enforce the federal consumer financial laws against these entities.
In an effort to insulate the CFPB from politics on Capitol Hill, Congress exempted the agency from the normal appropriations process. Instead, Congress is left out of the loop, and the Bureau receives its funding from the Federal Reserve, which is itself funded outside the appropriations process through bank assessments. Although the Bureau is an independent agency, it is housed within the Federal Reserve System.[5] Congress allowed the CFPB to demand from the Federal Reserve Board up to 12 percent of the Federal Reserve’s budget to help fund the Bureau’s operations.[6] Interestingly, the Federal Reserve’s budget is, in turn, funded not by direct congressional appropriations but through Reserve Bank operations, including interest on government securities acquired as part of those operations, and by assessments on the banks the Board supervises.[7]
The Appropriations Clause Challenge
The CFPB v. Community Financial Services Association case arose in connection with a challenge to the agency’s Payday Lending rule, which had been promulgated to regulate payday, vehicle title, and certain high-cost installment loans that the Bureau found “unfair” and “abusive.”[8] In addition to administrative law challenges to the rule, the plaintiffs argued that the Bureau’s funding mechanism violates the Appropriations Clause. The district court rejected that claim on summary judgment,[9] but the U.S. Court of Appeals for the Fifth Circuit reversed.[10]
Referring to the Bureau’s “anomalous . . . self-actualizing, perpetual funding mechanism,”[11] the Fifth Circuit held it unconstitutional as it constituted an unprecedented “double insulation” of the Bureau from Congress’s purse strings.[12] In the Fifth Circuit’s view, not only did Congress abdicate its role in the agency’s appropriations process, as the CFPB receives its funds from another agency that is also not subject to regular appropriations, but whereas the Board must normally remit to the Treasury excess or unused funds and thereby remains “tethered” to some form of political accountability, there is no comparable tether for the CFPB, making it essentially unaccountable.[13]
The Supreme Court granted certiorari in February 2023, but extensions of time for brief filings delayed resolution of the case. Ultimately, however, the Court upheld the Dodd-Frank Act’s CFPB funding mechanism.
Authored by Justice Thomas, the majority opinion concluded that “the Constitution’s text, the history against which that text was enacted, and congressional practice immediately following ratification” demonstrate that “appropriations need only identify a source of public funds and authorize the expenditure of those funds for designated purposes to satisfy the Appropriations Clause.”[14] Reviewing pre-Founding English and colonial sources, the Court found that the word “appropriations” would have been understood at the founding simply to mean the legislature’s authorization of expenditures.
Justice Thomas wrote that Bureau’s funding mechanism “fits comfortably within the First Congress’ appropriations practice” as it “authorizes the Bureau to draw public funds from a particular source—‘the combined earnings of the Federal Reserve System’—in an amount not exceeding an inflation-adjusted cap. And it specifies the objects for which the Bureau can use those funds—to ‘pay the expenses of the Bureau in carrying out its duties and responsibilities.’”[15] Finally, the majority concluded, neither the CFPB’s ability to request an amount of funds to be drawn (subject to a cap) nor the fact that the Bureau’s appropriation is not time-limited was material to the funding mechanism’s constitutionality. Justice Kagan wrote a concurring opinion joined by three other Justices,[16] and Justice Jackson authored a separate concurrence.[17]
Justice Alito, joined by Justice Gorsuch in dissent, took the majority to task for turning the Appropriations Clause “into a minor vestige.”[18] They would have held that the Appropriations Clause “imposes on Congress an important duty that it cannot sign away”[19] without undermining the separation of powers.
Unexpected by many, the Supreme Court’s decision will likely affect certain lower court challenges to CFPB rules on credit card late fees[20] and small business lending data reporting,[21] which had been stayed in reliance on the Fifth Circuit’s invalidation of the funding mechanism. Whether those rules, like the payday lending rule at issue in the Community Financial Services of America litigation, are upheld will have to await decisions on their respective merits.
Cmty. Fin. Servs. Ass’n of Am. v. CFPB, 51 F.4th 616 (5th Cir. 2022), rev’d, 2024 U.S. LEXIS 2169 (May 16, 2024). ↑
The majority’s constitutional analysis was grounded in the “take care” clause of Article II, which vests “[t]he executive Power . . . in a President” and commands the president to “take Care that the Laws be faithfully executed.” U.S. Const. art. II, § 1, cl. 1; id. art. II, § 3, cl. 1. ↑
51 F.4th at 638. This was not the first ominous language foreshadowing the holding on the funding mechanism. The Fifth Circuit’s opinion began as follows:
“An elective despotism was not the government we fought for; but one which should not only be founded on free principles, but in which the powers of government should be so divided and balanced . . . , as that no one could transcend their legal limits, without being effectually checked and restrained by the others.” The Federalist No. 48 (J. Madison) (quoting Thomas Jefferson’s Notes on the State of Virginia (1781)). In particular, as George Mason put it in Philadelphia in 1787, “[t]he purse & the sword ought never to get into the same hands.” 1 The Records of the Federal Convention of 1787, at 139–40 (M. Farrand ed. 1937). These foundational precepts of the American system of government animate the Plaintiffs’ claims in this action. They also compel our decision today.
Id. at 639. “Congress cut that tether for the Bureau,such that the Treasury will never regain one red cent of the funds unilaterally drawn by the Bureau.” Id. ↑
Consumer Fin. Prot. Bureau v. Cmty. Fin. Servs. Assn of Am., 2024 U.S. LEXIS 2169 at *14 (May 16, 2024). ↑
In recent years, the Delaware Court of Chancery (the “Court”) has increased its focus on the importance of preserving text and other messages, and delineated the implications of failing to do so. Indeed, in Twitter, Inc. v. Elon R. Musk et al., Elon Musk submitted an affidavit stating that he only recalled having one communication on the messaging app Signal that was related to his planned purchase of Twitter.[1] That representation turned out to be inaccurate, as at least one other Signal communication related to the disputed transaction was identified. The Court noted that it was likely that other relevant Signal communications were deleted via Signal’s auto deletion function and that if they were deleted while Musk was under a duty to preserve, then “some remedy is appropriate” (including potentially adverse inferences).[2]
Twitter settled before the Court had an opportunity to address what sanction would be appropriate, but other cases have made clear that both monetary sanctions and adverse inferences (including default judgment) may be an appropriate sanction for the deletion of responsive text messages when under a duty to preserve.[3] Indeed, within the last few months, the Court has issued two related opinions—both in Goldstein v. Denner, et al.—highlighting the importance of preserving messages, and the litigation risks for failing to do so. Those opinions, along with their practical implications, are discussed below.
I. Summary of the Cases
Facts
Alexander Denner (“Denner”) is the founder and controlling principal of Sarissa Capital (“Sarissa”), an activist hedge fund. In 2017, Denner was also a director of Bioverativ, Inc. (“Bioverativ”).
Sanofi SA (“Sanofi”) approached Denner and another Bioverativ director expressing an interest in acquiring Bioverativ. Denner and the other director allegedly told Sanofi that the time was not right for an acquisition. Days after Sanofi’s overture, Sarissa began purchasing Bioverativ stock. Based on these acquisitions, Sarissa allegedly stood to make significant profits if a transaction with Sanofi happened at least six months after the purchases. As such, plaintiff alleges that Denner delayed a transaction with Sanofi so that Sarissa could reap these profits. A Bioverativ-Sanofi transaction was announced on January 21, 2018.
In connection with the transaction, on February 21, 2018, Bioverativ circulated a litigation hold. Sanofi issued a litigation hold on March 15, 2018. Denner received both.
Thereafter, on September 4, 2019, the Securities and Exchange Commission (“SEC”) subpoenaed Denner and Sarissa seeking documents about trading in Bioverativ securities. The next day, on September 5, 2019, Sarissa’s general counsel circulated a litigation hold to “All staff”—which included Denner.
After circulating the hold, Sarissa’s general counsel spoke with outside counsel about implementation of the hold, and they discussed text messaging. Sarissa’s general counsel represented that he did not text for business purposes and that he did not believe that Denner did either, but that he would confirm. He later represented to outside counsel that he reviewed Denner’s text messages and confirmed that there were no relevant texts. Based on those representations, the general counsel and outside counsel agreed to hold off on collecting text messages but asked that text messages be preserved.
On December 15, 2020, plaintiff filed suit alleging that that Denner and Sarissa engaged in insider trading in connection with the Sanofi-Bioverativ transaction. In response to the lawsuit, Denner and Sarissa moved to dismiss the claims. After completing briefing, plaintiff served document requests in September 2021. Denner and Sarissa sought to stay discovery, and that request was denied.
In November 2021, after the request to stay discovery was denied—and almost a year after the litigation was initiated—Denner and Sarissa started to collect documents. Neither Denner nor any other Sarissa custodians had any texts despite the fact that other defendants produced text messages from Denner. Denner apparently lost all of his texts when he upgraded his phone, another custodian’s phone allegedly fell in a swimming pool, and a third custodian had his phone set to delete texts after thirty days. In addition, the text messages from the three phones were not backed up to the cloud or to other devices.
Relevant Rulings
On January 26, 2024, the Court issued an opinion (the “Opinion”) holding that Denner and Sarissa should have taken steps to preserve data sooner—and, if they had, text data would not have been lost. As to timing, the Court held that “[t]he plaintiff filed the case in December 2020. Defense counsel should have started taking steps to identify and preserve information by at least then”[4]—and “undoubtedly [the duty to preserve] arose much earlier”[5]—even before the first litigation hold was issued in February 2018—because “litigation involving M&A transactions is sufficiently common that Denner and Sarissa should have reasonably anticipated litigation challenging the Bioverativ-Sanofi transaction.”[6]
The Court explained that part of preserving data includes identifying the reasonably likely sources of information and taking “reasonable”—not necessarily perfect—“steps to collect and preserve it.”[7] As to specifically how Denner and Sarissa should have preserved text messages, the Court held that steps could have included “imaging phones or backing up [phone] data.”[8] None of this was done, and Denner and Sarissa were unable to “com[e] forward with other locations where the texts might be found”[9]—such as from Denner’s phone carrier or third parties.
The Court found that Denner and Sarissa’s failure to preserve the text messages was, at a minimum, reckless. To remedy the prejudice to plaintiff, the Court issued sanctions holding that the Court “will presume at trial that the hedge fund traded on the basis of a non-public approach”[10] from Sanofi, and that Sarissa’s “trading caused the sale process to fall outside a range of reasonableness.”[11] The Court also held that it would “require the defendants to meet a burden of proof that is increased by one level” such that, “[r]ather than rebutting the presumptions or proving issues by a preponderance of the evidence, the defendants will have to adduce clear and convincing evidence.”[12] The Court also awarded plaintiff fees and expenses in pursuing the motion.
In response to the Opinion, defendants filed an application with the Court to certify an interlocutory appeal. One of their arguments was that in the Opinion the Court adopted “new, difficult-to-impossible discovery standards, and penalized Defendants for not satisfying them” and that the “Opinion requires every potential litigant in Delaware to undergo the costly and invasive process of creating full forensic images of every potential custodian’s phones every time they anticipate litigation.”[13]
On February 26, 2024, the Court rejected defendants’ argument, stating:
Contrary to the defendants’ alarmist framing, the Opinion did not hold that everyone who might be a custodian in a Delaware action must image their phones immediately after receiving a litigation hold. Yes, the Opinion states that the defendants, “should have taken steps to preserve ESI, including by imaging phones or backing up their data. . . . In a world where people primarily communicate using personal devices, it will almost always be necessary to image or backup data from phones.” But the defendants seem not to understand the disjunctive conjunction “or.” The sentence that the defendants pick out spoke of either making an image or backing up data.
The Opinion did not establish a rigid checklist or bright line rule. It reiterated that parties must take reasonable steps to preserve evidence in a world where texts are often a source of evidence. A party can image or back-up a device to ensure there is no data loss. Or a party could turn off auto-delete features and let the texts accumulate. Or a party could just collect the text messages.[14]
After the Court denied defendants’ interlocutory appeal application, defendants continued to pursue an appeal with the Delaware Supreme Court (the “Supreme Court”). On March 14, 2024, the Supreme Court held that “interlocutory review is not warranted” because “the Court of Chancery’s decision in a discovery matter does not meet the strict standards for certification.”[15] The Supreme Court concluded by noting that “[t]rial is scheduled for next month, and the defendants may raise their claims of error on appeal following the entry [of] a final judgment if they are unsuccessful.”[16]
On April 23, 2024, the parties filed a letter advising the Court that the parties reached a settlement. Trial was set to begin on April 29, 2024.
II. Practical Application
When does the duty to preserve arise? As outlined by the Court in Goldstein I, the duty to preserve often arises well before litigation is initiated—when litigation is reasonably anticipated. Often, this duty coincides with the issuance of a litigation hold, but the duty can arise well before then. Indeed, in Goldstein I, the Court noted that that the duty to preserve “undoubtedly arose much earlier” than the issuance of the first litigation hold “because litigation involving M&A transactions is sufficiently common that Denner and Sarissa should have reasonably anticipated litigation challenging the Bioverativ-Sanofi transaction well before that.”[17] The Court did not, however, specify precisely when that might have been—such as when Sanofi first reached out to Denner, or later as negotiations developed, or when the board approved the merger. Goldstein suggests that when negotiating an M&A transaction, a party to negotiations should carefully consider whether, under the circumstances, there is a duty to preserve.
For purposes of preservation, is circulating a litigation hold enough?While circulating a litigation hold is important, and often a first step, the Court may not view it as enough for purposes of preservation. In Goldstein I, the Court held that the “organization must take steps to ensure that the recipients of the hold understand what it means and abide by it.”[18] This is particularly true for data that a company does not control, such as personal email and text messages—the latter of which was the Court’s focus in Goldstein.
How should data be preserved? When a duty to preserve arises, “a party must act reasonably to preserve the information that it knows, or reasonably should know, could be relevant to the litigation, including what an opposing party is likely to request.”[19] The standard, however, is not perfection—it is reasonableness—which requires “first taking reasonable steps to identify the information that should be collected and preserved.”
Importantly, there is not a “rigid checklist or bright line rule”[20] for preservation. For phone data, which was the Court’s focus in Goldstein, there are a variety of ways to ensure the data is preserved: “A party can image or back-up a device to ensure there is no data loss. Or a party could turn off auto-delete features and let the texts accumulate. Or a party could just collect the text messages.”[21] The specific approach taken will likely depend on the circumstance of the given case. In any case, it will likely be important to speak with custodians of potentially relevant data at the outset of litigation, if not sooner, to determine potential sources of data and methods of ensuring the data is preserved.
Twitter, Inc. v. Musk, C.A. No. 2022-0613-KSJM, 2022 WL 5078278, at *4 (Del. Ch. Oct. 5, 2022). ↑
See, e.g., Gener8, LLC v. Castanon, 2023 WL 6381635, at *15 (Del. Ch. Sept. 29, 2023) (holding an adverse inference was appropriate where defendant failed to turn off text messaging auto-delete, testified that he was “not a texter,” and text messages with the defendant were later discovered); DG BF, LLC v. Ray, 2021 WL 5436868 (Del. Ch. Nov. 19, 2021) (dismissing action as discovery sanction); Kan-Di-Ki, LLC v. Suer, 2015 WL 4503210, at *14 (Del. Ch. July 22, 2015) (drawing adverse inference that defendant’s deleted text messages would have supported plaintiff’s allegations). ↑
Id. at *21. See also id. at *2 (“The hedge fund and its principal failed to take reasonable steps to preserve texts, most notably by not imaging any personal devices.”); id. at *23 (“A reasonable preservation effort would have resulted in counsel imaging or backing up both phones.”). ↑
The opportunity to grow internationally has become mainstream. Businesses from all over the world have recognized that the ability to expand their profits either through wider market penetration or through outsourcing parts of their operations to lower-cost jurisdictions is no longer a strategy limited to the largest companies. If they don’t take advantage, their competitors will!
The latest statistics from the US Bureau of Economic Analysis show that in 2022, $6.58 trillion was invested by the US in overseas jurisdictions, while the US received $5.25 trillion in investment from overseas. Clearly, that indicates a huge amount of cross-border activity, and so US private equity (PE) and venture capital (VC) investors have become more focused on exploiting the opportunity—not only for their own direct investments into overseas assets but also to encourage their portfolio companies to explore international markets to advance their growth.
However, international expansion can also be challenging for the unwary; a local understanding of the overseas market opportunity should be a key prerequisite for a portfolio company board and its investor representative. Current knowledge cannot be underestimated, since market dynamics (including legislation, regulation, and local culture) can change from year to year, and outdated informal guidance has resulted in many wasted dollars being invested.
The mere size of the overseas market opportunity (i.e., about 95.7 percent of the world population lives outside the US) illustrates why many US businesses are interested in exploring chances to develop their customer base, employee headcount, or research-and-development-based intellectual property in other countries.
Certain countries offer lower-cost destinations for manufacturing or customer service hubs. Other jurisdictions have highly educated and talented individuals whose remuneration expectations are lower than market averages in the US. Correspondingly, many such workers are proud to work for US businesses and less prone to being poached; many international employment laws allow reasonable post-termination restrictions to protect trade secrets and confidential information, as well as a number of other noncompetes.
Consumers can equally be an opportunity for US businesses to expand; US products are often highly sought after, and technology (in particular) may be attractive to early adopters overseas when domestic customers may be slower to accept new innovation.
However, from a legal perspective, it is key to consider significant issues that may arise in growing overseas to ensure that laws and regulation do not derail the reasons for growth. Some initial considerations include:
Structure and tax: Whether to set up as a subsidiary business or operate under a different structure can impact regulatory and tax filings, contract engagement, and timelines to launch. Some jurisdictions have rules around local ownership or local resident board representation in such entities. Most will require a local address for service of formal documents and court papers. Minimum share capital and incorporation procedures (perhaps including the need for a local bank account) can impact timing materially.
Intellectual property (IP): IP is considered the most valuable asset for many US businesses. Protecting IP overseas through local registration and confidentiality will be key. The viability of litigation to protect the same, and of ensuring that employees or third-party contractors assign any new IP to the business, should be considered carefully.
Employment: Generally, the greatest difference between engaging US employees and overseas individuals is the terms of employment. Most overseas jurisdictions do not operate employment-at-will, necessitating a notice period, and many countries guarantee employees legal rights that often require set procedures to ensure fair and transparent treatment. Great care should be taken when recruiting, hiring, and terminating employees outside of the US.
Regulation and compliance: There are numerous areas of consideration when doing business in an international jurisdiction that will be industry specific. Many are aware of differences in privacy and consumer rights, but anti-corruption laws, labeling requirements, and safety regulations may also require adjustments to products or services offered in a US domestic market.
Finally, beyond legal obligations, businesses growing outside of the US should consider many of the other factors which could impact their success: culture adjustments are regularly overlooked, and lack of consideration can result in upset employees, disinterested consumers, or angry regulators. None of these help to establish a positive local presence, and most can be avoided with some simple local advice and respect for local market practices. Adjustments to operating procedures may also be needed in order to trade locally, whether by opening a local bank account, adjusting bookkeeping or tax filings in different currencies, or adopting local accounting standards. And of course, it’s important to recognize that a sensitive HR policy is needed for the people who will be implementing your local strategy, understanding that approaches to time zones, typical benefits, and time off can be very different overseas.
The above provides some general commentary that applies to any international growth. We now consider some of the more regional issues applicable to an international growth strategy, exploring examples from four different parts of the world.
United States
Expansion of Non-US Companies to the US
The US is a fairly business friendly market with low barriers to entry; however, certain types of businesses may be highly regulated by federal and state entities.
Companies expanding to the US will often reincorporate by forming a US holding company and having the non-US company become a subsidiary of the US holding company (known as a “Delaware flip”). This structure allows non-US companies to be more attractive to US investors but can create uncertainty for non-US investors. As a US company, the entity may be subject to certain restrictions prohibiting investment of investors from certain sanctioned countries and in certain industries. US investors may also request that the IP be held by the holding company.
The data privacy landscape is evolving in the US. Certain US states have passed laws that make privacy laws more restrictive, similar to European and Canadian privacy protections.
Additionally, the US is known for being protective of intellectual property rights, primarily through formal contractual protections and/or licensing as well as filing (and enforcing) registrable IP rights. Companies operating in the US may also be subject to various types of taxes including sales taxes, employee-related taxes, and income taxes.
While employment in the US is generally “at will” (i.e., employers may dismiss an employee for any reason that is not illegal and without warning), state laws govern the relationships between employees and employers. These laws may require employers to provide employees with certain rights and make employers liable for the actions of employees against others.
Expansion of US Companies Overseas
US businesses are global leaders when expanding their domestic operations overseas. Investors often have experience in growing revenues outside the US, and many serial entrepreneurs will have had positive experience with significant international customer acquisition.
However, as noted above, IP is key, and most investors will insist that IP is retained onshore and transferred to the US parent company if created in another jurisdiction.
Subsidiaries are usually 100 percent owned by the US parent company, and so subsidiary boards often are of less concern to investors who delegate responsibility for local corporate governance to their portfolio officers. There is an overriding presumption that the overseas business will follow the global strategy set by the main parent company board.
There is no set timing to international expansion, but most investors will expect a successful (preferably revenue-generating) domestic business to have demonstrated local growth before distracting management with challenging overseas markets. As a result, overseas expansion is usually considered around a corporation’s C or D round of funding (although there are many who make the move earlier and later). Good corporate governance will ensure the right team is available to support the launch, and consideration often needs to be given as to whether to transfer existing team members to the overseas market or hire locally (or a combination of both).
Europe
Corporate/Commercial Issues
Formal legal processes: One of the differences that companies face when expanding to Europe is the formalities present in some countries, like the role of notaries and the requirement to file certain documents with a commercial registry in order to make them enforceable. Likewise, a Power of Attorney is mandatory to prove capacity, as it is not valid to sign a document under a premise of apparent authority.
Liability of directors: In the years since the 2008 financial crisis, the European Commission has introduced a series of recommendations intended to harmonize and improve corporate governance regimes across Europe, based on the “comply or explain” principle. These days, board members in Europe are subject to increased scrutiny by regulators. It is important for directors of portfolio companies to document that they have been fulfilling their roles in compliance not only with European Union (EU) regulations, but also with the local regulations of the countries where the portfolio company operates.
Sanction regimes: Sanctions may be applied differently in the EU than in the US in ways that could potentially be used to structure a business model to enter into new markets without violating any sanction regimes. For example, a European parent holding company and European subsidiaries may be able to do business in Cuba while US subsidiaries cannot.
Foreign direct investment regulation:The EU’s Foreign Direct Investment (FDI) Regulation, in effect since October 2020, establishes common criteria to identify risks relating to the acquisition or control by foreign investors of strategic assets. The primary responsibility for vetting FDI remains with the Member States, which continue to apply national law while respecting the provisions of the FDI Regulation. The FDI Regulation also does not oblige Member States to adopt an FDI screening mechanism or seek to achieve the full harmonization of existing FDI screening mechanisms across the EU. Instead, it provides for information sharing and cooperation between Member States and the Commission. This involves the mandatory notification to the Commission and other Member States of any FDI scrutinized at the national level, including the provision of certain specified information. The FDI Regulation also requires that existing (and any new) regimes comply with a minimum set of requirements, while also encouraging those Member States that currently do not have an FDI regime to adopt relevant rules.
Antitrust: Analysis can be conducted by national authorities, EU authorities, or both. Likewise, the new Foreign Subsidies Regulation in the EU requires prior approval if the buyer is the recipient of significant non-EU subsidies.
Managing EU Employees
Hiring and firing in the EU: One of the biggest conceptual differences for companies expanding overseas is the unique US employment at-will doctrine—which does not exist in European employment law. Naturally, understanding this difference (among many others) is especially important when dealing with the European Union and its Member States. In some countries, termination without a legally valid reason may be null and void, and it may result in large severance and damage awards for unfair dismissal.
In Europe, there are also laws that relate to a wide variety of employee benefits, including caps on hours worked and allowances for vacation, holidays, sick leave, parental leave, and more. Yet another difference between European and US employment law is the requirement of written employment contracts in a great range of labor relationships. If the written contract requirement is not complied with, the employment is presumed to be for an indefinite period and on a full-time basis.
M&A transactions: A prior consultation with labor unions or work councils might be mandatory in some countries before completing an M&A deal. In principle, the workforce cannot be dismissed because of an M&A transaction. On the contrary, the workforce is transferred to the new owner, along with the workers’ contracts and accrued rights. If there is redundancy in jobs as a result of the M&A transaction, it will be necessary to negotiate a collective mass layoff with the work councils and under the supervision of the relevant labor authority.
Immigration issues: An EU national will generally not need a work permit to work anywhere in the EU. For non-EU residents, a work and residence permit will be required. In any employment relationship, the laws of both the country in which the employee resides and the country where the employee works apply. There are twenty entrepreneur and visa programs currently active in Europe, including Ireland and the UK. In any case, any worker who is not a resident of the country in which the work will be carried out must apply for and obtain an identification number for administrative and tax purposes in that country.
International or transnational telework: There is not a legally established definition of transnational telework, and there is a lack of a specific legal framework at national and international level. This makes transnational teleworking a situation that entails a few risks for companies and workers in terms of taxation, migration, labor, and social security.
Regarding social security, the general principle of lex loci laboris applies, i.e., the law of the place where services are provided applies, which in practice would imply social security contributions are required in the country from which the teleworker is working.
Care must be taken with alternatives to cover international teleworking situations that raise doubts about their legality. Of particular relevance is the transfer of workers within the EU, where differences in national employment laws and collective bargaining agreements among member states can give rise to legal complexities. These complexities often involve matters such as employment contracts, terms and conditions of employment, and collective rights, including the right to strike. Additionally, while the EU champions the free movement of workers, it’s important to note that some member states may enforce transitional arrangements or temporary restrictions on labor market access for workers from newer EU member states, as permitted by specific EU treaties.
C-level regulation: In many cases, European CEO contracts do not have the nature of an employment relationship but are considered to be corporate contracts. In these cases, such contracts are based on parties’ will. Critical clauses to consider in these types of contracts include post-contractual compete restrictions; confidentiality clauses; termination clauses; and garden leave.
Employee Stock Ownership Plans (ESOPs): European employees own less of the companies they work for than US employees. For late-stage startups, employees typically own around 10 percent, versus 20 percent in the US. Stock options are also executive biased: two-thirds of stock options are allocated to executives, and one-third to employees below the executive level. In the US, it is the reverse.
Essentially, in the EU, ESOPs can be “share option plans” or “phantom share plans.” The former give employees access to become partners in the company, while the latter only give employees the option to receive the increase in the value of the company generated during their service with the company. Phantom share plans operate as a bonus in an employment relationship.
In much of Europe, employees will be paying a high strike price, and they will be taxed heavily upon exercise as well as sale. Leavers often get nothing. There is wide variation in national policy, regulations, and tax frameworks across Europe, with the UK most supportive of employee ownership.
ESG Spotlight
EU regulation: In February 2022, the European Commission released a proposal for the Corporate Sustainability Due Diligence Directive, which aims to enhance corporate governance and promote sustainable and responsible business practices. The directive mandates specific due diligence measures and responsibilities to address negative human rights and environmental impacts.
M&A transactions: Private equity and venture capital firms need to assess sustainability risks in their investments—such as M&A transactions and equity investments—in order to implement ESG disclosures. Additionally, if the target company exceeds an average number of five hundred employees on its balance sheet during the financial year, these investors must consider the principal adverse impact (PAI) of their investments on ESG factors relevant to the target company. The company is required to make a statement on its website regarding its due diligence policies for adverse impacts, considering factors such as company size, nature of activities, and types of financial products offered. If the limit is not exceeded, investors’ consideration of the PAI of their investments on ESG factors is voluntary.
ESG factors have become critical drivers in PE and VC deals, as they can impact a target company’s long-term value and reputation. Assessing ESG factors and evaluating the alignment of the target company with them is essential to mitigate potential risks.
EU Taxation
Permanent establishments: The rules governing permanent establishments of companies in a Member State have become increasingly relevant to expanding companies, particularly with the rise of highly skilled teleworkers, including management personnel, potentially creating new permanent establishments. There has been a surge in the concept of “virtual permanent establishment,” especially related to e-commerce businesses.
Legal uncertainty: There is growing uncertainty regarding the taxation of outbound interest, royalty, and dividend income under the EU Parent-Subsidiary and Interest and Royalty Directives, influenced by interpretations from the EU Court of Justice. This uncertainty will affect decisions on corporate structure, such as EU holding and finance companies. This scenario is particularly pertinent in leveraged buyouts (LBOs) and debt push-down processes, where the deductibility of interests has undergone various modifications, requiring careful consideration in strategic planning.
Anti-abuse rules: Anti-abuse tax rules are being tightened at the EU level, resembling the domestic tax base erosion and profit shifting (BEPS) rules of the Organisation for Economic Co-operation and Development (OECD). This includes measures targeting the use of finance hybrids and controlled foreign company (CFC) rules.
Taxation of cross-border talent movement: Such taxation has become very relevant, with special tax regimes for “inpatriates” in countries such as Italy, Portugal, the Netherlands, Spain, and the UK, as well as salary incentives like ESOPs.
Transfer pricing: Valuation of cross-border income flows between related parties, especially in relation to intellectual property (IP) licensing activities, is of utmost importance.
Exits: When planning an exit strategy, most double taxation treaties offer protection from source taxation, but not all of them provide such provisions.
Other Relevant Obligations
AML: The EU implemented its first anti-money laundering directive in 1990 to prevent money laundering and require customer due diligence for obliged entities. Today, Directive (EU) 2015/849 is a key part of the EU’s anti-money laundering and terrorist financing legislation, requiring enhanced vigilance for high-risk third countries.
The new Anti-Money Laundering Authority (AMLA) will monitor risks within and outside the EU, directly supervising credit and financial institutions based on their risk level.
GDPR and privacy: In 2023, the European Commission adopted an adequacy decision for the EU-US Data Privacy Framework, which ensures data protection in data transfers to US companies, enabling the program to facilitate such transfers. The framework includes binding safeguards, a Data Protection Review Court, dispute resolution mechanisms, and an arbitration panel.
Compliance with the General Data Protection Regulation (GDPR) and EU-US Data Privacy Framework is crucial to avoid substantial fines (up to 4 percent of the company’s annual global turnover or up to €20M, whichever is greater), as demonstrated by the record fine imposed on Instagram by the Irish Data Protection Authority in 2022.
IP rights: Intellectual property rights—including patents, trademarks, trade secrets, copyrights, data, software, and technologies—are highly protected within the EU, with some local differences to consider. As an example, regarding Trademark Registration Procedures, while EU member states generally follow the EU Trademark Directive for trademark registration, there can be differences in procedural aspects such as examination criteria, registration timelines, and administrative requirements. For instance, some countries may have stricter criteria for trademark distinctiveness or may require additional documentation during the application process.
Consumer protection: The European Commission is in the process of conducting a “Fitness Check” of EU consumer law on digital fairness to ensure a high level of consumer protection in the digital environment and analyze the need for additional legislation or action.
India
Key Considerations
FDI approval routes: The pivotal aspects for consideration when it comes to expanding your business into the Indian subcontinent are the sector-specific regulations and entry routes for receiving investments into India. Foreign investments in India can be made through one of two means: the automatic route or the government approval route. While most investments fall under the automatic approval route, some may entail prior approval of the Government of India. For example, any investment in the defense sector will require prior approval of the relevant ministry along with concurrence by the Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry.
Further, pursuant to the Foreign Exchange Management (Non-debt Instruments) Rules, 2019, and the Consolidated FDI Policy dated October 15, 2020, detailing Press Note No. 3 of 2020 (PN3), if an entity of a country that shares a land border with India or where the beneficial owner of an investment into India is situated in or is a citizen of any such country, such investment will also require prior approval of the Government of India. FDI proposals in sensitive sectors and proposals falling under PN3 will be subject to further security checks and require security clearance from the Ministry of Home Affairs as well. The timeline for obtaining FDI approvals spans from about three to nine months, since it passes through several layers of scrutiny by the relevant authorities governing the sector of proposed investment.
Competition law guidelines: In addition to the structuring of a deal, investors must be aware of the compliance framework prevailing in India. Investments that are over certain limits prescribed in respect of turnover, existing asset value, or the newly introduced criterion of deal value are subject to the regulatory scrutiny of the competition watchdog of the country, the Competition Commission of India (CCI).
Choice of entity: It is important to determine the nature of the entity to be established in India for the purpose of carrying out business objectives. Subject always to the guidelines prescribed by the Reserve Bank of India, foreign companies can operate through a subsidiary, branch office, liaison office, project office, or representative office. While a branch office is not allowed to carry out manufacturing or processing activities in India (either directly or indirectly), project offices are set up to execute only specific projects in India. Liaison or representative offices are only meant to promote the parent company’s business interests, such as promoting its parent entity’s products. The establishment and management of a subsidiary are governed by the Companies Act, 2013, and the extant Foreign Exchange Management Act (FEMA) guidelines. Therefore, the choice of the nature of entity in India would depend upon the commercial exigencies in consonance with the objectives envisaged by the business plan.
Industrial policies: The Indian government has established foreign trade zones such as Special Economic Zones and Software Technology Parks (STPs) to incentivize foreign investments, improve the ease of doing business, and reduce the tax burdens on businesses operating in these zones. In addition to these, Export Processing Zones (EPZs) offer incentives to foreign investors involved in export-oriented businesses. Further, the Government of India also offers several production-linked incentives that are aimed at incentivizing foreign manufacturers to set up production units and manufacture in India under the “Make In India” scheme.
Nature of funding: Indian companies can issue equity shares; fully, compulsorily, and mandatorily convertible debentures; and fully, compulsorily, and mandatorily convertible preference shares subject to pricing guidelines/valuation norms prescribed under FEMA regulations. The price at the time of conversion should not in any case be lower than the fair value worked out, at the time of issuance of such instruments, in accordance with the extant FEMA rules/regulations. Companies may also receive funds through issuance of other preference shares/debentures (non-convertible, optionally convertible, or partially convertible) other than from foreign sources. Further, Indian companies are permitted to issue warrants or partly paid shares to a person resident outside India subject to the terms and conditions stipulated by the Reserve Bank of India.
Borrowing from foreign companies or individuals is governed by the Master Direction—External Commercial Borrowings, Trade Credits and Structured Obligations. Within the contours of these regulations, the Reserve Bank of India lays down detailed guidelines in respect of external commercial borrowings (ECB), including the term of such ECB, minimum average maturity period, permitted end uses, and reporting requirements of the borrower.
Repatriation of funds: Profits from an Indian entity can be repatriated abroad by various means, such as dividends, buyback of shares, reduction of share capital, use towards fees for technical services, consultancy services/business support services, or royalty. Funds resulting from winding up or dissolution of entities can also be repatriated. Some of these require prior approval of the Reserve Bank of India and in some cases with the approval of specific tribunals (e.g., National Company Law Tribunal).
Statutory dues, licenses, and registrations: Other than the aforementioned approvals from the Reserve Bank of India and the CCI, investors in India should also be acquainted with the nuances of the statutory payment such as taxes, levies, and stamp duties. They also need to ensure compliance with the provisions under the Companies Act, 2013, such as obtaining local certifications and payment of employment benefits. Further, if the company will establish of a new entity or manufacturing facility, the relevant registrations, and the various licenses, both at central and state levels, are to be obtained under the applicable Indian laws.
Hiring of employees and labor law compliance: Foreign companies intending to venture into India must also consider the plethora of labor laws in India. In the absence of a subsidiary, project office, liaison office, or branch office, it is not legally permissible for a foreign entity to directly hire Indian resident employees for running their business operations in India. In such a case, the Indian resident employees can only be hired through an appropriate agency (Professional Employer Organization (PEO) or Employer of Record (EOR)). When hiring through a PEO, service providers will be beneficial to a foreign entity that already has an establishment in India. An Employer of Record (EOR) may be preferred where a foreign entity does not have any existing establishment. On the other hand, if the foreign company has already established its Indian entity or intends to establish a subsidiary, such entity must ensure compliance with the extant labor and employment laws in India. Several factors such as the number of employees, mode of employment, salary structure, etc., affect the extent of applicability of labor laws and the necessary steps for compliance.
Taxation: India has entered into various double taxation avoidance agreements (DTAA) with foreign countries that provide benefits to non-residents who may be subject to tax both in India and their home jurisdiction. Investors must consider the tax implications under the DTAA between India and their home jurisdiction and under the Income Tax Act, 1961, to minimize tax leakage and efficiently reap the benefits of the DTAA.
Further, a company is said to be a resident in India—and therefore, taxable—in any previous financial year if such company has its place of effective management in India. A company may be construed to have its place of effective management in India when its key management and commercial decisions that are necessary for the conduct of its business as a whole are in substance made in India. In such a case, the global income of such company becomes taxable in India at the rates applicable to a foreign company in India.
Other Factors
Choice of law: Choice of governing law and dispute resolution mechanism is of vital importance for cross-border investments and M&A. Whether the forum for dispute settlement is India or the foreign country is a question that is to be determined and agreed by the parties based on the nature of contract(s) entered into and on a comparison of costs involved therein. In India, arbitration is increasingly preferred over traditional dispute resolution through courts due to delays and time consumption in resolving disputes through the court system. Even arbitrations conducted under the aegis of an international arbitration institution such as the London Court of International Arbitration, International Chamber of Commerce, or Singapore International Arbitration Centre are enforceable by the Indian courts, and the final award is appealable only on very limited grounds.
Fiduciary duties: Investors should also be cognizant of the fiduciary duties that are associated with holding a directorship position or the role of a promoter of an Indian entity. In the case of private companies that have an IPO as an exit mechanism, promoters have a lock-in period of eighteen to thirty-six months. Foreign individuals who intend to be appointed as directors on the board of an Indian entity should obtain a director identification number, Digital Signature Certificate, and a permanent account number prior to such appointment. Further, Indian entities require at least one director to be a resident in India.
Social responsibility: Companies are also required to honor their social responsibility by being accountable to themselves, their stakeholders, and the general public. India takes a self-regulating approach in which companies integrate social and environmental concerns in their business operations and interactions with their stakeholders instead of focusing entirely on profit-making objectives, as well as use a part of their profits towards corporate social responsibility activities.
Sustainability reporting: Since fiscal year 2022–23, the Securities Exchange Board of India—the primary regulatory body governing listed companies in India—has made it mandatory for each of the top one thousand listed companies to submit a business responsibility and sustainability report. This is intended to help investors make informed decisions while investing in such entities and understand which companies are making a positive social and environmental impact.
Chile
Taxes and structuring: Chile has undergone several tax reforms in the past fifteen years and is currently discussing the need for a new tax reform. The Chilean tax system is applied on a national level and generally does not have special regimes for different industries. As an exception, Chile has approved a Mining Royalty that applies in addition to the corporate tax. A tax invariability regime called DL600 was recently repealed, leaving all foreign investors subject to the general tax regime and its potential changes.
Chile has entered into more than thirty-five tax treaties and is guided by the OECD guidelines in most tax matters. Most recently, a tax treaty between the US and Chile entered into force in December 2023. The Chilean tax administration, the Servicio de Impuestos Internos, is a very modern and highly digitalized entity and is pushing to make all interactions with taxpayers take place through digital means. Chile has specialized and independent first instance Tax and Customs Courts. The Appellate Courts and Supreme Court, however, are not specialized.
The corporate tax under the general tax regime is currently 27 percent, and it can be used as a credit against the tax on dividends (at 35 percent), making the effective tax rate for dividends either 35 percent (under a tax treaty scenario where the corporate tax is fully creditable) or 44.45 percent when the corporate tax is only creditable at 65 percent.
Intellectual property: IP is a constitutional right in Chile, for both industrial property rights (trademarks, patents, trade secrets) and copyrights. This type of ownership of rights is protected with the same force as regular property under Chile’s constitution. Those provisions are the source of Chile’s Industrial Property Law (N° 19.039) and Copyright Law (N° 17.336).
Chile is part of various international treaties related to IP, such as the Paris Convention, the Bern Convention, the Trademark Law Treaty, the Patent Law Treaty, and, recently, the Madrid Protocol, which includes the Chilean jurisdiction in the Madrid System (along with 128 other countries) for the centralized prosecution and maintenance of trademarks internationally.
Also, the Chilean Industrial Property Law has been recently modernized to include non-traditional trademarks, such as smells, 3D trademarks, and others, as long as they are distinctive. It also incorporates provisional patents and industrial design deposits for priority purposes, without having to spend resources on a full-scale application process. Often a decision to proceed can be delayed until there is a commercial and financial benefit in the protection offered by the design.
Hiring of employees and labor law compliance: Foreign entities planning to hire employees in Chile need to consider that the country has a strong range of regulations set out on the Constitution, the Labor Code, and different minor legislation regulating the country’s social security system. Additionally, the protection of employees’ rights has been considered a key principle for employment courts, which decide cases with a pro-employee criterion.
Labor regulations set out minimum employment rights regarding employee classification, minimum wage, working time restrictions, protections of salaries, protection against termination of employment, outsourcing, health and safety, fundamental employment rights, and collective employment rights. Chile is not an employment at-will country, so employers are required to invoke legal grounds for terminations even in redundancies.
Foreign entities are allowed to hire employees in Chile, provided they designate a local legal representative and address or set up a subsidiary. Local regulations do not acknowledge PEO (Professional Employer Organizations) or EOR (Employer of Record), restricting the provision of employees to specific time-restricted scenarios. Companies are allowed to outsource the provision of services from third parties, but the law provides a solidary liability for the compliance of employment duties towards the outsourcing entity.
In Chile, trade union organizations are relevant within the company, being allowed to engage into a collective bargaining processes and strike with their employer. Currently, collective bargaining regulations are restricted to the company as a legal entity, but the current administration has announced its intention to create industry-based collective bargaining obligations.
Finally, local regulations consider a strong protection of fundamental employment rights, which are a set of constitutional rights protected in the context of employment such as the rights to life, to work, and not to be discriminated against. Litigation related to such rights can allow employees to claim their reinstatement on serious discrimination claims and can involve additional penalties and restriction on the company’s participation in biddings with public entities for a two-year period. This last sanction also applies to anti-union practices.
Regulatory considerations: Finally, Chile has been a very stable country for the last thirty years. It is now in the process of drafting a new constitution, which likely will end up granting more rights to the Chilean population. Its regulation is sophisticated and provides a number of areas that need to be understood by investors and their portfolio companies who are targeting consumers or who profit from the collection and exploitation of personal data. Chile supports innovation through its regulations and encourages international investment in its forward-looking and established economy.
Renewable energy has become a significant industry since recent governments issued regulations toward promoting foreign investment in this area. Solar and wind projects have been active during recent years, receiving significant amounts of investment from abroad. Now, green hydrogen has triggered interest, since experts consider Chile to have the best conditions for these types of projects.
Conclusion
Opportunities for overseas growth are huge, but navigating the local issues needs to be prioritized. Many businesses consider their international expansion a quick and easy add-on to their US domestic business, but in fact, the unfamiliarity of overseas markets can often mean greater time should be spent on ensuring a proper approach is taken. Doing it right is far more likely to lead to a successful market entry and greater profits, ensuring the return on investment for the investor is maximized and keeping everyone happy!
This discussion is a general, high-level summary and not an exhaustive checklist or legal advice. Obtaining local counsel is vital, and adequate time and resources should be allocated to any international expansion project.
This article is related to a CLE program titled “What Legal Issues Should Investors Ask Their Portfolio Companies to Prioritize When Growing Overseas?” that took place during the ABA Business Law Section’s 2023 Fall Meeting. To learn more about this topic, listen to a recording of the program, free for members.
Investment advisers’ Marketing Rule compliance remains one of the examination priorities of the U.S. Securities and Exchange Commission (“SEC”). On April 17, 2024, the SEC’s Division of Examinations issued a Risk Alert sharing the staff’s initial observations (the “Observations”) from their real-life examinations of investment advisers’ compliance with amended Rule 206(4)-1 (the “Marketing Rule”) under the Investment Advisers Act of 1940 (“Advisers Act”). The Observations focus on advisers’ compliance with Marketing Rule–related aspects of Advisers Act Rule 206(4)-7 (the “Compliance Rule”), Advisers Act Rule 204-2 (the “Books and Records Rule”), and the Marketing Rule’s “General Prohibitions,” as well as accurate disclosure of their Marketing Rule compliance in Form ADV.
I. Positive Observations
The Risk Alert mentioned some positive aspects of advisers’ activities that the staff observed during their examinations. The following list highlights those positive Observations.
A. Compliance Rule
Advisers’ compliance policies and procedures typically covered processes to comply with the Marketing Rule.
Advisers typically provided training for relevant personnel on both the Marketing Rule’s statutory requirements and the advisers’ marketing policies and procedures.
When advisers had updated their written marketing policies and procedures to reflect the Marketing Rule, the policies and procedures typically included a process for reviewing their advertisements.
Many advisers required preapproval of advertisements before dissemination.
B. Books and Records Rule
Advisers had typically updated policies and procedures to include Marketing Rule–related books and records maintenance and preservation requirements.
C. Form ADV
Many advisers updated their Form ADVs and brochures with respect to advertising—in particular, Part 1A, Item 5.L and Part 2A, Item 14 (e.g., client referrals and other compensation).
Advisers can learn from the above positive Observations, because they tell what practices of other advisers have been recognized by the staff.
II. Negative Observations
The Risk Alert highlighted more details about how advisers’ practices fell short of the Marketing Rule’s requirements. The following list identifies those negative Observations.
A. Compliance Rule
Some advisers’ policies and procedures:
Only mentioned some general descriptions and expectations regarding the Marketing Rule.
Failed to address how advisers’ marketing channels (e.g., websites and social media) can comply with the Marketing Rule.
Were not in writing.
Were not updated to reflect the Marketing Rule.
Were incomplete or partially updated.
Were not tailored to advisers’ advertising practices (e.g., how to comply with the Marketing Rule with respect to testimonials, endorsements, and third-party ratings utilized by advisers in advertisements).
Failed to adequately cover how to keep marketing-related books and records (e.g., how to keep questionnaires or surveys used in third-party ratings).
Were not implemented (e.g., advisers’ policies required net performance while their advertisements only included gross performance).
B. Books and Records Rule
Some advisers failed to maintain copies of questionnaires or surveys used in third-party ratings, copies of information posted to social media, or substantiation documents supporting their advertised performance.
C. Form ADV
On Form ADV, Part 1A, some advisers failed to disclose third-party ratings, performance results, or hypothetical performance.
On Form ADV, Part 2A, some advisers used outdated language, such as references to provisions of the prior Cash Solicitation Rule; failed to disclose referral arrangements in their marketing practice; or omitted material terms and compensation of their referral arrangements.
D. Marketing Rule’s General Prohibitions
Advisers were found to have violated the Marketing Rule’s seven General Prohibitions in the following ways.
(1) Statements of material facts were untrue or unsubstantiated. For example, some advisers:
Failed to disclose conflicts of interest.
Exaggerated their number of advisory professionals.
Inaccurately described advisers’ and/or their professionals’ credentials.
Inaccurately described advisory services or products (e.g., included nonexistent investment mandates, investment process validation, risk tolerance consideration, approved securities lists, securities screening processes, and/or client base).
(2) Advertisements omitted material facts or were misleading. For example, some advisers:
Misled clients to believe that the advisers’ acting “in their clients’ best interests” distinguished them from others, when in fact this is all advisers’ fiduciary duty.
Failed to disclose compensation paid to or received by the advisers for their recommendations.
Failed to disclose advisers’ appearances in national news media were paid ads.
Failed to disclose celebrities did not endorse the advisers although their marketing materials included celebrities’ images in a manner that implied endorsement.
Included untrue or misleading advertisements on performance (e.g., (i) advertised unachievable performance results, (ii) failed to disclose share classes specific to certain performance returns, (iii) used lower than actual fees in calculating net performance, or (iv) omitted certain fee/expense information used in calculating returns).
Implied that SEC registration was representative of a particular level of skill or ability, or that the SEC had either approved or passed upon the advisers’ business practices, when actually all advisers are prohibited from advertising so.
Advertised third-party ratings in a misleading way (e.g., (i) failed to disclose the advisers were not the sole/top recipients of such ratings, or (ii) failed to disclose the methodologies for such ratings).
Advertised testimonials in a misleading way (e.g., misled people to believe testimonials about a third-party product were about the advisers’ services).
Contained misleading performance advertisements (e.g., (i) failed to define the index used or sufficiently explain the basis for benchmark index comparisons, (ii) advertised outdated market data or unavailable investment products, or (iii) advertised misleading performance track records).
(3) Advertisements violated prohibitions related to the “fair and balanced” criteria. For example, some advisers:
Failed to provide fair and balanced disclosure of any material risks/limitations associated with potential benefits connected with the advisers’ services or methods of operation.
Advertised only the most profitable investments or specifically excluded certain investments without explaining why.
Failed to establish criteria in advisers’ policies and procedures to ensure fair and balanced presentation of investment advice.
Failed to disclose the time period or explain the time period related to performance information.
Included or excluded certain performance results in manners that were not fair and balanced—for example, advertised only realized investments and excluded unrealized investments.
(4) Advertisements were also materially misleading in other ways; for example, advertisements on websites or in videos presented disclosures in an unreadable font.
Advisers may want to reflect on their own policies, procedures, and practices to avoid fraudulent or misleading advertising like the above negative Observations.
Conclusion
The Observations in the Risk Alert tie in closely with the discussion on page thirteen of the SEC’s 2024 Examination Priorities regarding examination of advisers’ Marketing Rule compliance. Therefore, the Observations provide itemized illustrations to investment advisers registered, or required to be registered, with the SEC of questions they may face in the SEC’s future examinations related to the Marketing Rule and frequent pitfalls they may want to avoid. Although the Marketing Rule does not apply to exempt reporting advisers or state-registered advisers, the Observations can help them understand how to better comply with the Advisers Act’s antifraud rules in their day-to-day advertising practices.
This is a summary of the Hotshot course “Claims ‘If True’: Market Trends,” in which M&A members discuss market trends for the claims “if true” concept in private M&A deals, drawing on data from the ABA M&A Committee’s 2020–21 Private Target M&A Deal Points Study. View the course here.
Claims ‘If True’: Market Trends
According to the ABA M&A Committee’s Private Target Deal Points Study, of the deals covered in 2022 and the first quarter of 2023:
83% limited indemnification for actual breaches of the reps and warranties; and
17% included indemnification for alleged breaches (the “if true” concept).
However, this might be understating how much the “if true” concept is included in deals.
A purchase agreement might include the “if true” concept within a broader indemnification right for certain third-party claims.
For example, a purchase agreement might give the buyer the right to indemnification for any third-party claims that relate to the business of the seller during the pre-closing period.
The purchase agreement might also include additional bases for indemnification beyond breaches of reps and warranties, such as claims related to excluded assets or excluded liabilities.
While the ABA Study looked for various ways the “if true” concept could be included, it’s possible that the number of deals that provide indemnification for alleged claims could be higher.
The rest of the video includes interviews with ABA M&A Committee members Joanna Lin from McDermott Will & Emery and Jessica Pearlman from K&L Gates.
This is a summary of the Hotshot course “Claims ‘If True’: Drafting,” a look at how and where claims “if true” language appears in acquisition agreements, including sample provisions. View the course here.
Drafting Claims ‘If True’Language
The ‘if true’ concept can appear in various places in a purchase agreement and can be drafted in different ways.
The main places the concept can be found are in:
The list of bases for indemnification;
Certain defined terms; and
Provisions addressing procedures for third-party claims.
The Bases for Indemnification
‘If true’ language is often found in the indemnification section, whether in:
The basis for breaches of representations and warranties; or
A stand-alone basis for indemnification generally.
Below are some examples of different formulations that may be found in a list of bases for indemnification. Note:
There’s no one way to word this concept.
Each of the following is only an ‘if true’ example if the definition of “Damages” or “Losses” (or similar terms) arising under these bases for indemnification includes buyer’s costs and expenses.
Examples:
“any breach, or any claim by parties other than Buyer that, if true, would constitute a breach, of any Company representation or warranty in Article III”
This formulation uses the ‘if true’ language.
It ties it to breach of reps and warranties language.
“any third-party claim resulting from any alleged breach of this Agreement”
This example includes the ‘if true’ concept as a stand-alone basis for indemnification.
It’s not limited to breaches of reps and warranties.
“any Proceedings arising from or relating to the subject of the matters set forth in the foregoing clauses”
This example is another version of including the ‘if true’ concept as a stand-alone basis for indemnification.
Whether this is tied to just breaches of reps and warranties depends upon the subject matter of the clauses that come before it.
“any third-party claims that relate to the pre-Closing period”
This example doesn’t expressly mention breaches or inaccuracies.
It isn’t specific as to the type of claim—it could relate to anything having to do with the business before the closing.
“use of the Assets pre-Closing”
Like the example above, this formulation doesn’t expressly call out claims or breaches or inaccuracies.
It’s also not limited to third-party claims.
Some versions of ‘if true’ language can suggest that the third-party claim would have to allege that the seller breached its representations in the agreement with the buyer.
A provision like that might say:
“(i) any breach of any Company Representation, including any breach of any such representation or warranty alleged by a third party;”
However, typically, third parties wouldn’t even know what the representations are.
While the parties’ intent on this issue should control, buyer’s counsel will want to be sure that any claims ‘if true’ language in the purchase agreement does not require the third party to specifically allege a breach of the representations and warranties.
In the example above, the buyer would likely mark up the provision by:
Adding the ‘if true’ language; and
Striking out the language saying that the third party must be alleging a breach of a rep or warranty:
“(i) any breach of any Company Representation, including any third-party claim alleging facts that, if true, would constitute a breach of any such representation or warranty alleged by a third party ;”
Defined Terms
The claims ‘if true’ concept can also be found in the following commonly used definitions in purchase agreements.
“Losses,” “Damages,” “Indemnifiable Amounts,” and similar terms
Definitions such as “Losses,” “Damages” and similar terms provide the scope of what’s recoverable under each of the bases for indemnification but can broad enough to cover claims ‘if true.’
The buyer might include in this definition the costs and expenses incurred in connection with defense, settlement, or resolution of a third-party claim. This can be argued to make the seller responsible for the costs associated with claims without regard to whether there’s an actual breach.
“Excluded Liabilities”
In deals in which the buyer is indemnified for certain identified liabilities, the buyer might include in the definition of these excluded liabilities “claims arising from the pre-Closing period” or similar language.
This is to make the seller responsible for the cost associated with claims, not just actual breaches and not just amounts awarded to a claimant.
Provisions Addressing Procedures for Third-Party Claims
Purchase agreements usually include provisions regarding the procedural handling of third-party claims.
These procedural provisions may include language giving the buyer the right to recover for its costs and expenses in defending against a third-party claim without regard to whether a seller breach has been found to have occurred.
For example, the provisions could say that damages include reasonable costs and expenses connected to a defense of a third-party claim, “whether or not it is ultimately determined that the third-party claim is indemnifiable.”
In other words, the seller is responsible for those costs and expenses, whether or not the seller is responsible for any underlying breach of a representation.
The rest of the video includes interviews with ABA M&A Committee members Joanna Lin from McDermott Will & Emery and Jessica Pearlman from K&L Gates.
This is a summary of the Hotshot course “Claims ‘If True’: Buyer and Seller Perspectives,” a look at buyer and seller perspectives regarding claims “if true” language in acquisition agreements. View the course here.
Buyer and Seller Perspectives
The parties’ positions on the concept of ‘if true’ claims in M&A agreements are straightforward:
The buyer wants it in.
The seller wants it out.
One side usually wins the issue outright.
Buyer’s View
If there’s a third-party claim that’s based on how the seller operated the business before closing, the buyer wants to be made whole regardless of whether the buyer ultimately prevails against the claimant.
The buyer doesn’t want to take any of the risk for third-party claims that:
Arise during the indemnification period; and
Are based on facts that existed or occurred before the buyer acquired the business, whether or not the claim is proven.
The buyer is worried that if the claim isn’t proven, it’ll cost them a lot of money to defend that claim.
Without the ‘if true’ language in the agreement, the buyer won’t be able to recover that money from the seller.
The buyer isn’t worried about claims that are proved to be true, since those would be protected under the indemnification provisions.
Note this is different from:
The risk the buyer knows it will assume after the indemnification period ends; and
Claims based on facts that existed or occurred after the buyer acquired the business.
Seller’s View
The seller’s typical response to proposed language making the seller responsible for the costs and expenses of defending unproven allegations is that the underlying third-party claim might be frivolous.
The seller doesn’t think it should be responsible for the buyer’s costs and expenses of defending against a claim that arises after closing where the seller has not done anything wrong.
This is particularly true if the seller believes the announcement of the deal or the identity of the buyer is more likely to attract frivolous claims.
This might happen when the buyer is much better known than the seller and has greater ability to pay out on claims.
In general, the seller’s view is that any unproven claim that arises after closing is a risk of owning and operating the business that the buyer should bear.
Buyer’s Response
The response the buyer might make to the seller is that refusing to allow the buyer recovery for the costs of unproven claims incentivizes the buyer to lose the case with the third party, costing the seller even more money.
If the third party wins the claim, a breach of a rep would likely be proven.
This puts the buyer in the position of being able to recover (under typical indemnification provisions):
The damages the third party receives from the buyer; and
The buyer’s costs and expenses related to the proceeding.
This response assumes the buyer has the right to control the defense of third-party claims.
This may not be the case under the given acquisition agreement.
Compromises
One party usually wins outright, but there are some areas for potential compromise.
The parties might consider handling the issue differently based upon the type of claim involved.
Example:
The seller might refuse to indemnify the buyer for unproven IP infringement claims but be willing to indemnify the buyer for its costs and expenses in defending against other unproven third-party claims.
For example, for claims of employee discrimination or employee misclassification.
Seller’s comfort with providing indemnity for various types of unproven claims will depend on the relative risk of the claims.
This, in turn, will depend on:
The nature and history of the business; and
The industry in question.
Another area for compromise could be in the amount of cost and expenses that are recoverable.
The parties could agree to share the burden in some manner, giving both parties “skin in the game.”
This could be accomplished by:
Splitting the burden equally, for example with language indicating that “only 50% of losses are recoverable”;
Splitting it in some other proportion; or
Having the seller bear only an initial capped amount of the costs and expenses, to ensure that the buyer isn’t motivated to run up the fees but instead settle as inexpensively as possible.
The rest of the video includes interviews with ABA M&A Committee members Joanna Lin from McDermott Will & Emery and Jessica Pearlman from K&L Gates.
This is a summary of the Hotshot course “Claims ‘If True,’” an explanation of the claims “if true” concept in private M&A deals, including an analysis of the implications to the parties if an acquisition agreement does or does not contain this concept. View the course here.
Explaining Claims ‘If True’
An essential part of a private purchase agreement is that the buyer can seek indemnification from the seller for breaches of the seller’s reps and warranties and other negotiated indemnification rights.
That’s why the parties spend so much time negotiating:
The scope of the reps and warranties; and
The amount and type of damages that can be sought if there’s a breach or other indemnity claim.
Buyers want the seller’s indemnification obligation to be as broad as possible.
They want sellers to be responsible for anything that relates to the pre-closing period.
They want to be made whole for all of their costs related to any third-party claims, including the costs of defending claims whether or not those claims later turn out to be true.
That’s why buyers often want to include an indemnification right based on the ‘if true’ concept for third-party claims.
The ‘if true’ concept is commonly referred to as “claims if true” or “facts if true.”
It means that the seller has to indemnify the buyer for costs the seller would be responsible for if the facts alleged in the third-party claim were true.
This issue typically relates to indemnification for breaches of reps and warranties.
But it can relate to other indemnified areas as well.
Impact on the Parties
To illustrate the impact this issue has on the parties, let’s look at what can happen if, after closing, there’s a third-party claim against the buyer for a matter that’s covered by a seller representation.
If the third party prevails, the ‘if true’ issue is moot.
This is because under most purchase agreements, the buyer’s costs and expenses in defending against third-party claims are indemnifiable under the purchase agreement because there has been a breach of a seller representation.
If the buyer prevails (because it won the case) or neither party prevails (because the case was settled or the claim is never finally determined), the ‘if true’ issue comes into play.
In these cases, the buyer can’t show a breach of the related seller representation, so the ‘if true’ concept becomes important.
If the purchase agreement does not contain the ‘if true’ concept, the buyer is responsible for the costs and expenses of defending against the claim and cannot recover those amounts from the seller.
Unless the buyer is able to prove in the indemnification claim against the seller that the underlying facts of the claim are true.
It’s hard for a buyer to do this, as they have already defended the claim from the third party by taking the position that the facts underlying the claim were not true.
If the agreement does include claims ‘if true’ language, the buyer can recover its costs and expenses of defending the claim.
The buyer is covered whether or not the third-party claim demonstrates a breach of the related seller representation.
The rest of the video includes interviews with ABA M&A Committee members Joanna Lin from McDermott Will & Emery and Jessica Pearlman from K&L Gates.
