New Publication: Model Asset Purchase Agreement for Bankruptcy Sales
Using the Negotiated Acquisitions Committee’s 2001 Model Asset Purchase Agreement as a guide, the Business Bankruptcy Committee created a Model Asset Purchase Agreement for bankruptcy sales. Bankruptcy sales differ in many respects from a non-bankruptcy sale. This publication highlights the differences, includes commentary as a teaching mechanism, and provides ancillary documents and appendices.
This new publication is not a stand-alone asset purchase agreement. Instead, it highlights how certain terms and provisions may vary between a bankruptcy and a non-bankruptcy sale and, in some circumstances, provides commentary and case law to explain the reasoning underlying those variations. This publication about bankruptcy asset purchase agreements (and sales generally) does not include provisions that do not vary between a sale that would be consummated in bankruptcy and one that would be consummated outside of bankruptcy. For example, a definition for “Assets” is not included in this publication as it is generally identical in a bankruptcy and non-bankruptcy asset purchase agreement.
In addition, sample provisions and language not typically in non-bankruptcy asset purchase agreement are included—provisions concerning bid procedures, credit bidding rights, and executory contracts, for example. This publication should be used in conjunction with another asset purchase agreement and, in particular, the Negotiated Acquisitions Committee’s 2001 Model Asset Purchase Agreement. Such an approach will provide you with a comprehensive and flexible agreement for bankruptcy sales as well as a deep understanding of the purposes underlying each provision.
Section members can order the book at the price of $199.95 here.
Payments made under supply-of-goods contracts, or contracts for the sale of goods, are often the subject of bankruptcy avoidance actions. Sections 546(e) and (g) of the Bankruptcy Code (11 U.S.C. § 546(e) and (g)) prohibit the avoidance and recovery of preferential and constructively fraudulent transfers made in connection with forward contracts and swap agreements. Specifically, section 546(e) protects settlement payments made to a forward contract merchant in connection with a forward contract, whereas section 546(g) protects transfers made to a swap participant in connection with a swap agreement.
At first blush, sections 546(e) and (g) seemingly apply exclusively to forward contracts and swap agreements relating to financial markets. Indeed, in amending several of the safe-harbor provisions in 1982, Congress explained that, “the amendments are intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583. Yet, despite Congress’s intentions, the terms “forward contract,” “forward contract merchant,” “settlement payment,” and “swap agreement” are so broadly defined that they arguably encompass transfers made in connection with ordinary supply-of-goods contracts. This article explores the Bankruptcy Code’s safe harbors and the ambiguities that can arise when dealing with such contracts.
Section 546(e) and Forward Contracts
Except for actual fraudulent transfers, section 546(e) prevents a bankruptcy trustee from avoiding and recovering: (1) a transfer that is a settlement payment made by or to (or for the benefit of) a forward contract merchant; or (2) a transfer made by or to (or for the benefit of) a forward contract merchant in connection with a forward contract that is made before the commencement of the case. Thus, to establish a section 546(e) defense, a defendant must show that: (1) the underlying agreement between the parties is a forward contract; (2) one of the parties to the agreement is a forward contract merchant; and (3) the transfers at issue constitute settlement payments.
Establishing the Existence of a Forward Contract
A party must first establish the existence of a forward contract to invoke section 546(e). The Bankruptcy Code defines a “forward contract,” in relevant part, as a contract for the sale of a commodity that is presently or in the future becomes the subject of dealing in the forward contract trade with a maturity date more than two days after the date into which the contract is entered. In defining “forward contract,” Congress stated that the “primary purpose of a forward contract is to hedge against possible fluctuations in the price of a commodity. This purpose is financial and risk-shifting in nature, as opposed to the primary purpose of an ordinary commodity contract, which is to arrange for the purchase and sale of the commodity.” H.R. Rep. No. 101-484, at 4 (1990), reprinted in 1990 U.S.C.C.A.N. 223, 226. Although legislative history relating to forward contracts indicates otherwise, the Bankruptcy Code’s definition arguably is broad enough to encompass ordinary supply-of-goods contracts so long as the contract: (1) is for the purchase, sale, or transfer of a commodity or any similar good that is presently or in the future becomes the subject of dealing in the forward contract trade; and (2) has a maturity date more than two days after the date into which the contract is entered.
The broad scope of the term “forward contract” can be limited only by its elements. As for the first element, the Bankruptcy Code specifically defines a “commodity” as wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats, oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, frozen concentrated orange juice, and all other goods and articles in which contracts for future delivery are presently or in the future dealt in. Given this broad, and circular, definition of “commodity,” nearly any and all goods and articles will fall within its scope.
However, the term “commodity” must be “the subject of dealing in the forward contract trade” to fall within the scope of a forward contract. The Bankruptcy Code does not define the term “forward contract trade.” In the context of an ordinary supply-of-goods contract, a litigator could introduce expert testimony to establish that such a contract does not involve a commodity involved in the forward contract trade. Still, the litigator likely will face an uphill battle, as numerous goods and articles are the subject of dealing in the forward contract trade.
As for the second element of a forward contract, the Bankruptcy Code does not define the term “maturity date.” Courts have reached differing conclusions on the term’s meaning. For instance, some courts have held that the maturity date is the date of delivery, while others have held that it is “the future date at which the commodity must be bought or sold.” McKittrick v. Gavilon, LLC (In re Cascade Grain Prods., LLC), 465 B.R. 570, 575 (Bankr. D. Or. 2011).
This lack of consensus is ripe for a savvy litigator to explore. For example, a typical supply-of-goods relationship involves a purchase order for certain goods, delivery of the goods, and payment in full 30 days after delivery. It is unclear at what point the maturity date occurs in such a relationship, if one occurs at all. A litigator could argue that the contract fully matures when the purchase order is issued, when the goods are delivered, or when payment is received. A litigator could even argue that the contract lacks a maturity date, as once the purchase order is issued and accepted, the parties’ obligations have matured. Finally, a litigator could introduce expert testimony to limit the scope of the term “maturity date” to its traditional meaning in the financial markets.
The Forward Contract Merchant Requirement
Having established the existence of a forward contract, one of the parties to the contract must be a forward contract merchant to invoke section 546(e). The Bankruptcy Code defines in section 101(26) a “forward contract merchant” in relevant part as “an entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity or any similar good . . . which is presently or in the future becomes the subject of dealing in the forward contract trade.” Courts and commentators alike have interpreted this definition broadly and narrowly. For instance, Collier on Bankruptcy ¶ 556.03[2] (Alan N. Resnick & Henry J. Sommer eds., 16th ed.) provides that “[t]he language ‘in whole or in part’ in th[e] definition substantially broadens its coverage to include any person that enters into forward contracts as or with merchants in a commodity business context.” At least one bankruptcy court has followed Collier’s broad definition, which arguably would apply to supply-of-goods contracts.
Other courts, however, have followed a narrower definition espoused by Judge Dennis M. Lynn in Mirant Americas Energy Marketing, L.P. v. Kern Oil & Refining Co. (In re Mirant Corp.), 310 B.R. 548 (Bankr. N.D. Tex. 2004). In that case, Judge Lynn focused on the undefined terms “business” and “merchant” within the term “forward contract merchant” and found that the definition is limited in scope. Specifically, Judge Lynn defined “merchant” as “one that is not acting as either an end-user or a producer. Rather, a merchant is one that buys, sells, or trades in a market.” Judge Lynn further defined “business” as “something one engages in to generate a profit.”Accordingly, the court defined a forward contract merchant to be “a person that, in order to profit, engages in the forward contract trade as a merchant or with merchants,” with “merchant” meaning an individual or entity that is not acting as either an end-user or a producer.This construction gives effect to all parts of the definition because “[w]ithout references to ‘business’ and ‘merchant,’ the definition of ‘forward contract merchant’ could as easily have been ‘a person that enters into forward contracts.’”Most courts have adopted this interpretation over Collier’s construction.
Judge Lynn’s interpretation, if followed, might preclude the application of section 546(e) to an ordinary supply-of-goods contract. In such a context, a buyer simply purchases goods from a supplier. The buyer is an end-user and the supplier is a producer. To fall within the definition’s scope, a merchant would have to buy, sell, or trade the underlying contract in a financial market. This interpretation is not only logical, but also gives effect to Congress’s overall intentions in enacting section 546(e).
Transfers as Settlement Payments
Once the existence of a forward contract and forward contract merchant are established, a defendant must finally show that the transfers at issue constitute settlement payments. The Bankruptcy Code at section 101(51A) defines a “settlement payment” as, “for purposes of the forward contract provisions of this title, a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade.” Although tautological, courts have held that a commodity settlement payment must, at a minimum, be some kind of payment on a commodity forward contract.Therefore, any payment on account of a forward contract likely falls within the definition, making this element easily met.
As the foregoing discussion demonstrates, the requirements to enter the safe harbor are seemingly straightforward, but the definitional issues may make section 546(e) much broader than Congress intended.
Section 546(g) and Swap Agreements
If unable to meet any of the elements contained in section 546(e), a party may seek protection under section 546(g). Except for actual fraudulent transfers, section 546(g) prohibits a bankruptcy trustee from avoiding a transfer made by or to (or for the benefit of) a swap participant or financial participant, under or in connection with any swap agreement that is made before the commencement of the case. To establish a section 546(g) defense, a defendant must show that: (1) the parties entered into a “swap agreement”; (2) one of the parties to the swap agreement is a “swap participant” or “financial participant”; and (3) the transfer was made “under or in connection with” the swap agreement. The second and third elements rarely are litigated because the essential element is whether a swap agreement exists. If a swap agreement exists, section 546(g) undoubtedly will be satisfied because the transfer sought to be avoided will be in connection with a swap agreement to a “swap participant,” which is defined as an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor.
Establishing the Existence of a Swap Agreement
The Bankruptcy Code defines a “swap agreement” broadly as, in relevant part, a commodity index or a commodity swap, option, future, or forward agreement.Although the Bankruptcy Code defines a “forward contract,” it does not define a “commodity forward agreement.” The leading and only authoritative case on the term “commodity forward agreement” is the Fourth Circuit’s decision in Hutson v. E.I. du Pont de Nemours & Co. (In re National Gas Distributors, LLC), 556 F.3d 247, 259–60 (4th Cir. 2009). In that case, the Fourth Circuit held that a commodity forward agreement exists when the following are present: (1) the subject of the agreement must be a commodity; (2) the agreement must require a payment for the commodity at a price fixed at the time of contracting for delivery more than two days after the date into which the contract is entered; (3) the quantity and time elements of the agreement must be fixed at the time of contracting; and (4) the agreement must have a relationship with the financial markets (although it need not be traded on an exchange or be assignable).
Subject to the previous discussion regarding section 546(e), the first three elements for a swap agreement likely will be met in the context of an ordinary supply-of-goods contract. Yet, the contract must also have a relationship with the financial markets. Whether this is the case depends on the terms of the contract. For instance, a purchase order for oil could have a relationship to the financial markets if the price of the oil depends on the overall market price for oil. On the other hand, a purchase order for corn at a fixed price likely lacks a relationship with the financial markets. Again, a litigator could use expert testimony to determine whether the agreement has such a relationship.
To be fair, Hutson’s interpretation of “commodity forward agreement” is problematic because it nullifies the forward contract merchant requirement that exists in section 546(e). In other words, a contract that does not meet the definition of “forward contract” for purposes of section 546(e) may meet the requirements of a forward agreement for purposes of section 546(g). In reaching its decision, the court in Hutson determined that the term “agreement” is broader than the term “contract”: “As Black’s states, the term ‘agreement,’ although frequently used as synonymous with the word ‘contract,’ is really an expression of greater breadth of meaning and less technicality. Every contract is an agreement; but not every agreement is a contract.”Using Hutson’s definition, any party to a commodity forward agreement can invoke the safe-harbor protections, even if neither party is a forward contract merchant.
Whether this was Congress’s intention is unclear. On the one hand, Congress seemingly intended a broad definition by stating that “[t]he use of the term ‘forward’ in the definition of ‘swap agreement’ is not intended to refer only to transactions that fall within the definition of ‘forward contract.’ Instead, a ‘forward’ transaction could be a ‘swap agreement’ even if not a ‘forward contract.’” H.R. Rep. No. 109-31, at 122 (2005), reprinted in 2005 U.S.C.C.A.N. 88, 184. On the other hand, Congress also stated that “[t]he definition of ‘swap agreement’ . . . should not be interpreted to permit parties to document non-swaps as swap transactions. Traditional commercial arrangements, such as supply agreements . . . cannot be treated as ‘swaps’ under . . . the Bankruptcy Code because the parties purport to document or label the transactions as ‘swap agreements.’”
As of now, the Hutson elements, if followed, would protect any commodity forward agreement that has a relationship with the financial markets, even if neither party is a forward contract merchant. Similar to section 546(e), the definitional issues of section 546(g) may render section 546(g) broad enough to encompass supply-of-goods contracts.
Conclusion
Congress’s adoption of sections 546(e) and 546(g) has created unintended results. Although clearly seeking to protect transfers made in connection with forward contracts and swap agreements relating to financial markets, Congress may have inadvertently protected transfers made in connection with ordinary supply-of-goods contracts. If the legislative history surrounding the safe-harbor provisions accurately reflects Congress’s intentions, the provisions should be amended to expressly exclude supply-of-goods contracts. As it currently stands, litigators that prosecute or defend bankruptcy avoidance actions should familiarize themselves with the safe-harbor provisions because their ambiguities may present unanticipated curveballs in what normally are considered straightforward avoidance actions.
Do you have a financial interest in or signature authority over a foreign nest egg that is worth over $10,000 on any day of the year? Then you cannot afford to hide your head in the sand and ignore the annual Report of Foreign Bank and Financial Accounts (FBAR) filing and recordkeeping requirements. In addition to negligence or fraud penalties, steep civil and/or criminal penalties may apply if you fail to file the FBAR. What can happen, you ask? Consider the creator of Beanie Babies, H. Ty Warner, as an example. In 2008, he paid $53.6 million (i.e., 50 percent of the maximum balance of his foreign account), one of the largest FBAR penalties the United States has collected to date. United States v. Warner, 792 F.3d 847 (2015). Enough to make anyone’s feathers ruffle!
The United States requires its citizens, residents, and domestic entities to file FBARs because foreign financial institutions (unlike domestic ones) are not under U.S. jurisdiction and, therefore, are not subject to U.S. reporting obligations and to the power of the U.S. district courts to enforce the Internal Revenue Service’s (IRS) summons authority. The United States has several foreign asset filing requirements (see Chart 1). However, the FBAR is unique in that, unlike the IRS forms and schedules depicted in Chart 1, the FBAR is not a tax return protected under the taxpayer confidentiality rule, found in IRC (Internal Revenue Code) section 6103. Rather, it is a required yearly report, regardless of whether income is earned. It assists the United States with ferreting out secret foreign accounts used to fund international terrorist activities, launder money, hide income, and other illegal acts. Accordingly, it is freely shared among a network of law enforcement agencies.
Additionally, the FBAR, or the Financial Crimes Enforcement Network (FinCEN) Form 114 (formerly TD F 90-22.1), is not filed with the IRS but electronically through the FinCEN BSA E-filing system (no paper filing as of July 2013). Beginning in 2017, the FBAR due date will be moved from June 30 to April 15, and a maximum six-month extension to October 15 will be allowed (as a result of the enactment of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015). Thus, this new due date will coincide with that of tax return filings.
Since the Bank Secrecy Act’s (BSA) enactment, the FBAR has been around for over forty-five years, and is codified in Title 31 of the U.S. Code. Then why all the recent attention? Because the United States has stepped up FBAR enforcement efforts.
During the late 1990s, there were few FBAR indictments. In response to the tragic events of September 11, 2001, however, the United States made several efforts to improve the tracking of foreign funds. In April 2003, through a Memorandum of Agreement, FinCEN delegated full civil investigatory and enforcement authority to the IRS, giving the IRS power to assess and collect penalties, investigate civil violations, employ the summons power, issue administrative rulings, and take any reasonably necessary enforcement actions. The advent of the American Jobs Creation Act of 2004 (Jobs Act) created more stringent civil penalties for noncompliance. In 2008, the Department of Justice launched a crackdown into secret overseas assets, starting with Swiss Bank UBS, one of Europe’s largest financial institutions. In February 2009, UBS entered into a deferred prosecution agreement, agreeing to pay a settlement of $780 million to the United States as well as to identify over 4,000 U.S. taxpayers with hidden Swiss accounts. Finally, in March 2010 came a momentous change in the detection of offshore tax evasion: Congress passed the Foreign Account Tax Compliance Act (FATCA). FATCA enhanced the enforcement of the FBAR through mandatory disclosures by both foreign financial institutions (FFIs) and U.S. taxpayers. As IRS Commissioner John Koskinen commented in a March 15, 2016 IRS News Release, “Taxpayers here and abroad need to take their offshore tax and filing obligations seriously.”
This article focuses on the elements triggering a mandatory FBAR filing (with a skeletal flowchart) and concludes with a short overview of the possible outcomes for noncompliance.
Do You Need to File an FBAR?
To make the determination whether you are obligated to file an FBAR, ask yourself the four questions presented in Flowchart 1. Certain IRS forms and schedules also direct you to a possible FBAR filing requirement, if you check the box “Yes” as to having a financial interest or signature authority over a foreign financial account (see Item 5 of Chart 1).
Question 1: Is the Filer a U.S. Person?
Under the BSA, U.S. persons include: (1) U.S. citizens; (2) U.S. residents; and (3) entities formed within the United States. For FBAR purposes, the United States includes the 50 states, the District of Columbia, the territories and insular U.S. possessions (i.e., American Samoa, the Commonwealth of the Northern Mariana Islands, the Commonwealth of Puerto Rico, Guam, and the U.S. Virgin Islands), and the Indian lands as defined in the Indian Gaming Regulatory Act. Children are also included in the definition of U.S. persons, although their parents or guardians may file on their behalf. Let us look at these terms in more detail:
(1) Citizens. U.S. citizens are those with a U.S. birth certificate or naturalization papers.
(2) Residents. Residents are individuals who meet one of the following tests: (1) the green card test (i.e., a green-card holder who has entered the United States); (2) the substantial presence test (i.e., physically present in the United States for at least 183 days out of the current year, or at least 31 days during the current year and the sum of the number of days as calculated in IRC section 7701(b)(3) ); and (3) the resident alien election (i.e., filing a first-year election to be treated as a U.S. resident alien under IRC section 7701(b)(4)).
(3) Entities. Domestic entities may be corporations, partnerships, LLCs, estates, or trusts. The key to determining whether an entity is required to file an FBAR is the law under which it was created (e.g., state certificate of incorporation). A foreign entity that has elected to be treated as a U.S. entity for U.S. tax purposes and a foreign subsidiary do not need to file an FBAR. However, a domestic parent (or U.S. individual) may be obligated to file an FBAR if it has a financial interest in a foreign subsidiary that owns an offshore account.
The entity’s tax exemption and disregarded federal tax status are irrelevant for FBAR reporting purposes. For example, a domestic charitable organization, IRC under section 501(c)(3) and a single-member LLC may be obligated to file an FBAR (in conjunction with his or her owner), despite their tax situation.
Domestic subsidiaries may be exempt from filing an FBAR, however, if their parent entities name them in a consolidated FBAR. A parent may file a consolidated FBAR on behalf of itself and its subsidiary if it is formed under U.S. law, owns a greater than 50-percent interest in its subsidiary, and files an FBAR (which includes its financial and other information as well as its subsidiary’s). Thus, Subsidiaries O2, a California corporation, and O3, a Nevada corporation, do not need to file an FBAR when Parent O1, a Delaware corporation, files a consolidated FBAR (identifying all reportable accounts, itself, and its subsidiaries; see Part V of FinCEN Form 114).
Question 2: Does the Filer Have a Financial Interest in a Foreign Financial Account?
This question involves three special terms, namely, “foreign,” “financial account,” and “financial interest.” First, what does “foreign” mean, for FBAR purposes? It does not refer to the financial institution’s nationality, but to its geographical location outside the United States, District of Columbia, the Indian lands, and the territories and insular possessions of the United States. So, an account in a branch of a French bank that is located in New York is not a reportable account. By contrast, an account in a branch of a U.S. bank that is located in France is a reportable account.
What about “financial account”? This includes but is not limited to the following:
bank account, or an account maintained with a person engaged in the business of banking, such as a checking account;
securities account, or an account with a person engaged in the business of buying, selling, holding, or trading stock or other securities, for example a brokerage account;
commodity futures or options account;
insurance or annuity policy with a cash value, such as a whole life policy;
mutual fund or similar pooled fund, meaning a fund that issues shares to the general public that have a regular net asset value determination and regular redemption (foreign hedge funds and private equity funds are excluded); and
any account with a person that is in the business of accepting deposits as a financial agency. See 31 C.F.R. (Code of Federal Regulations)
§1010.350.
Let us examine a couple of financial account examples. In a 2016 case, the district court ruled that a U.K. poker fund, used for the exclusive purpose of facilitating poker playing, was not a financial account. Similarly, a credit card is generally not an account. However, the IRS posited, in I.R.S.Legal Memorandum 2006-03-026 (Jan. 20, 2006), that a credit card may constitute an account if the cardholder was making advance payments and using the card like a debit card or checking account. Likewise, a safe deposit box is customarily not an account; however, if it is used in ways similar to an account, such as holding and issuing cash to the owner and facilitating the transmission of funds or extension of credit, then the IRS may argue that it is an account (IRS’s expressed position at the June 12, 2009 ABA Section of International Law’s Committee on International Taxation).
Finally, what does “financial interest” mean? The regulations define it as a U.S. person being the foreign account’s owner of record or having ownership or control over the owner of record, which rises to a level of having a financial interest. Generally, it can be any one of these possibilities: (1) an owner of record; (2) an agent; or (3) a U.S. person with greater than a 50-percent interest in an entity (either directly or indirectly) that owns a foreign account. Let us examine each of these situations in more detail:
Owner of record (or legal-title holder). A U.S. person has a financial interest if he or she is the legal owner or titleholder of a foreign account, regardless of whether he or she benefits from the account. This is true even if the account is used for the benefit of a non-U.S. person. If there are multiple U.S. persons who share ownership or title to the account, then each of them has a financial interest and a separate FBAR obligation (e.g., each U.S. co-trustee of a trust with an offshore account).
An exception exists for a married couple that jointly owns a foreign account(s). In that case, the couple may file a joint FBAR as well as complete and sign FinCEN 114a, Record of Authorization to Electronically File FBARs. Nevertheless, to prevent the risk of joint FBAR liability due to a noncompliant spouse, each spouse may file his or her own separate FBAR. If one spouse has signature authority and/or separately owns other offshore account(s), then each spouse should separately report his or her FBAR, including those jointly held account(s).
Agent, nominee, attorney, or a person acting on behalf of a U.S. account beneficiary. A U.S. person has a financial interest in an account if he or she uses an agent (or other person acting on his or her behalf) to acquire account benefits. For example, if U.S. citizen Oscar opens a foreign account in the name of his brother Ollie, who maintains it for Oscar’s benefit, such as in paying Oscar’s bills, then Oscar has a financial interest. If Ollie is a U.S. citizen or resident, then Ollie also has an FBAR reporting requirement.
Note: Financial interest encompasses those U.S. persons who may desire to avoid an FBAR obligation with a non-U.S. agent or nominee who obtains account benefits on their behalf (i.e., FBAR responsibilities follow economic reality). Thus, if a U.S. individual structures a foreign entity (e.g., trust or corporation) to own his or her overseas accounts, that individual still has a financial interest in the offshore accounts. The regulations’ anti-avoidance provision captures situations in which U.S. individuals create entities for the purpose of evading their FBAR obligations.
Person with a direct or indirect interest (e.g., voting power or equity interest) that is greater than 50 percent in an entity (e.g., corporation or trust) that is the record owner or titleholder of a foreign account. This situation may take on various scenarios, but we will focus on corporations and partnerships. If a domestic or foreign corporation directly or indirectly owns an overseas account, then a U.S. person who owns more than half of thetotal value of the corporate shares of stock or voting power of all shares of stock has an FBAR reporting obligation. Similarly, if a domestic or foreign partnership owns an offshore account, then a U.S. person who directly or indirectly owns more than half the partnership’s profits or capital has an FBAR reporting requirement.
To illustrate, U.S. resident Odell owns 75 percent of a California parent corporation that, in turn, owns 100 percent of a foreign subsidiary that has a foreign account. Both Odell and the California parent must file an FBAR because they are both U.S. persons with a majority financial interest in the total value of shares of the foreign subsidiary’s stock (even though Odell’s interest is indirect).
In contrast, if Odell owns only 40 percent of the California parent corporation while each of his children own 20 percent, none of the family members have an FBAR financial interest (unless, as described above, the anti-avoidance rule applies). Nevertheless, they may still have an FBAR reporting requirement if they have signatory authority over the offshore account.
Question 3: Does the Filer Have Signature or Other Authority Over the Foreign Account?
Signature or other authority is defined as an individual (either alone or in conjunction with another) who can control the disposition of account assets (e.g., withdrawing funds) by directly communicating (e.g., in writing or by oral mandate) with the person in charge of maintaining the account. 31 C.F.R. § 1010.350(f)(1). In other words, “signature or other authority” means that a financial institution will act upon a person’s direction (although more than one individual’s communication is required), regardless of whether the power is exercised.
Generally, a person who can control the deposits and withdrawal of bank funds has signature or other authority. The mere ability to control the investment of funds does not constitute such authority. Likewise, there is no such authority when an individual is an intermediary in the chain of command regarding the disbursement of account property. However, if the intermediary were introduced for the purpose of evading FBAR reporting, then the IRS can impose a higher FBAR penalty for a willful violation.
Let us look at an example: Omar opened an Australian account and hired an Australian attorney for the purpose of serving as the power of attorney over the account. Omar gave his partner the authority to make the account’s investment decisions and to instruct the attorney, but not the bank. Here, Omar has a financial interest because he is the owner of the account.Additionally, his attorney has signature authority allowing him to control the disposition of account funds by directly communicating with the bank representative who maintains the account. However, Omar’s partner has no such authority because he can control only the investment of account funds and is unable to control any transmission of these funds.
FBAR reporting exceptions apply to the following officers and employees who have signature or other authority but no financial interest: (1) certain financial institutions; (2) certain authorized service providers; or (3) certain entities whose security is listed on any national security exchange or registered under section 12(g) of the Security Exchange Act. See 31 C.F.R. § 1010.350(f)(2).
For all other officers and employees who have signature or other authority but no financial interest, the regulations impose a duty to file an FBAR. However, the IRS has granted several extensions (from May 31, 2011 to December 8, 2015) and a new filing due date of April 15, 2017. See FinCEN Notice 2015-1. On March 1, 2016, FinCEN proposed to modify the regulations by exempting certain officers, employees, and agents of domestic entities with signature or other authority but no financial interest, provided that the FBAR is otherwise reported by the entities and that the entities maintain records regarding these individuals for at least five years.
Question 4: Is the Aggregate Value of All the Foreign Financial Account(s) Greater Than $10,000 at Any Time during the Calendar Year?
Now it is time to dust off your calculators! Aggregate value refers to the highest total amount of all those offshore accounts (in which you have either a financial interest or signature or other authority) at any time from January 1 to December 31.
You may rely on periodic quarterly or more frequently issued statements so long as they reasonably reflect the maximum account balance during the year. So, if you make several-thousand-dollar deposits in one month and withdraw all those monies before the end of the monthly statement, then your statement will not fairly reflect the largest account balance.
To determine your maximum account balance, you must value each account’s largest amount separately. Based on the Treasury Reporting Rates of Exchange’s (https://www.fiscal.treasury.gov/) end-of-year conversion rates, each account’s local currency value is transformed into U.S. dollars. You then add the maximum values of all your foreign accounts to see if you exceed the threshold of $10,000. Make sure that you do not double count the same monies transferred from one account to another.
For example, Oliver opened three Swiss bank accounts: A ($3,000 balance), B ($3,000 balance), and C ($2,000 balance). Presently, Oliver need not file an FBAR because the total account value of his overseas accounts is below $10,000. Suppose, however, that he closes bank account C and transfers the entire amount to account D. Suppose further that the value of each of his accounts increased by $1,000 during the following year. In that case, although none of the accounts (A, B, or D) individually exceed the threshold amount, their aggregate value does, so Oliver has an FBAR obligation. Note also that the transferred monies from account C to account D are counted only once.
What Are the Rules for U.S. Persons With a Financial Interest in or Signature or Other Authority for 25+ Foreign Financial Accounts?
Currently, the regulations provide that, if a U.S. person has a financial interest in 25 or more accounts, then that person may provide certain basic information regarding these accounts. A similar rule applies to those with signature or other authority over 25 or more accounts. See 31 C.F.R. § 1010.350(g). However, detailed information should be available upon the request of either the IRS or FinCEN (i.e., recordkeeping is still mandatory). On March 1, 2016, FinCEN proposed to make detailed information about all such offshore accounts mandatory, despite their numerousness.
Conclusion
In summary, the FBAR is a yearly, mandatory report on offshore accounts that helps the government to combat tax evasion, money laundering, and other illegal activity. As can be seen from the above FBAR requirements, there can be multiple filers for one account, such as joint owners and account co-signers. Accordingly, each filer may be subject to a penalty for noncompliance.
Civil penalties range from $10,000 for a non-willful violation (i.e., good-faith inadvertence, mistake, or negligence) to the greater of $100,000 or 50 percent of the amount of the transaction or account balance at the time of the willful violation (e.g., an intentional violation or a conscious effort to avoid learning about the FBAR reporting and recordkeeping requirements). Both criminal and civil penalties may be imposed simultaneously, as well as non-FBAR penalties (e.g., an accuracy-related penalty). However, the IRS may apply mitigation measures, provided that certain conditions are met. In addition, there is penalty relief if the violation was: (1) due to reasonable cause (i.e., a violation despite an exercise of ordinary business care and prudence); and (2) the amount of the transaction or the balance of the account at the time of the transaction was properly reported.
If you believe you have an FBAR filing requirement (or may be a delinquent FBAR filer), you should consult with your tax professional. Quietly disclosing your late FBAR may open you to risks (e.g., filing an amended return and past-due FBAR without reasonable cause and enrollment in an FBAR amnesty program). There are different options for delinquent FBAR filers; for example, the streamlined program for a non-willful violation and the offshore volunteer disclosure program (OVDP) for a willful violation, which may be better than paying the full penalty. Of course, it is best to avoid all penalties by timely filing; therefore, remember that, when it comes to the FBAR, do not be an ostrich!
Raising seed capital is not easy. Most entrepreneurs raise capital by using up savings, soliciting donations or small loans from friends and family, or convincing a local bank to provide a loan, which usually requires personal collateral and years of cash-flow projections, which are fairly arbitrary for a business that has not even started yet.
Many entrepreneurs seek out angel investors or, at later stages, consider going public, but even for more mature start-ups, going public is not always feasible. There are substantial legal and accounting costs associated with taking a company public, not to mention the complexity of facilitating and keeping up with ongoing reporting and disclosure requirements.
The goal of this article is to give small businesses some creative and viable financing ideas that do not require expensive legal filings, complicated securities regulations, or even angel investors.
Subscriptions and Preselling Products
So far, preselling a product generally is not considered selling a security in most states; therefore, regulators have not interfered with these rewards-based funding ideas. United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975) (the Supreme Court reasoned, “What distinguishes a security transaction […] is an investment where one parts with his money in the hope of receiving profits from the efforts of others, and not where he purchases a commodity for personal consumption […].”). See generally 15 U.S.C. § 77b(a)(1). The key to ensuring that preselling does not attract the attention of securities regulators seems to be making sure that customers who purchase the product do not receive any extra financial return in exchange for their payment (in addition to the product itself, that is). Buyers can receive their purchased products weeks or months after paying for their order. Put another way, funds can be raised from the public, in advance, without restrictions on the amount of money raised or the number of customers, and without subjecting the business to securities registration, reporting requirements, and the associated fees.
KICKSTARTER, for example, lets you set up a company project and accept money from any person in exchange for products, services, or other copies of the work produced. Indiegogo offers donors VIP perks in exchange for their donations. Awaken Café in Oakland California raised money to open a new store by preselling its coffee. Michael H. Shuman, 24 Top Tools for Local Investing (Oct. 11, 2013), available at http://michaelhshuman.com/wp-content/uploads/2013/12/Top-Tools-2.0.pdf. Some co-ops, like Weaver Street Market, a natural foods grocery store in North Carolina, offer their members a t-shirt, bag, and coupons to buy the market’s food products in exchange for their membership fee.
Allowing investors to prepurchase goods and services is a good way to attract more investors and, more importantly, customers all in one go; whereas, simple requests for donations are a one-way street—donors receive nothing in return for their contribution, and they may or may not decide to become a customer.
As mentioned previously, another benefit of this financing option is that federal securities laws generally do not apply to this kind of transaction because products, rather than securities, are sold. Forman, 421 U.S. at 852 (1975). State securities regulators, however, may have a different point of view. For example, in 1959 a country club in California presold club memberships and used the membership funds to start the business. Under federal securities laws, these memberships likely would not be considered securities, but a California court found that there was a significant risk that the business might fail before members got a chance to use their membership benefits. Because of the risk of loss involved, the memberships were deemed securities, and the club was found to be in violation of state securities laws for not registering the membership sales with California’s state securities regulator. Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 814–16 (1961). But see Moreland v. Dep’t of Corp., 194 Cal. App. 3d 506, 522 (1987).
Roughly 17 states, including California, use the risk-capital test to determine whether a presold good might be considered a security (Alaska, Arkansas (1987), California, Georgia, Guam (Appellate Division, 1981), Hawaii (1971), Illinois, Michigan, New Mexico, North Carolina, North Dakota, Ohio (10th District, 1975), Oklahoma, Oregon (1976), Washington, Wisconsin, and Wyoming). Cutting Edge Capital, What is a security, and why does it matter? (last visited Dec. 2016). The risk-capital test focuses on whether there is a possibility that an investor will lose value (i.e., money) rather than whether the investor might make a profit from the investment, and has three elements: “(1) an investment, (2) in the risk capital of an enterprise, and (3) the expectation of a benefit.” Joseph C. Long, 12 Blue Sky Law § 2:80 (2014). For example, an investor in a risk-capital state might prepurchase 100 widgets. If the investor never receives the 100 widgets, then the investor has lost money, which potentially would make the transaction a security in a risk-capital state. In states that do not follow the risk-capital model, however, the investor never expected to receive a profit when paying for the widgets; consequently, the transaction likely will not be classified as a security. Therefore, it is important to understand how your state defines a security.
In addition to understanding securities regulations, budgeting and planning will be a critical part of preselling your product. Costs like taxes on the income and the shipping, packaging, and manufacturing expenses should be kept in mind when the orders start rolling in.
Further examples of this financing model in action include Credibles, an online food voucher company that lets anyone prepay a local restaurant for food that they will eat in the future. When the customer makes payments, they receive credits to use at their favorite restaurant. The restaurant owners receive those payments in advance and use the funds to grow their businesses.This strategy is not news to local farmers, who commonly have customers pay in advance for a year’s worth of produce, giving the farmer enough money to cover planting costs.
Gift Cards and Coupons
As far as securities laws go, selling regular gift cards is very similar to preselling products. In fact, one start-up called Stockpile actually allows customers to buy stock and place it on a gift card to give to someone else. Discounted gift cards, however, may be cause for concern from a regulator’s perspective. For example, if you sell a gift card with a purchasing value of $20 for only $15, then the gift card owner technically has the expectation of receiving $5 worth of extra value for his or her money. Unfortunately, this looks to regulators fairly similar to hedging futures on Wall Street.
As a general rule of thumb, securities regulators usually look to the substance and characteristics of a transaction, rather than the label you use for it. Sec. & Exch. Comm’n v. Howey Co., 328 U.S. 293, 298 (1946). See also Tcherepnin v. Knight, 389 U.S. 332, 339 (1967). Anything that creates an expectation of an increased value or profit, over and above what was given in exchange for it, can be characterized as a security. For instance, if you issue coupons that can be used later to buy a product, the market value of the product that will be purchased might increase in value between the time for which the coupon is paid and the time the product is actually purchased. Getting a deal like this arguably encourages people to buy coupons to get extra value (i.e., as does any other investment).
When it comes to selling gift cards and coupons, some ideas for avoiding regulator attention might include limiting gift card maximum values, having a fixed value, and having very clear disclaimers to purchasers that the gift card is not a security. In addition, there are other legal considerations. These include federal limits on card fees that may be charged to customers, if and when the card should expire, and what should be included in any required disclosures. See Kaufman v. Am. Express Travel Related Serv. Inc., 283 F.R.D. 404 (N.D. Ill. 2012) (wherein American Express failed to notify purchasers of the full terms and conditions applicable to its gift cards). For example, money on a gift card cannot expire in less than five years after purchase under the Credit Card Accountability Responsibility and Disclosure Act of 2009 (commonly referred to as the CARD Act), 12 C.F.R. § 1005.20(e)(2), and card service fees generally cannot be charged under 12 C.F.R. § 1005.20(c)(3) and (d) unless there is no activity on the card for at least one year and prior disclosure of the fee is made. In addition, gift cards that are issued in amounts greater than $2,000 may be subject to certain additional recordkeeping and reporting requirements under the Bank Secrecy Act (otherwise known as the Currency and Foreign Transactions Reporting Act of 1970, 31 C.F.R. § 1010.100(ff)(4)(iii)(A) (2011)).
Each state also has its own separate restrictions and requirements as well, which preexempt the CARD Act rules described above (e.g., expiration is not permitted at all in about half of all U.S. states). Emily Atkin, 3 Tips to Keep Gift Cards from Bestowing Legal Trouble, Law360 (Sept. 24, 2013); National Conference of State Legislatures, Gift Cards and Gift Certificates Statutes and Legislation (last updated Apr. 22, 2016). Some states prohibit imposing fees on gift cards. Also keep in mind that, if the gift card is purchased in one state and used in another, there may be two different sets of gift card laws with which to comply.
Keeping within a few guidelines, gift cards are a good way to avoid costly regulatory fees and, according to some marketing research, tend to make customers who shop with gift cards less sensitive to price and spend more money, not to mention the potential for referral business. A gift card vendor can offer information about what type of gift card might be most suitable.
Cooperatives
A cooperative is a group of members that pool their capital to make a common purchase, such as a piece of real estate. All members usually are co-owners of the collective purchase and are entitled to take advantage of any services provided by the cooperative and to use the purchased item, which an individual might not be able to afford alone.
Cooperatives do not just work in real estate. Equal Exchange is an example of a successful produce cooperative that has over 100 owner employees. Though Equal Exchange also raises money through selling securities and using an exemption from securities laws, a primary source of funding comes from employee contributions that do not require going through securities regulators. Daniel Fireside, How Equal Exchange Aligns Our Capital with Our Mission (May 29, 2015). Similar to many other types of businesses, each owner periodically gets a share of profits and losses, one equal vote in making decisions for the business, and an opportunity to serve on the managing board. Employees each put half of their annual profit earnings into a joint account used to reinvest in the co-op. Other cooperatives, like Coop Power, a consumer-owned energy cooperative in Massachusetts, pool funds from customers (who contribute and become members) and use the pool of capital to run their businesses, which involves investing in other sustainable energy businesses and developing job training programs.
The SEC has given certain cooperatives an exemption from registration requirements under federal securities laws. 17 C.F.R. § 240.15a-2. See Forman, 421 U.S. at 858. For example, collectively buying an apartment building through a licensed real estate agent generally is not subject to securities laws, even if each investor’s ownership interest takes the form of a share of stock, so long as the primary purpose of the purchase was not to make a profit from increases in the property value. Forman, 421 U.S. at 851. See also Grenader v. Spitz, 537 F.2d 612 (2d Cir. 1976), cert. denied, 429 U.S. 1009 (1976). Typically, the primary purpose of such a purchase is to have a place to live.
Based on court rulings thus far, a cooperative is more likely to qualify for an exemption if:
members are prohibited from selling or transferring their membership interest to others;
voting rights are equal, rather than directly proportional to the amount contributed;
membership interests do not appreciate in value over time;
the primary purpose or motive of the contribution is not financial gain (Forman, 421 U.S. at 851–54); and
all members are actively involved in management of the cooperative (Howey, 328 U.S. at 301).
State securities laws vary. Some states have an exemption from securities laws for all cooperatives, some do not have an exemption, some have a limited exemption if certain conditions are met (e.g., a maximum contribution amount is imposed), and others only have exemptions for certain kinds of cooperatives (e.g., farmer’s cooperatives). See Ariz. Rev. Stat. Ann. § 10-2080 (2015); Ariz. Rev. Stat. Ann. § 10-2146 (2015); Cal. Corp. Code § 25100(m) (West Supp. 1983); Ark. Stat. Ann. § 67-1248(a)(12) (1980). Also see Colo. Code Regs. 11-51-307(1)(j) (2015); Mass. Ann. Laws ch. 110A, § 402(a)(12) (Michie/Law. Co-op. Supp. 1983); Tex. Rev. Civ. Stat. Ann. art. 581-5(N) (Vernon Supp. 1982–83). Therefore, it cannot be stressed enough how important it is to be familiar with your state’s point of view.
Revolving Loan Funds
Another way to attract investors is to offer loans that pay a reasonable interest rate. In addition to borrowing funds from the community and/or members, some organizations take loans from investors and then use those funds to make microloans to other businesses and earn interest. For example, the La Montanita Grocery Co-op in New Mexico uses its members’ capital to financially support local farmers and food processors. Mountain Bizworks, a small business lending company headquartered in North Carolina, borrows money from investors, lets the investors choose their own loan terms, and loans the pooled funds to other small businesses.
Generally, a loan is represented by a promissory note. The definition of a security under the Securities Act at 15 U.S.C. § 77b(a)(1) includes any “note.” However, the law is not black and white about whether a promissory note is a security; the question is whether the note resembles a security close enough. For example, some ways to differentiate a loan from a security include:
providing some collateral for the loan (offering collateral also attracts more lenders);
disclosing to all lenders: (1) that the loans are not intended to be securities or registered pursuant to securities laws; (2) what laws would apply to protect the lender in the event of default (e.g., FDIC laws); and (3) the specific purpose of the loan;
advertising primarily through private networks, rather than to the general public;
keeping the number of lenders to a minimum;
using the funds for specific business purposes, rather than general business use;
offering investors that contribute to your loan fund services perks or products instead of interest in return (which is evidence that the lenders’ main interest is to make the business grow, not to earn a profit on an investment);
offering a very low interest rate (i.e., well below the prime market rate) if you do decide to pay interest;
borrowing from a bank or credit union rather than individuals (when possible); and
setting the loan term for less than nine months. 15 U.S.C. §§ 77c(a)(3), 78c(a)(10); See also Exch. Nat’l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137–38 (2d Cir. 1976) (created a rebuttable presumption that a note with a maturity greater than nine months is a security unless it bears a strong family resemblance to an item on the judicially crafted list of exceptions); Reves v. Ernst & Young, 494 U.S. 56, 64–65 (1990); Lee Lashway, Promissory Notes as “Securities”—A Trap for the Unwary? (July 16, 2013); HG.org, When Is a Promissory Note a Security?(last visited Dec. 2016).
As with all other types of fundraising, keep in mind that both federal and state laws should be followed. Lending laws in both the lender’s state and borrower’s state may apply.
Certificates of Deposit
Regular bank CDs generally are considered bank deposits rather than securities, which keeps CD issuers relatively safe from securities registration and reporting. Marine Bank v. Weaver, 455 U.S. 551, 555–61 (1982); 15 U.S.C. § 78a(10); 12 U.S.C. § 1813(l). SeeLloyd S. Harmetz, Frequently Asked Questions About Structured Certificates of Deposit, Morrison & Foerster LLP, (2015), at 4. As many small business owners already know, local banks and credit unions are not eager to make business loans without full collateral. That is not only because conservatism often makes good business sense, but also because, by law, banks are required to be conservative with their assets.
Some local businesses have created a financing model that involves a three-way partnership with banks and investors essentially to get fully collateralized loans from banks using CDs. For example, Equal Exchange created its own private CD. Equal Exchange advertises its CD publicly, and anyone who wants to invest in its purpose simply buys the CD from Eastern Bank. In exchange, like a normal CD, investors get the future return of their principle plus reasonable interest. Eastern Bank then loans the funds back to Equal Exchange to help finance its business. Essentially, investors who buy the CDs are agreeing to allow the CD funds to be used as cash collateral for the line of credit to Equal Exchange. In the event that Equal Exchange defaults on its loan to Eastern Bank, Eastern bank keeps the investor’s deposit. Daniel Fireside, How Equal Exchange Aligns Our Capital with Our Mission (May 29, 2015).
Similarly, Alternatives Credit Union in Ithaca has formed a partnership with several local, environmentally focused businesses. The Credit Union offers CDs to any investor interested in contributing to the betterment of the environment. The investor’s deposits are pooled and distributed as loans to various businesses that share this common purpose. Alternatives Credit Union not only facilitates the CD/loan set-up for small businesses, but also helps nonprofits by matching the nonprofit’s funds raised dollar-for-dollar and issuing microcredit loans with the combined amount. For example, if investors purchase a total of $5,000 in CDs, Alternatives loans out a total of $10,000 to the intended beneficiaries of that nonprofit.
A regular CD usually is FDIC-insured (or NCUA-insured in the case of credit unions), and the investor is entitled to a return of his or her deposit if the bank goes under. 12 U.S.C. § 1821(f)(1); Federal Deposit Insurance Corporation, A Guide to What Is and Is Not Protected by FDIC Insurance (last visited Dec. 2016); Federal Deposit Insurance Corporation, When a Bank Fails—Facts for Depositors, Creditors, and Borrowers (last visited Dec. 2016). This insurance protection may be what keeps securities regulators from seeing the need to get involved. Harmetz, Frequently Asked Questions About Structured Certificates of Deposit, Morrison & Foerster LLP (2015). However, the insurance recovery is only available in the event that the bank becomes insolvent. Default of the small business on its loan to the bank will not qualify for FDIC insurance coverage under 12 U.S.C. § 1821(b), (f)(1). Therefore, the investor’s funds are still wholly at risk if the business defaults, just as any other collateral would be.
This model requires that the investor be aware that he or she is putting up collateral on behalf of a small business owner who may not be able to do so. The risk for the investor is essentially the same in a CD-loan set-up as it would be if the investor had made a loan directly to the small business. The benefit of this set-up, however, is that the bank acts as a facilitator and administrator of the transaction, adding a sense of legitimacy and formality to the deal. In addition, banks and credit unions are experts at processing loan paperwork, handling cash, and providing regular reporting statements to both the investor and the small business borrower.
Conclusion
In short, there are many creative funding structures, including the few discussed above, that can allow small businesses to access a wider number of contributors without spending large amounts of money on legal and accounting fees and without becoming overburdened with extensive reporting and disclosure requirements.
Trevor Norwitz delivered the following remarks at the 2016 Delaware Business Law Forum, held in Wilmington, Delaware, during the week between Halloween and Election Day.
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Is the Delaware appraisal rights remedy in need of repair? You may as well ask: is the American electoral system in need of repair?
In both cases the flaws are manifest and the scary results apparent. The difference is that the Delaware legislature can easily fix the General Corporation Law to eliminate the artificial and socially destructive phenomenon of appraisal arbitrage. This, of course, is the investing strategy in which an arbitrageur buys shares in a target company after the announcement of a deal specifically for the purpose of asserting appraisal rights. It is a recent development that has resulted directly from judicial interpretations of the outdated wording of section 262. Appraisal arbitrage leads to perverse incentives, unjust results, and a reduction in overall social benefit. Delaware lawmakers brought this Frankenstein creature into the world; they can and should take it out. (I hope you will forgive my gruesome metaphors and horror-flick references, but it is Halloween week, and we are still living through “The Nightmare on Pennsylvania Avenue.”)
Note that the question is not, “Is Section 262 good enough?” “Good enough” is not good enough for the State of Delaware. Delaware is the greatest jurisdiction for corporate law in the world—its sensible statutes; highly responsive legislators; sophisticated, fair-minded, and efficient judges; superb bar; and unparalleled deal- and case-flow all combine to make it the jurisdiction of choice for states in which to incorporate, conduct M&A deals, and litigate. That is good for Delaware. It is also good for business and for America. Delaware’s excellence in corporate law is part of America’s “secret sauce.”
In embracing appraisal arbitrage, however, Delaware distinguishes itself negatively, adding complexity and inequity to deal-making and threatening stockholder value in a wide range of transactions.
I am not arguing today for a total revamp of the appraisal rights remedy, such as the inclusion of a market out (which many other states recognize). I am not even arguing that the appropriate time for appraisal to attach should be the stockholder vote rather than the closing, or that stockholders should have to vote against a deal in order to assert appraisal rights. There are good arguments that can be made for those positions, and I believe those are conversations worth having over time. Today I am merely urging that the legislature should pluck the low-hanging fruit with alacrity. A modest amendment can eliminate the looming dark cloud of appraisal arbitrage. The need is clear and the fix is easy: dissenters’ rights should be for dissenters, not for speculators.
My learned opponent likely will say that this is all overblown, that Delaware’s judges are perfectly capable of making sense of the statute as it is and of dispensing justice to the parties before them, that the law was recently amended and should be given time to work before making more changes, and that appraisal arbitrage is actually beneficial.
These are inapt arguments. Of course Delaware’s judges are capable of dispensing justice, but they should not have to twist themselves into pretzels to deal with a poorly worded, outdated statute, creating artificial and perverse incentives in the process.
The fact that the statute was recently amended—seemingly as a compromise between the interests of the appraisal arbitrage community on the one hand, and those of Delaware corporations and their stakeholders on the other hand—is no reason not to fix the law. The interests of appraisal arbitrageurs should have no more weight in determining the appropriate legislative outcome to this question than the interests insider traders should have in determining what our insider trading laws should be.
I would like to be clear that I am not suggesting that appraisal arbitrageurs are evildoers who must be stopped. Well, they must be stopped, but that is because what they are doing is bad for Delaware corporations and stockholders and, ultimately, bad for Delaware and for America, not because they are bad people. They are merely doing what opportunistic investors are supposed to do, namely, find market inefficiencies, or gaps and loopholes in the law, and take advantage of them to divert wealth to themselves. I should not even call it an abuse. They are really just doing their civic duty by pointing out that our laws are broken and, as currently written, allow them to profit at everyone else’s expense. If they point this out to us and we do not fix it, then that is not their fault. Shame on us.
Why do I say that appraisal arbitrage leads to perverse incentives, unjust results, and a reduction in overall social benefit? Because it does. Let us go back to basics.
When you are buying a business, the most fundamental things you must know are what you are going to get and what you are going to pay for it. That is the essence of the deal—the quid and the quo. Buyers know they have to take some risks on the “get” side and go to great lengths and cost to minimize them, but at least they have some certainty as to what they will pay for the company they are buying, right? Unfortunately, in Delaware today that is not right.
Today, if you are buying a Delaware corporation, you can participate in an auction admirably conducted by independent directors unquestionably satisfying their fiduciary duties, engage in tough negotiations with those independent directors, compete with other bidders, potentiallty get held up by activist “bumpitrageurs” and be forced to raise your price to get their support, then have the stockholders of the target company approve the transaction based on full and fair disclosure—by a majority of the minority if you are a controlling stockholder—and still run a significant risk of having to write a large check years later because an “expert” testifies based on a subjective discounted cash flow (DCF) analysis, or a petitioner points to your success in running the business since you bought it, that the price you paid did not reflect fair value for the company.
You paid a market-clearing price in a fair and open process, yet you face a claim that the price was not fair; the fair price—which no one offered to pay—was really 30, 40, or even 50 percent higher.
This is not just a theoretical risk. These are basically the core facts of the Dell appraisal decision handed down a few months ago, which I will talk a bit more about (and in which, in the interests of full disclosure, my firm represented Michael Dell). This risk is one that troubles buyers of Delaware companies (especially private equity firms), preventing them from paying the highest prices they can pay or causing them to structure deals in ways that are not optimal just to avoid the appraisal risk. This means that it is also a worry for Delaware companies looking to sell because they know that buyers cannot pay top dollar due to the asymmetrical appraisal risk: the buyer takes all the downside risk, but arbs get an option on the upside.
Buyers must take all known risks into account, and they know what likely lies ahead: aggressive activist investors who get multiple bites at the proverbial apple. After negotiating the deal with independent directors, the buyer is not only at risk of the “headless highwayman” who jumps out from behind the bushes and tries to force a price bump before the stockholder vote (remember, it is Halloween week), but now must also worry about being chased for years after the deal closes by “zombie stockholders” who were never real investors in the company in the first place. These arb-zombies invested in a litigation play, not in the company.
Buyers must protect themselves, and they will. Sometimes they can structure a deal specifically to avoid appraisal rights, even if it is not the most economically desirable or efficient manner in which it could be done. In one large, pending merger in which my firm is involved, the deal was originally going to include some cash consideration for stockholders who wanted cash, but that changed. I am not going to go beyond the public disclosure, but it is a matter of public record that originally this was proposed as a stock-and-cash deal with appraisal rights. There was discussion over an appraisal condition, and by the time the deal was announced, it was an all-stock deal with no appraisal rights. Companies should not have to factor in appraisal risk when determining the optimal deal structure. If buyers cannot avoid the risk structurally, they must deal with it some other way, typically by holding back some of the price they would have been willing to pay to all stockholders so that they can pay off the “highwaymen” and the “zombies.” Of course they are never going to admit to holding back, but as someone who sits in these meetings and strategizes with the decision-makers, I can assure you that what they are calling the “Dell-risk” is not lost on anyone. A sizable appraisal award could make the difference between a successful transaction and an unsuccessful one. In a leveraged deal, where the risks to the buyer are significant and the margin for miscalculation is razor thin, it can mean the difference between viability and insolvency.
The only argument anyone has offered to suggest that there is any social value to appraisal arbitrage at all is that it performs a “policing” or “monitoring” function in that it discourages abuse by controlling stockholders. That claim applies only to conflict transactions, or squeeze-outs. It has absolutely no force to the vast majority of arm’s-length deals, and even in conflict deals, that was never the purpose of appraisal. Delaware already has a mechanism for discouraging abuse by controlling stockholders called fiduciary duty litigation, and Delaware lawyers and judges are the olympians of that particular blood sport. If there is a view that the Delaware courts are incapable of enforcing fiduciary duties of controllers and directors, someone should try to make that case, and anyway the remedy would be to improve that mechanism if it is flawed. Allowing statutory appraisal rights to be abused as a back-door method of policing fiduciary duties not only leads to injustice, but also creates perverse incentives throughout the system.
Here’s why: the great advantage of appraisal suits from the claimants’ point of view is that they do not have to prove or even allege any wrong-doing by the board, controlling stockholder, or anyone else; they must only convince a judge (years after the deal) that the fair value of the shares at closing was greater than the deal price. What this means is that, if the board or controller can be shown to have acted improperly (i.e., to have breached their fiduciary duties), then all stockholders share in any recovery. If the board and controllers cannot be said to have done anything wrong—as was the case in Dell—only the opportunistic “hold-outs” benefit from any award. That is not right. If stockholders were, in fact, harmed by a bad process, and that can be shown, they should all be made whole. In addition, it creates perverse incentives, not only on the part of the arbitrageurs (who know that buyers will hold back value from stockholders at large to satisfy their more aggressive claims), but also on the part of buyers themselves (who, frankly, know that there are far fewer holdouts seeking appraisal than there are stockholders).
So how did we get into this scary movie? (I am not sure whether you would call it “American Werewolf in Wilmington” or “Rocky Horror Appraisal Show.”) Not surprisingly, through a series of unrelated, mostly well-intentioned acts that had unintended consequences.
Appraisal rights themselves are not the problem. They have been part of Delaware law longer than any of us have been alive. Delaware companies never had to worry about them too much. They were not pursued very often and only resulted in large awards in egregious circumstances where there was real abuse of an insider position (e.g., Emerging Communications).
Section 262, added to the General Corporation Law in 1967, provides that a stockholder of a corporation engaging in certain fundamental transactions may, so long as their shares are not voted in favor of the transaction and certain other formalities are followed, ask the Court of Chancery to appraise the fair value of their shares. The legislative history of this provision is clear that this was intended to compensate minority stockholders who dissented from a fundamental transaction like a merger for the loss of their right to veto it. That appraisal rights were intended as a remedy for dissenting stockholders has been explicitly recognized by Delaware courts for decades (see, e.g., Weinberger, Technicolor and Transkaryotic).
Over the years, the appraisal remedy evolved: Weinberger opened up the range of permissible valuation techniques, whereas a series of later cases (see, e.g., MG Bancorp and Cox Radio) established DCF as the strongly favored valuation technique for establishing going-concern value. Golden Telecom posited that the Court of Chancery may not simply defer to the merger price full stop, but had to undertake an independent appraisal.
A key development was the dematerialization of shares. Unlike in 1967 when section 262 was enacted, we live in a world where almost all public company shares are held through depositaries in undifferentiated fungible bulk, as Chancellor Chandler so poetically put it. The question arose as to what should happen when a stockholder who bought shares in the market was not able to establish the statutory precondition to asserting appraisal rights, that the shares were not voted in favor of the transaction—that they were really dissenting shares. Almost 10 years ago, in Transkaryotic, the Court of Chancery held, regrettably, that the literal language of section 262 did not require that appraisal seekers must actually demonstrate that their shares were not voted in favor of the transaction. It is sufficient that enough shares were not voted in favor by the depositary for it to be mathematically possible. At the end of his decision, Chancellor Chandler noted the concern that his decision would “pervert the goals of the appraisal statute by allowing it to be used as an investment tool for arbitrageurs as opposed to a statutory safety net for objecting stockholders.” However, relief, he wrote, “more properly lies with the legislature.”
In effect this was a double invitation: to the arbitrageurs to “pervert the goals of the appraisal statute by allowing it to be used as an investment tool” and to the legislature to stop them. Sadly, only one of those invitations has thus far been taken up.
Even though Transkaryotic noted, like many cases before it, that appraisal rights were created as a remedy for “dissenting stockholders,” the interpretation it adopted allowed one to seek appraisal of shares one owns or later buys without being a dissenting stockholder as to those shares.
Transkaryotic laid the groundwork for a new industry—appraisal arbitrage—which was pioneered in part by members of the Delaware plaintiff’s bar who saw the lucrative potential in this legislative misalignment. Funds were raised specifically for the purpose of targeting this strategy, and a few years ago the all-out assault was launched, with a host of appraisal claims brought by speculators who were not real stockholders of the target companies. Among the first deals targeted were the buyouts of Ancestry.com, Ramtron, and BMC software. (In the interests of full disclosure, my firm represented Ancestry.com.)
Vice Chancellor Glasscock, in his first decision in Ancestry (that case has become known as Ancestry I), followed Transkaryotic and allowed the arbitrageurs to pursue their claims. He repeated Chancellor Chandler’s admonition that, if the legislative intent behind appraisal rights was not met by the words of the statute, then it was for the legislature, not the judiciary, to fix. Unfortunately, that has still not happened, and that is why we are having this debate.
After Ancestry I, a great hue and cry was heard across corporate America. Many people in business, legal practice, and academia (myself included) wrote to warn of the danger of appraisal arbitrage and implore the Delaware legislature to fix the statute. The problems were well-documented, including subversion of the legislative purpose, the uncertainty and deal risk created by buyers’ not knowing what they will have to pay, and the risk that they would hold back consideration to pay off arbitrageurs or seek to insert appraisal conditions in deals, which create dangerous uncertainty for both sides, but especially for sellers.
These problem were then exacerbated by the very high statutory interest rate that, in this current low-interest-rate environment, created an irresistible “heads I win; tails I win a bit less” dynamic. When the current statutory interest rate was adopted about 10 years ago, it was double the federal discount rate; now it is six times the federal discount rate.
Plaintiff’s lawyers were, to a large degree, driving the appraisal arbitrage gravy train, using slick marketing presentations to show hedge funds how to profit from appraisal arbitrage. Billions of dollars in hedge fund money were now targeting this unintended little aberration in the law.
The appraisal arbitrage claims kept coming—Dole, Petsmart, Safeway, Zale, and on and on. By one account, appraisal actions were filed in about a quarter of all Delaware transactions eligible for appraisal, making up a substantial part of the Delaware Court of Chancery docket. Add to the parade of horribles the wasting of judicial resources and the diversion of judicial brainpower to the intricacies and rabbit-holes of DCF analyses.
After all the fuss over Ancestry I, the Delaware Corporation Law Council proposed a partial measure to ameliorate the problem. I assume everyone here knows that this proposal was to exclude small, de minimis nuisance claims and to allow companies facing appraisal suits to make partial payments to the appraisal claimants, thereby cutting off the compounding above-market interest as to the amount paid. This proposal was criticized as inadequate by some (including yours truly), but it became embroiled with the fee-shifting tempest in a teapot, and the Delaware legislature did not take it up in 2015.
Then last year, we went into a period of a few months when the Court of Chancery was issuing its valuation determinations in a number of appraisal cases, and these decisions—Ancestry II, Autoinfo, Ramtron, and BMC II—suggested that, so long as a proper sale process was followed, the court would show a high degree of deference to the negotiated deal price. This “judicial solution” made people feel a lot better. The critics of the council’s proposal were mollified by the comforting notion that, even if the statute still facilitated appraisal arbitrage, the judges would step in to ensure that the rights were not abused. In that environment, the council repeated its anti-nuisance and partial-payment recommendations in 2016, and these changes were adopted by the legislature, taking effect this past August.
The recent revisions to section 262 are not very controversial as far as they go, but they do not go nearly far enough. This is because, at best, they may reduce but do not eliminate the artificial incentive to arbitrage appraisal rights. They may actually encourage appraisal arbitrage because they create a path for up-front funding for the litigation costs. Appraisal arbitrageurs will get most of their capital back, be able to pay their lawyers, and still be able to roll the dice for the upside. In Atlantic City they call this “playing with the House’s money.” It is early days, but so far in most cases, companies facing arbitrageur claims have chosen not to pre-fund their attackers, and the changes do not appear to have affected the tide of appraisal claims much.
At the time, however, with this legislative tweak and the Court of Chancery emphasizing the gravitational force of negotiated deal prices so long as a proper sale process was followed, a warm and fuzzy feeling set in among the M&A community. People stopped worrying and quit whining. (The noise level went from Texas Chainsaw Massacre to Silence of the Lambs.) It felt safe to go back into the water. Then came Dell. That decision made a lot of us feel like those holidaymakers on the beach at Amity Island.
Let us briefly recall the salient facts in Dell, as recounted in the court’s opinion. Dell Inc. was in deep trouble, facing declining prospects and a “changing ecosystem.” One analyst cited by the court called the company a “sinking ship.” Its stock was plummeting, its market share was declining, and its projections kept dropping lower and lower. Blue-chip private equity parties were dropping out of the process like Republican presidential candidates. KKR said it could not get its arms around the risk to the PC business; TPG said the cash flows were too uncertain and unpredictable to establish a business case.
The independent special committee of the Dell board ran an exemplary sales process. They negotiated hard and they achieved the best price that was available in the market. After the deal’s announcement, they engaged a second bank to run a full-go shop, which reached out to 60 new parties. Blackstone took a whiff and passed; there was only one guy who actually made a proposal: Carl Icahn. Talk about the mouse going to the cat for love. Icahn did not want to buy Dell, of course, but rather was merely playing his favorite game of “bumpitrage” and succeeded in extracting a price bump as tribute for his support of the deal.
The entire process followed in this case was pristine. Vice Chancellor Laster so held, noting expressly that, “this court could not hold that the directors breached their fiduciary duties or that there could be any basis for liability.” Indeed, the Vice Chancellor praised the manner in which the members of the special committee, acting for the sellers, conducted themselves, as he did Michael Dell, the controlling stockholder who was the largest member of the buyout group. Nevertheless, he found that the fair value of Dell was almost one-third higher than that hotly negotiated, stockholder-approved price that had even won Arbzilla’s approval.
In his decision, the Vice Chancellor effectively acknowledged that the fair value he decided on was not attainable in the circumstances in which the Dell special committee found themselves. It was not available in the market. There were no strategic buyers (as the Dell board and its advisers had correctly determined). All of the private equity firms who bid based their offers, as private equity firms do, on what they could afford to pay to receive the rate of return they required to justify the investment and the risk of taking on huge debt. Nevertheless, he determined that the fair value for statutory appraisal purposes was 28 percent higher than the established fair market value.
Was a great injustice done in Dell? Of course not. Only a small percentage of the overall shares had perfected their appraisal rights. The arbitrageurs who held them were very happy. With the benefit of almost three years of hindsight, one could see that Michael Dell and his co-purchasers at Silver Lake were doing rather well on the acquisition. Their bet was working out. So this might appear to be one of those win-win/no-loser situations, right? Not right. The losers are the stockholders of Delaware corporations in future transactions because decisions like this create a disincentive for buyers to pay top dollar out of a rational fear that a court will later require them to pay some theoretical “fair value” that the market itself would not support.
The appraisal process has largely become a battle of DCF experts-for-hire offering “chasmically” diverging opinions on the same sets of facts. As Chancellor Bouchard recently wrote (quoting Justice Jacobs in part): “The advantage of an arm’s-length transaction price as a reliable indicator of fair value is that it is ‘forged in the crucible of objective market reality (as distinguished from the unavoidably subjective thought process of a valuation expert) . . . .’”
The Dell case was not a mere aberration. Shortly after Dell, there was another case concerning the appraisal of DFC Global in which the Chancery Court awarded the appraisal plaintiffs a fair-value award of 7.5 percent above the negotiated deal price, despite the fact that the deal was the product of a robust two-year, arms-length sale process.
These were two very different cases, and 7.5 percent is a lot less than 28 percent, but to some ears, DFC Global amplified the alarm bells that Dell had sounded, alerting purchasers that they still must contend with appraisal risk.
In DFC Global, the company’s board also faced extremely difficult circumstances. As the Chancellor noted, “at the time of its sale, DFC was navigating turbulent regulatory waters that imposed considerable uncertainty on the company’s future profitability, and even its viability . . . the potential outcome could have been dire, leaving DFC unable to operate its fundamental businesses. . . .” In these dire straits, the DFC Global board made the decision that it was best to sell the company and let the buyer bear those risks. So the board ran an exhaustive process to successfully secure for stockholders the best price the market would deliver. Nevertheless, the Chancellor agreed with the appraisal plaintiffs that the company was sold “at a discount to its fair value during a period of regulatory uncertainly that temporarily depressed the market value of the company” and awarded them a price increase (admittedly not as much as they had hoped).
The Chancellor expressed that “[t]he merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value in an appraisal proceeding as a general matter, but the market price is informative of fair value only when it is the product of not only a fair sale process, but also of a well-functioning market.” In that case, he found, “the transaction . . . was negotiated and consummated during a period of significant company turmoil and regulatory uncertainty, calling into question the reliability of the transaction price as well as management’s financial projections.” These are carefully calibrated words, but not every lawyer reads every word.
So long as appraisal arbitrage is allowed, appraisal claims likely will be brought in certain situations, for example where DCF models suggest theoretical valuations higher than the deal price, or when the deal is struck at a time of great uncertainty. This litigation will be much more extensive and serious than traditional appraisal litigation because it will not be brought by real dissenting stockholders who are unhappy with the price, but by professional opportunists who are well-funded and who have organized themselves specifically to game the system and take advantage of this legislative quirk.
These decisions not only have troubling policy implications, but they also raise doctrinal questions. The law defers to the decisions of loyal and well-informed directors. That is especially true under the new MFW “unified standard” where the combination of effective independent director negotiation and minority stockholder approval leads to business judgment review of board action. It is difficult to see these determinations—that the fair value of these companies was higher than the board achieved or could possibly have achieved in the circumstances—as anything other than second-guessing the decisions of the board in each case that it was the right time to sell the company. The Dell and DFC Global boards decided to accept a premium to the trading value—the best price they could get—and to allow someone else to take the risk (the risk of righting the “sinking ship” in Dell’s case, or of regulatory Armageddon in DFC Global’s case). Rather than deferring to their loyal and well-informed decisions, the court said they sold too cheap. There is an inconsistency there, and it is not eliminated by the fact that the immediate consequences of this judicial second-guessing are borne not by the directors themselves, but by the buyers because the buyers simply will pass those costs on.
Some of the problem is inherent in the appraisal rights concept itself and in the wording of the statute. The judge’s statutory obligation is to determine de novo the target company’s fair value as of the closing date, which might be many months after a sale process has established the company’s fair market value. A company’s fair value is not necessarily the same as its fair market value, especially if the two determinations are separated in time. The temporal aspect is baked into the appraisal statute, and with the appraisal arbitrageurs attacking deals that can make it very hard to sell companies in certain circumstances, such as during regulatory turmoil or if they have a significant FDA approval pending. The legislature might consider revising the statute to have the appraisal valuation speak as of the date the stockholders make their decision to sell, as some jurisdictions do, but I am not promoting that amendment today.
Most appraisal fights are not driven by the timing differential, but by the difference between fair value and fair market value. This means the litigation battleground centers on valuation metrics, the intricacies of DCF modeling, projections, discount rates, terminal multiples, and dueling valuation experts. It is the Wharton version of Alien vs. Predator, and it is up to the courts to decide how deeply they want to get dragged into that quicksand, or whether the “value that is forged in the crucible of objective market reality” is close enough in most cases.
The modest changes I am urging would not completely eliminate the risk of timing or valuation arbitrage, but it would greatly alleviate the magnitude of the problem by limiting appraisal rights to those whom the law is supposed to protect. What the legislature should do is amend section 262 of the Delaware General Corporation Law to specify that only shareholders on the record date who can demonstrate that their shares were not voted in favor of the transaction are eligible for appraisal.
If that simple change were made, the number of appraisal cases, the dollars involved, and the risks to corporations doing business in Delaware will go down dramatically, with no loss of protection for the dissenting stockholders the law was aimed to protect. In fact, any “policing” value added by the fact that appraisal claims are easier to win than fiduciary claims would still exist; it would simply benefit the people it was always supposed to benefit, namely, dissenting stockholders rather than enriching opportunistic, quick-buck artists.
The Delaware Supreme Court might get the opportunity to weigh in on these questions, in Dell or in other cases in the pipeline, but there is no reason to ask the Supreme Court to fix what the legislature could with the stroke of a pen. The Delaware legislature must be The Exorcist.
The Legal Opinions Committee of the ABA Business Law Section recently published a report on cross-border closing opinions (the ABA Report). The City of London Law Society (CLLS) and the Toronto Interfirm Opinion Group (TOROG) have also published reports providing guidance for English and Canadian lawyers on closing opinions. In addition, lawyers in the Netherlands, Germany, and other countries have significant experience reviewing, and responding to requests for, closing opinions from counsel to U.S., English, and Canadian parties to business transactions. Nevertheless, the absence of a shared conceptual framework among lawyers in different jurisdictions often gives rise to misunderstandings due to differences among legal systems and language barriers (even when documents are in English). A program presented at the Spring 2016 ABA Business Law Section meeting in Montréal brought together opinion practitioners from the United States, Canada, the Netherlands and England to discuss how to make cross-border opinion practice more efficient and less contentious.
The premise of the program was that lawyers and their clients would benefit from consensus on recurring issues in transactions where opinion givers and recipients are from different jurisdictions, given that it is unlikely that a body of “supra-national” cross-border customary opinion practice will develop any time soon. The topics included: Which specific opinions should not be requested or given? What assumptions, qualifications or exceptions are appropriate in the cross-border context? How do different national laws interact and impact opinion practice? How do we account for the peculiarities of international transactions? How do opinion givers deal with the risk that their opinion will be litigated in a foreign jurisdiction? Can there be agreement on standard limitations on the liability of the opinion giver?
Not so long ago the practice of giving closing opinions to nonclients (so-called third-party legal opinions) was restricted to the United States. For example, in England the lender typically would receive an opinion that a loan agreement was valid, binding, and enforceable from its own counsel, whereas in the United States, it would be the borrower’s counsel that gives that opinion to the lender. Over the past decade, the practice of giving third-party legal opinions in cross-border transactions has spread beyond the United States, raising the question: Would it be helpful to establish some degree of uniformity in the opinion practice? It is critical, however, to strike the right balance between uniformity and respect for national practice, especially as it becomes more common that the governing law in cross-border transactions is notU.S. or English law—jurisdictions where third-party opinions have been most common—but rather the law of another country.
The program panel agreed on a number of core principles:
although parties must look primarily to advice from their own counsel to help structure financial transactions, negotiate agreements, and deal with potential legal issues, there are situations where requesting third-party closing opinions to complement that advice makes sense;
weighing the benefits of third-party legal opinions against the cost is critical;
third-party closing opinions should be limited to specific legal issues that involve the exercise of professional judgment by the opinion giver;
opinions are expressions of professional judgment, not guarantees that a court will reach the same conclusions as the opinion giver;
the specifics of a transaction may require exceptions or make it impossible to give an opinion; in such cases, if the parties wish to consummate the transaction, they must do so by accepting the risk or restructuring the terms which cause the opinion problem, not by attempting to coerce an unwilling opinion giver;; and
the meaning of an opinion must be understood in light of the customary practice in the jurisdiction of the lawyer giving it, which also shapes the diligence required to issue the opinion.
This last point is particularly important because, in some jurisdictions, customary practice may be to squeeze everything believed relevant into the four corners of the opinion letter, whereas in other jurisdictions (such as the United States) opinions may take a more streamlined form based on an understanding among the parties that matters not expressed in the opinion letter nevertheless are to be read into it. Customary practice in the United States also relies on a “golden rule” that: (1) an opinion should not be requested by counsel for the recipient if such counsel would not give the opinion if it represented the opinion giver’s client; and (2) the recipient should not be denied an opinion that lawyers experienced in the matter would commonly give in comparable circumstances.
Although the United States approach to legal opinions has its limitations, there is ever growing agreement on what third-party legal opinions should cover and what assumptions, exceptions, and qualifications are appropriate; there is no such custom in most foreign jurisdictions.Given the lack of a customary practice in cross-border transactions, applying the golden rule is even more difficult because counsel to a recipient in one jurisdiction may request an opinion that is commonly given in that jurisdiction, but not in the jurisdiction of the opinion giver. In addition, the golden rule is based on the premise that the roles of counsel for the opinion giver and the recipient could be reversed in a subsequent transaction, but this role reversal may not be as realistic in the cross-border context as it is in the U.S. domestic context. Nevertheless, the panelists agreed on a core tenet that should always apply: a closing opinion should be neither a bargaining chip between the parties, nor a zero-sum game; instead, it should be an exercise in professionalism with a limited purpose.
In light of the foregoing, the panel considered whether it makes sense to form a small working group, drawn from the growing community of lawyers active in cross-border transactions who deal regularly with third-party closing opinions to: (1) identify key practices in the most recurring jurisdictions; (2) define some broad archetypes of closing opinions; (3) define the most common areas of friction; and (4) develop common guidance to make giving and receiving cross-border opinions more consistent and less costly. The panel also considered whether the “charter” of such a cross-border working group should extend to closing opinions that counsel gives to its own client in connection with specific transactions, which may be functionally equivalent in some jurisdictions to third-party legal opinions. Developing a common lexicon might be especially helpful to in-house counsel which may have less experience than outside counsel in the area of opinion practice and may have to ensure that client checklists are met in circumstances where such lists and the law of the opinion giver’s jurisdiction may be at odds.
The interaction among members of the panel clearly illustrated both commonalities and differences among jurisdictions. For example, Canadian practitioners have led the way in developing guidance for giving and receiving cross-border opinions because many transactions involving Canadian clients have links to London or the United States, resulting in a fairly robust cross-border opinion practice in Canada. TOROG, which has been widely followed, has been instrumental in creating standard practices among Canadian law firms. Consequently, model opinion language and customary practice for Canadian lawyers engaged in transnational transactions has developed over the last 15 years and evolved into a fairly well-established body of guidance, which generally is consistent with U.S. practice. There are, however, recurring points of friction, particularly with English recipients, such as opinions in the financing context on bank regulatory matters, tax opinions, and, to a lesser extent, insolvency and creditor priority opinions. A Canadian lawyer pointed out that there are occasional requests for what he called “broad-form enforceability opinions:” an opinion under Canadian law on the enforceability in Canada of a document governed by foreign law (e.g., a loan agreement governed by English law with Canadian borrowers). The ABA Report refers to this kind of opinion as an “as if” enforceability opinion and takes a firm stand against giving such an opinion in cross-border transactions. Although Canadian lawyers sometimes give “as if” opinions, often in combination with opinions covering local enforceability of security interests in collateral located in Canada, the consensus is that Canadian lawyers would not have difficulty accepting the guidance in the ABA Report.
It also became apparent during the panel discussion that Dutch lawyers habitually give opinions to recipients in other jurisdictions when their clients engage in cross-border transactions. In the context of financing transactions involving Dutch borrowers, Dutch firms often face the issue of who should give a closing opinion that the loan agreement is valid, binding, and enforceable– lender’s counsel, as is the practice in London, or borrower’s counsel, as is the practice in the United States. Dutch lawyers tend to adopt a practical approach: when the transaction involves a U.S. lender, Dutch counsel representing the borrower is prepared to give the enforceability opinion, but when the transaction involves a U.K. lender, London practice is followed. Using both practices, however, can create difficulties for Dutch lawyers who do not participate regularly in cross-border transactions. Apparently, Belgian and Luxemburg law firms adhere to the English practice of borrower’s counsel giving opinions only on matters such as their client’s corporate status, power, and authority, whereas lender’s counsel gives enforceability and choice-of-law opinions. There seems to be well-established market practices among BeNeLux firms on giving most of the opinions discussed in the ABA Report, although friction sometimes arises on who can rely on the opinion and on limitations on the liability of the opinion giver. With respect to “as if” enforceability opinions, an experienced Dutch practitioner remarked that for the last 15–20 years, Dutch firms have given them when pressed but with significant qualifications that end up eroding coverage to something like “we are not really saying that the foreign law agreement is enforceable in the Netherlands, rather that, if the lender goes to a Dutch court, some remedy will be available.” Again, in this context there was support for the ABA Report’s position against giving “as if” enforceability opinions in cross-border transactions because they are costly and rather meaningless. Apparently, while Dutch firms generally are willing to give tax opinions in financing transactions, they often refuse to give (without facing much resistance) no-conflict, no-violation-of-law and no-litigation opinions. Some Dutch firms give a no-violation opinion limited to violations that would cause the contract to be unenforceable.
A lawyer familiar with both English and U.S. opinion practice made the point that many of the opinions identified by the panel as contentious are routine in the United Kingdom, which can result in friction when English lawyers are faced with different practice for cross-border opinions. She remarked that European lawyers have developed ways to accommodate those requests over 20 years of transactions among parties who share the commonalities of the European Union; therefore English lawyers are sometimes surprised when they face resistance from U.S. or Canadian lawyers. The conversations that ensue can be difficult, but are necessary, as evidenced by United States customary practice on issues such as withholding-tax opinions and “as-if” enforceability opinions. She also pointed out that for transactions involving English lenders, it is the in-house lawyers’ responsibility to confirm that their “standard checklist” of required items is fully satisfied; therefore, when U.S. borrower’s counsel refuses to cover an item on the list, much time can be spent explaining to the lenders’ in-house counsel how else those matters can be addressed. Similar issues arise in other countries with respect to certifications, for example, when a notary must be involved in the closing and certain matters which U.S. counsel typically does not cover (such as factual matters) must be addressed to the notary’s satisfaction.
Based on the views expressed by both panelists and members of the audience who practice in different jurisdictions, there was a consensus that a working group of lawyers experienced in requesting and preparing closing opinions in cross-border transactions could productively undertake an effort to build a common lexicon to bridge conceptual divides on issues that often make the negotiation of opinions time-consuming and unnecessarily acrimonious, such as:
the differences in approach between common law and civil law practitioners;
the nature and function of “true” closing opinions versus reasoned legal opinions versus the lawyer’s responsibility for due diligence reports;
the rights of opinion recipients versus those of nonaddressees who are given access to or allowed limited reliance on the opinion versus those of future assignees who are permitted to rely on a previously given opinion; and
the role of factual assumptions versus reliance on certificates of clients or public officials versus knowledge-based factual confirmations.
The working group could also work toward developing common ground on foundational matters, such as:
whether uniform structures can be developed for third-party closing opinions in common types of transactions;
how far assumptions can be taken (“I have no reason to doubt X” versus “I wash my hands of X regardless of reasonableness.”);
whether assumptions relate to only facts or can extend to legal matters;
how assumptions, qualifications, and exceptions differ;
when is disclosure to the opinion recipient appropriate if the law is uncertain;
whether choice-of-law and forum-selection clauses should be included in opinions; and
what fair limitations could be placed on the liability of opinion givers.
It was agreed that the working group’s analysis would transcend the law of individual jurisdictions and focus on ways for lawyers across jurisdictions to better communicate about opinion issues and that, to discover common ground, it may help to take a step back and ask:What are we trying to accomplish by asking counsel to client A in jurisdiction X to provide a legal opinion at closing to client B in jurisdiction Y who is represented by its own counsel in the transaction (who may or may not be familiar with the law of jurisdiction X)? Sometimes practitioners fail to address this basic question; focusing on it could allow both counsel and their clients to determine whether it is worthwhile to spend client A’s money on specific opinions or on a third-party opinion generally. The answer may be “yes,” but there may also be more efficient ways to satisfy client B’s concerns. On the other hand, in cross-border transactions, client B may fear unexpected results under the law of jurisdiction X and may not have its own counsel in that jurisdiction; then a third-party opinion covering agreed-upon aspects of the transaction, framed by an understanding of the customary diligence expected of the opinion giver and balanced by reasonable assumptions, qualifications, and exceptions, could be the right answer. Nevertheless, cross-border opinions are often significantly more costly than similar domestic opinions, and should not go beyond what is justified by a rigorous cost-benefit analysis. Moreover, the opinion giver cannot be expected to assume risk when it is not possible to reach “opinion-level” legal certainty on a particular issue.
The difficulty of this last point is illustrated by one member of the panel having witnessed increasing requests, primarily from civil law jurisdictions, for so-called “certifications” by counsel for a U.S. party, possibly because in those jurisdictions a notary may be responsible for certifying both the facts underpinning the transaction and the law that makes the contract valid, binding, and enforceable. When a third-party opinion is seen as part of the record before the notary, the distinction between factual confirmations and legal conclusions can blur. Although the request for a certification may be understandable, it puts the U.S. opinion giver in a difficult position because as a matter of U.S. customary practice, it is standard for a U.S. lawyer is to rely on a secretary’s or officer’s certificate without taking responsibility for the facts. That practice may be seen as problematic, at least in the eye of the recipient, because it lacks a “professional imprimatur.”
It seems important for the working group to grapple with the extent to which different jurisdictions may allow third-party opinions to be based on “customary practice” being read into the opinion without having to spell out every detail within the four corners of the document. For example, the CLLS report reads that all matters upon which an opinion is based are to be set out within the text of the opinion letter.By contrast, U.S. practitioners generally have moved toward avoiding expressing in opinion letters those matters which are well understood as a matter of customary practice. English lawyers in the audience pointed out, however, that the CLLS report represents one version of London opinion practice and, although useful and helpful, is not as authoritative as some U.S. bar groups’ reports. A Canadian lawyer on the panel pointed out that Canadian practitioners do not tend to rely heavily on unstated assumptions and scope limitations. The working group could analyze whether the courts of different jurisdictions might be willing to consider customary practice as one of the sources of evidence for resolving disputes over third-party legal opinions. If judges recognize something as “customary practice” and are prepared to use it as a benchmark for interpreting an opinion, then expert testimony would become relevant. That could be helpful, but the agreement on use of customary practice must be such as to avoid the definition of “customary practice” degenerating into a battle of the experts, where judges are left to decide whether to prefer one interpretation over another or reject all of them and do their best based solely on the wording of the opinion.
Knowing how different jurisdictions deal with this important aspect of opinion practice would lay a foundation for further work on cross-border opinions. The U.S. practitioners on the panel pointed out that they spend significant time thinking about customary practice with beneficial effects. First, customary practice can be invoked when counsel is asked to do something out of the ordinary or to give an opinion covering novel or unsettled areas of the law. Secondly, it establishes the work opinion preparers must do to support particular opinions. Thirdly, it helps define which assumptions or limitations are commonly understood to apply, whether they are stated or not. The “duly authorized” opinion offers a good example: would Canadian or English lawyers feel a need to state what U.S. lawyers typically do not (“we are only covering the requirements of the corporation law of the jurisdiction in which the company is organized, and we are not covering regulatory or other requirements that the company might have to satisfy, even though they may be applicable and relevant, despite what the opinion recipient might think if he or she simply relied on the plain meaning of the words ‘duly authorized’ without more”) because unlike U.S. lawyers they do not rely on customary practice to determine how opinion recipients should understand the scope of the words “duly authorized” in a third-party legal opinion?
Although non-U.S. lawyers on the panel generally agreed that practitioners in their jurisdiction often do have an understanding of what is covered in a legal opinion and what opinion preparers are doing to support the statements made in an opinion, what makes non-U.S. lawyers uncomfortable about relying on a customary practice concept is the wide range of contexts in which opinions are given. For example, finance lawyers may share an understanding that opinions in lending transactions do not cover tax or bank regulatory issues unless they are covered expressly, but lawyers operating in other transactional settings may lack a common understanding of what is or is not covered. As a general matter, then, an opinion giver in Canada, for example, would not be comfortable saying that an express statement with respect to the matters not covered is needed “because in Canada there is no customary practice which implies a scope limitation,” but rather would decide whether to add one based on the circumstances. It is also the case that there is limited case law in Canada on opinions.The discussion ended with consensus that, even if one starts from the position that there is no reliable customary practice and things must be spelled out, the reality is that the terms lawyers use in closing opinions are laden with special legal meaning, and no matter how much one tries, it is not possible to spell everything out. Thus, this looks like a productive area of analysis for a cross-jurisdictional working group.
The final topic the panel discussed was whether part of the effort to find common ground should address uncertainty around litigation with respect to cross-border opinions. In the United States it has been well settled for many years that opinions are neither contracts nor guarantees, and liability is predicated on the doctrine of negligent misrepresentation without any limits on liability. English lawyers routinely limit their liability to the opinion recipient, specify the choice of English law to cover disputes regarding the opinion, and insist on jurisdiction in England. That is not the practice in the United States, although all three topics increasingly have been the subject of debate. In the Netherlands, choice of Dutch law and Dutch forum selection are seen as noncontroversial because there is a strong sentiment that, when a Dutch firm renders an opinion on Dutch law, the recipient should not have the right to sue that firm in an English or U.S. court if that is where the opinion recipient happens to be. The same seems to be true in Canada, at least according to the TOROG report. There may be a compelling counterpoint, however: when a firm from jurisdiction X gives an opinion to a party in jurisdiction Y, the recipient might not be sympathetic to the concept that litigation should always take place in jurisdiction X, at least when there are significant contacts between the transaction and jurisdiction Y.
Even more complicated are issues relating to limitations on the liability of opinion givers because there is such a difference in understanding among jurisdictions as to the standards of liability of lawyers in general and of opinion givers to nonclient recipients in particular. For example, Dutch law provides that one of the considerations in awarding damages in a tort claim is what kind of insurance is in place. Thus, for a Dutch lawyer to limit liability to insurance proceeds, particularly where Dutch professional rules speak to appropriate levels of insurance coverage for lawyers, is absolutely uncontroversial. In England, lawyers mostly give opinions to their own clients, so liability is governed by the terms of engagement but for third-party opinions, where there are no such terms, opinion givers worry about potentially uncapped liability, particularly when the opinion is addressed to a party in a foreign jurisdiction and that party may turn out to have larger or broader claims than the opinion giver’s own client would not have if it were receiving the opinion. For that reason, English lawyers spell out a number of restrictions on the rights of a nonclient recipient in their opinions. It appears that it is rare in Canada for the opinion to get into matters such as forum selection, limitation of liability, and limitations on reliance principally as a result of limited experience with lawsuits against opinion givers. Moreover, it is not clear that Canadian case law on the liability of lawyers would always be favorable for opinion givers, so leaving the issue vague may be an attractive option as compared to agreeing expressly to governing-law and forum-selection language in cross-border opinions, particularly because those clauses might permit opinion recipients to bring contract-based claims, which might be a worse result.
The panel only scratched the surface on a host of other meaningful issues for lawyers who request or give legal opinions in cross-border transactions. It is undeniable that there are many substantive and procedural differences in opinion practices in different countries. Although there is no “right way,” it was agreed that understanding the differences and, ideally, promoting some measure of convergence where consistent with the legal regime of the opinion giver would seem like a worthwhile exercise. The Legal Opinions Committee of the ABA Business Law Section has authorized its leadership to pursue formation of a cross-border working group as a useful first step toward reducing the difficulties encountered in rendering opinions in cross-border transactions. Although this may be a small first step in what will be, at best, a long journey, U.S. lawyers look back at the very first attempt in Silverado, California, to deal in U.S. domestic opinion practice with many of the issues (which over the years have been resolved) with which we now wrestle anew in cross-border transactions as evidence that the journey can be successful.
This new journey is well worth undertaking for the benefit of all lawyers involved in cross-border transactions, as well as their respective clients.The fact that lawyers from, for example, the U.S. and Germany who are active in transnational transactions operate without the benefit of a largely shared conceptual framework in the same way as lawyers from New York and California is important, but need not force us to throw up our hands. We must be attentive to the tension between different legal systems, how international financial markets operate, and the fact that language barriers in legal analysis are still present even when everybody communicates in English. Nevertheless, the possibilities are exciting.
It is now time for a large number of non-U.S. companies to prepare their annual reports on Form 20-F. For companies with a calendar year-end, the Form 20-Fs must be filed with the U.S. Securities and Exchange Commission (SEC) by May 2, 2017.
To facilitate the preparation of this year’s annual reports, 20-F filers should note the following recent developments, trends, and topics that may be important focus areas of the SEC in the 2017 review process.
Trends in SEC Comment Letters in 2016
During the 2016 review process of Form 20-Fs, the SEC focused on the following themes.
Non-GAAP and Non-IFRS Disclosures
Disclosures of non-GAAP and non-IFRS measures continue to be important areas of focus for the SEC, as indicated by its comments not only on Form 20-F filings, but also on other SEC filings, such as quarterly earnings releases furnished on Form 8-K. In May 2016, the SEC updated its Compliance and Disclosure Interpretations (C&DIs) regarding the use of non-GAAP and non-IFRS financial measures and highlighted the following topics covered in comment letters to various Form 20-F filers.
Equal or Greater Prominence. The SEC has requested, as required by Regulation G and Item 10 of Regulation S-K, that a presentation of the most directly comparable GAAP financial measure must be presented “with equal or greater prominence” whenever a non-GAAP measure is disclosed. Accordingly, headings, bullets, and tables must first present the GAAP and then the non-GAAP measures (in that order). In addition, derivative non-GAAP metrics such as “adjusted EBITDA as a percentage of sales” need both reconciliation and a presentation of the comparable GAAP measure in a location of equal or greater prominence; in this case, a presentation of net income as a percentage of sales. Such presentations, to the extent they appear elsewhere in the 20-F, must also follow the same chronological order as presented in the first instance.
Reasons for Inclusion of Non-GAAP/Non-IFRS Measures. It may not be sufficient to include boilerplate language that management believes the company’s non-GAAP or non-IFRS measures provide investors with helpful supplemental information. In several comment letters, the SEC has asked companies to elaborate on the usefulness of each non-GAAP or non-IFRS measure to the specific circumstances of the company, sometimes focusing on particular adjustments.
Accurate Labeling. Measures such as “EBITDA” or “Free Cash Flow” must be labeled as “adjusted” if they include adjustments beyond those customarily made for measures with those names. Similarly, “pro forma” could only be used where such financial measures have been prepared in accordance with the SEC’s rules for pro forma financial statements in Article 11 of Regulation S-X.
Proper Adjustments and Reconciliation. In its updated C&DIs, the SEC has identified several adjustments as problematic, taking the position that certain non-GAAP adjustments, while not expressly prohibited, are presumed to be misleading. Those adjustments include, among others: normal, recurring cash operating expenses; acquisition-related expenses; and purchase accounting adjustments. In upcoming 20-F filings, companies can still provide explanations as to why such adjustments are relevant but may now face an uphill battle in retaining such adjustments.
Dealings with Sanctioned Countries
As in past years, the Office of Global Security Risk of the SEC’s Division of Corporation Finance continues to review annual reports on Form 20-F for transactions in or with countries and entities subject to sanctions implemented by the Office of Foreign Assets Control of the U.S. Department of Justice. In its comment letters (sometimes even referencing 20-F filings as far back as 2011), the SEC has required 20-F filers to disclose any past, current, and anticipated contacts with sanctioned countries, such as direct or indirect agreements, commercial arrangements, or other contacts with the governments of those countries or any entities that might be controlled by those governments. Given this practice, 20-F filers may want to review their prior filings to prepare themselves for any inquiries in this area.
In particular, the comments have instructed 20-F filers to describe the materiality of their contacts with any sanctioned countries and explain whether those contacts constitute a material investment risk for security holders. The materiality assessment should be provided in both quantitative and qualitative terms. Quantitatively, estimates should be denominated in U.S. dollar amounts of the associated revenues, assets, and liabilities for a period spanning the last three fiscal years and any subsequent interim period. Qualitatively, the disclosure should provide any information that a reasonable investor would deem important in making an investment decision, including the potential impact of the transactions on the company’s reputation and share value.
Litigation Disclosure
The SEC has continued to request 20-F filers to disclose, whenever possible, their best estimates of the potential outcome of pending litigation, and to describe the effects the outcome would have on their financial condition. In particular, where there is at least a reasonable possibility that a loss may have been incurred (in excess of the amounts already recognized), the comment letters have requested further information on the nature of the loss contingency. Additionally, the SEC has requested disclosure on a) the amount or range of reasonably possible losses in excess of amounts accrued, b) whether reasonably possible losses cannot be estimated, or c) whether any reasonably possible losses are not material to the company’s financial statements.
Where a reasonable estimate cannot be made, the SEC has requested 20-F filers to explain a) the procedures the 20-F filer undertook to develop a range of reasonably possible losses for disclosure and b) for each material matter, what specific factors are causing the inability to estimate and when the company expects those factors to be alleviated. In light of these instructions, however, the SEC has recognized that uncertainties associated with loss contingencies exist. To address this potential area of concern for companies, the SEC has allowed 20-F filers to disclose pending matters on an aggregated basis.
Impairment Charges
Impairment calculations, including the methodology and assumptions, have continued to be an area of interest for the SEC. In certain instances, the comment letters noted inconsistencies in the impairment assessment between certain impairment calculations compared against other impairment calculations performed throughout the 20-F filing. In other cases, the SEC has requested clarification on why certain segments of the company’s business were not subject to impairment pursuant to IAS 36. Where an impairment assessment was made, the comment letters instructed companies to explain which factors (including external factors such as declines in commodity prices in 2015) led companies to recognize an impairment charge.
Disclosure of Government Payments by Resource Extraction Issuers
On June 27, 2016, the SEC adopted a final rule implementing Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). Pursuant to Section 1504 of the Dodd-Frank Act (commonly known as “publish what you pay”), the SEC implemented rules requiring resource extraction issuers to disclose payments made to governments for the commercial development of oil, natural gas, or minerals.
The commercial development of oil, natural gas, or minerals is given broad scope to include stages from exploration to midstream activities, but does not extend to the final processing stages of refining and smelting. A wide range of payments, such as taxes, royalties, fees, bonuses, infrastructure payments, and community social responsibility payments, whether made in cash or in-kind, must be reported if paid to any level of government, including majority state-owned enterprises. Under the rule, payments must be disclosed by type and total amount at the project level.
The new rule will take effect for an issuer’s first fiscal year ending on or after September 30, 2018, and will require disclosure of government payment information annually in a specialized disclosure report on Form SD no later than 150 days after an issuer’s fiscal year-end. For companies with a calendar year-end, the first year of compliance will be the year ending December 31, 2018, and the filing deadline will be May 30, 2019. Reports filed in compliance with the substantially similar Canadian and European Union reporting regimes will be accepted by the SEC for purposes of compliance with the SEC rule.
Risk Factors Relating to “Brexit” and the U.S. Presidential Election
Several 20-F filers began including Brexit-related risk factors, and some (as a result of their filing date) have also disclosed potential risks relating to the results of the U.S. presidential election. Although SEC comment letters have not yet requested 20-F filers to assess any risks related to Brexit or the election, some comments directed at U.S. filers have requested consideration of those factors.
Brexit
A number of Brexit-related risk factors disclosed in 20-F filings have focused on the uncertainty surrounding the United Kingdom vis-à-vis its relation to the European financial and banking markets. Almost all risk factors explain that the withdrawal of the United Kingdom from the European Union will involve lengthy negotiations, and the uncertainty could increase volatility in the markets. Some risk factors also note that the Brexit vote is non-binding and that the United Kingdom has yet to invoke Article 50 of the Lisbon Treaty to trigger the withdrawal (which is currently expected to occur in late March of this year). Examples of Brexit risks identified by 20-F filers include: the fact that sales are denominated in British pounds the depreciation of which may impair purchasing power of European customers, potentially leading to cancellation of contracts or default on payments; restriction of imports and exports; reduction in movement of skilled professionals between the United Kingdom and the rest of the European Union; and increase in regulatory compliance costs.
U.S. Presidential Election
Results of the U.S. presidential election have led to identification of a few risk factors, namely potential changes to existing trade policies and agreements, proposed reforming of the U.S. Food and Drug Administration, potential repeal of the Patient Protection and Affordable Care Act (Obamacare) as well as perceived changes in U.S. social, political, regulatory, and economic conditions. As the SEC has continued to emphasize the need to tailor risk factors to the particular company’s circumstances, 20-F filers may need to carefully consider how potential changes in the U.S. social, political, regulatory, and economic landscape could impact the companies’ operations and financial conditions. While the result of the election may not be considered a risk itself, subsequent changes in legislation, trade policy, and economic conditions may be important considerations in drafting risk factors.
Iran Sanctions Update
On January 16, 2016, the Joint Comprehensive Plan of Action (JCPOA), which was signed among the Islamic Republic of Iran and the E3/EU+3 (China, France, Germany, the Russian Federation, the United Kingdom and the United States, with the High Representative of the European Union for Foreign Affairs and Security Policy), was implemented, lifting a number of “secondary” sanctions. However, the “primary” U.S. sanctions, which are directed primarily at U.S. persons, continue to apply, as well as certain sanctions outside the scope of the JCPOA, such as those relating to terrorism and human rights violations in Iran.
Furthermore, the results of the U.S. presidential election suggest that the lifting of “secondary” sanctions might be short-lived. The JCPOA contained a provision allowing any party to unilaterally “snap back” sanctions if it determines that Iran has violated the terms of the agreement. Although there is no public information indicating that to be the case, the JCPOA is only an executive agreement, and President-elect Trump has stated that one of his first tasks will be to withdraw from the JCPOA and reimpose the full panoply of sanctions on Iran. For European and other non-U.S. companies that have cautiously reopened commercial ties with Iran, the election considerably raises the risk that sanctions will be reimposed. Companies in the financial and oil and gas sectors face a choice of pursuing Iranian business and thereby taking the risk of facing secondary sanctions. The Office of Foreign Assets Control (OFAC), however, published Frequently Asked Questions guidance that should sanctions snap back, the U.S. government would provide a 180-day wind-down period for payments. For further details, please see our recent memo on this topic.
Even though the JCPOA has lifted certain sanctions, the current reporting company disclosure requirements under the Iran Threat Reduction and Syria Human Rights Act of 2012 (TRA) have not been eliminated. Under the TRA, any foreign private issuer that prepares annual reports on Form 20-F is required to disclose in its annual report certain of its (and its affiliates’) investments and transactions relating to the Iranian petroleum and petrochemical sectors and transactions involving the government of Iran. The company is required to disclose the nature and extent of the activity, the gross revenues and net profits attributable to the activity, and whether the activity will be continued. In addition, the TRA requires companies to continue to file separately with the SEC a notice that the disclosure of that activity has been included in the company’s annual report on Form 20-F.
SEC Updates
Updated Compliance and Disclosure Interpretations
The Division of Corporation Finance last updated its Compliance and Disclosure Interpretations in November 2016. The Compliance and Disclosure Interpretations are available here.
Updated Financial Reporting Manual
The Division of Corporation Finance last updated its Financial Reporting Manual in November 2016. The Financial Reporting Manual is available here.
The Annual Survey Working Group reports annually on the decisions we believe are the most significant to private equity and venture capital practitioners.1The decisions selected for this year’s Annual Survey are the following:
1.Prairie Capital III, L.P. v. Double E Holding Corp.(liability of fund sponsors for portfolio company fraud)
2.In re Molycorp, Inc. Shareholders Litigation(fiduciary duties in the context of the exercise of demand registration rights)
3.Halpin v. Riverstone National, Inc.(drag-along rights and waivers of appraisal rights)
4.TCV VI, L.P. v. TradingScreen, Inc.(funds available for redemption of preferred stock)
5.SIGA Technologies, Inc. v. PharmAthene, Inc.(expectation damages as a remedy for breach of an express contractual obligation to negotiate a definitive agreement in good faith)
6.Fox v. CDX Holdings, Inc.(treatment of stock options in a merger)
In this case,2the Delaware Court of Chancery dismissed several of a purchaser’s fraud-related counterclaims against a portfolio company seller based on the exclusive representations and integration clauses contained in the parties’ stock purchase agreement. In refusing to look beyond the “four corners” of the stock purchase agreement, the court found that the purchaser clearly disclaimed reliance on the seller’s extra-contractual misrepresentations.3However, the court rejected the seller’s motion to dismiss other fraud-based claims arising from representations made expressly within the stock purchase agreement.4The court also held that the purchaser’s fraud claims against certain of the officers and directors of the portfolio company and its private equity sponsors survived the purchaser’s motion to dismiss under aiding and abetting and conspiracy theories of liability.5According to the court, the purchaser’s allegations created an inference that such defendants either provided substantial assistance to, or acted in concert with, those making the stock purchase agreement’s fraudulent misrepresentations.6This decision has far-reaching implications: not only does it expose the fund sponsors of portfolio companies to potential liability for fraud claims in connection with a sale of the portfolio company based on the portfolio company’s contractual representations and warranties, but it also expands the ability of these firms to shield themselves against extra-contractual fraud claims.
BACKGROUND
Before its acquisition by Incline Equity Partners (“Incline”), Double E Parent LLC (“Double E”) was a Delaware limited liability company controlled by Prairie Capital III, L.P. and Prairie Capital III QP, L.P. (the “Prairie Funds”) and their affiliates.7The Prairie Funds were private equity funds sponsored by Prairie Capital Partners (“Prairie Capital”) and managed by Daniels & King Capital III, LLC (“Daniels & King”).8In the summer of 2011, Prairie Capital and Double E retained Livingstone Partners LLC (“Livingstone”) as their joint financial advisor in connection with a sale of Double E.9The sale process was managed by a group that included Mark B. Fortin, the chief executive officer of Double E; Jeffrey Vancura, the chief financial officer of Double E; and Christopher Killackey and Sean McNally, partners at Prairie Capital and directors of Double E.10
Throughout the initial due-diligence process, Livingstone and Double E touted Double E’s “growth story” as a focal point in attempting to appeal to potential acquirers, including Incline.11Specifically, Livingstone and Double E focused on Double E’s revenue growth in 2010 and 2011 and projected growth for 2012 and beyond.12Killackey and McNally worked in the background to control the due diligence information Double E provided to Incline.13In February 2012, Livingstone provided Incline with Double E’s financial statements, which included Double E’s actual financial results for 2011 and its interim financial results for January and February 2012.14Incline made an offer of $26.5 million contingent on Double E meeting its monthly sales goals of $3.2 million through closing at the end of March 2012.15Incline expressed doubt about the ability of Double E to satisfy this target by the middle of March because of a backlog report of Double E’s daily and cumulative sales figures for the month; however, Fortin, Vancura, and Livingstone represented to Incline that Double E had sufficient orders to meet the target.16Double E’s financial statements were falsified by Fortin and Vancura to conceal an actual shortfall.17
The parties executed a stock purchase agreement (the “SPA”) and closed the transaction on April 4, 2012.18Incline paid $27 million for Double E less $500,000, which was withheld in an escrow fund to satisfy the indemnification obligations of the parties.19Any amount remaining in this fund on June 30, 2013, was to be distributed to the Prairie Funds.20On June 28, 2013, Incline submitted a notice of various claims to the sellers’ representative, including fraud, against Double E, Double E’s management and the Prairie Funds.21Several months later, the sellers’ representative filed suit against Incline, and Incline asserted counterclaims against the Prairie Funds, Daniels & King, Fortin, and Vancura.22The counterclaims included claims of fraud against the Prairie Funds, Daniels & King, Fortin, and Vancura based on (1) extra-contractual statements, (2) extra-contractual omissions, and (3) representations made within the purchase agreement.23
ANALYSIS
Extra-Contractual Representations.The court found that a claim based on fraudulent representations that the sellers allegedly made during the sales process was foreclosed by an exclusive representations clause contained in Section 11.10 of the SPA and by an integration clause contained in Section 11.7 of the SPA.24Specifically, the exclusive representations clause defined the universe of information on which Incline could rely. Incline acknowledged that it had “conducted to its satisfaction an independent investigation of the financial condition, operations, assets, liabilities, and properties of the Double E Companies” and represented that “the representations and warranties of the Double E Parties expressly and specifically set forth in this Agreement, including the Schedules,” constituted “THE SOLE AND EXCLUSIVE REPRESENTATIONS AND WARRANTIES OF THE DOUBLE E PARTIES TO THE BUYER.”25Incline argued that it did not affirmatively disclaim reliance in the exclusive representations and reliance clauses.26The court disagreed and stated that anti-reliance language need not include any specific language such as “disclaim reliance” or other “magic words” so long as the buyer made the disclaimer affirmatively.27
Extra-Contractual Omissions.As an alternative means of avoiding the “non-reliance” provisions of the SPA, Incline argued that even if the SPA barred fraud claims based on extra-contractual representations, the non-reliance provisions did not apply to claims of fraudulent omission and concealment.28The court refused to distinguish between claims for misrepresentations and omissions for purposes of the “non-reliance” provisions of the SPA.29According to the court, any misrepresentation may be reframed for pleading purposes as an omission.30Accordingly, the exclusive representations and integration clauses precluded any fraud claim based on an extra-contractual omission.31
Accountable Defendants.The Prairie Funds, its managers, Fortin, and Vancura argued that they could not be held accountable for any misrepresentation contained in the SPA because the representations were made only by Double E.32The court disagreed, finding that Fortin and Vancura could be liable for the SPA’s misrepresentations because Incline alleged that they knew that the SPA’s representations were false and they were the agents through which Double E made its representations to Incline.33Relying on section 533 of theRestatement (Second) of Tortsand Delaware jurisprudence, the court noted, “‘[a] corporate officer or agent who commits fraud is personally liable to a person injured by the fraud. . . . Therefore, [a]n officer actively participating in the fraud cannot escape personal liability on the ground that the officer was acting for the corporation.’”34Additionally, the court found that Incline’s claims against the Prairie Funds and its managers survived a motion to dismiss because Incline alleged that the Prairie Capital directors (Killackey and McNally) had knowledge of the false nature of the representations made to Incline and actively assisted or approved the entire fraud, including the providing of false sales results to Incline.35
Secondary Liability.Furthermore, the court held that Incline sufficiently pled aiding-and-abetting fraud by the Prairie Funds and conspiracy to commit fraud by the Prairie Funds, Fortin, and Vancura.36Under the aiding-and-abetting theory, the alleged affirmative involvement of Killackey and McNally in the sales process was found to constitute the “substantial assistance” required to adequately plead this theory.37Additionally, the alleged communications among Killackey, McNally, Fortin, Vancura, and Livingstone suggested that they worked together to disclose to Incline only information that would convey continued Double E growth.38These allegations were likewise held to constitute a sufficient pleading under a conspiracy theory, which requires that the defendants act in concert for purposes of the fraudulent representations.39
CONCLUSION
ThePrairie Capitaldecision highlights for sellers the importance of having well-written disclaimer provisions within an agreement to reduce liability for fraudulent extra-contractual behavior. While the court reminds the reader that no rigid framework or exact language is required to disclaim reliance on extra-contractual statements,40the draftsman must be careful and clear to ensure the intended result. The recent decision inFdG Logistics LLC v. A&R Logistics Holdingsreemphasized this point.41In that case, the Delaware Court of Chancery held that a non-reliance provision contained in a merger agreement was ineffective to bar a buyer’s fraud claims based on extra-contractual statements made during the due-diligence and negotiation process because the non-reliance provision was formulated solely as a limitation on the seller’s representations and warranties.42According to the court, for a non-reliance provision to be effective against a buyer, it must be formulated as an affirmative promise by the buyer that it did not rely on any extracontractual statements that the seller made during the sales process.43
Even with the seemingly broadened ability to disclaim reliance on extracontractual statements, thePrairie Capital III, L.P. v. Double E Holding Corp.decision confirms that officers and directors of a portfolio company and its sponsor’s funds may be found liable for fraudulent misrepresentations made to a buyer in the course of a sale of a portfolio company, even if the sponsor did not directly communicate with or make any representations to the buyer. The extent of the sponsor’s involvement “behind the scenes” of the transaction and the level of knowledge held by the sponsor in relation to the fraudulent representations being made will determine the potential liability for the accompanying funds more than will the language of the agreement itself.
2. IN RE MOLYCORP, INC. SHAREHOLDERS LITIGATION (FIDUCIARY DUTIES IN THE CONTEXT OF THE EXERCISE OF DEMAND REGISTRATION RIGHTS)
SUMMARY
In this case,44the Delaware Court of Chancery granted the defendants’ motion to dismiss a derivative complaint in connection with a secondary stock offering of Molycorp Inc. (“Molycorp”) demanded by certain private equity investors that collectively owned 44.1 percent of Molycorp’s stock (the “Private Equity Investors”). The complaint alleged breaches of fiduciary duties by the Private Equity Investors and by the eight directors of Molycorp who facilitated the offering (the “Defendant Directors”), four of whom sold in the offering, while three others held significant positions within at least one of the Private Equity Investors.45The court assumed, without deciding, that the Private Equity Investors constituted a control group, that a majority of the Defendant Directors had disqualifying interests by reason of personal gains or relationships with the Private Equity Investors, and that demand would be excused, but the court dismissed the complaint for failure to state a claim in light of the Private Equity Investors’ clear contractual rights to take the challenged conduct.46
BACKGROUND
Molycorp is a publicly traded Delaware corporation engaged in the production and sale of rare earth oxides.47In April 2010, before Molycorp’s initial public offering (“IPO”), Molycorp’s Private Equity Investors had executed a registration rights agreement, giving them the right to have Molycorp register their shares for a secondary offering following the IPO subject to certain limitations, including Molycorp’s right to delay the offering for up to ninety days in certain circumstances.48The July 2010 IPO yielded a disappointing $360 million (short of the $478 million Molycorp had wanted to raise).49However, in September 2010, rare earth element prices spiked following China’s limits on exports and Molycorp’s stock rose, but Molycorp struggled to raise additional capital.50In May 2011, the Private Equity Investors invoked their right to a demand registration and Molycorp complied.51In the secondary offering that followed, the Private Equity Investors received approximately $575 million.52By September 2011, prices for rare earth elements fell significantly, as did Molycorp’s stock price, and the difference between cash on hand and its capital and operating budget stood at $388 million.53Molycorp proceeded to raise a further $390 million in a private offering of stock in February 2012, but the company would have raised $248 million more at the secondary offering price per share of $51.54The plaintiffs thereafter commenced a derivative action alleging, among other claims, that the Private Equity Investors and the Defendant Directors had breached their fiduciary duties by favoring their own interests over Molycorp’s, thereby closing Molycorp out of the equity markets.55In particular, the plaintiffs argued that the board of directors should either have delayed the secondary offering to allow Molycorp to hold its own offering first or at least allocated a substantial portion of the secondary offering to Molycorp.56
ANALYSIS
While the court noted that the registration rights agreement did not permit any fiduciary to breach its fiduciary duties, it found it unnecessary to determine whether a more exacting standard of review applied because its decision turned on the failure to state a claim.57The court held that, even when a form of heightened scrutiny (such as entire fairness) applies, a plaintiff cannot prevail by advancing unreasonable inferences, based on speculation or hindsight, or by making conclusory statements.58The court refused to find a breach of fiduciary duty merely because the Private Equity Investors and certain Defendant Directors failed to predict stock price movements accurately, particularly where there were no allegations that the defendants knew that the market for rare earth elements would rise and fall as dramatically as it did or that they knew the date when such price drop would occur (and prices did not, in fact, fall until a few months after the offering).59The court stated, “it is simply not wrong to sell stock knowing that ‘a pin lies in wait for every bubble,’ before a company with other opportunities decides to sell its stock.”60
In granting the defendants’ motion to dismiss, the court found it critical that the plaintiffs did not allege that the registration rights agreement was invalid or unfair. The court held that, “contending that the Private Equity Investors exercised rights that benefitted themselves, but were fairly extracted and disclosed in public filings, does not itself state a claim that the Private Equity Investors took advantage of Molycorp and its minority stockholders.”61The court commented that “a finding otherwise could discourage would-be investors from funding start-ups for fear that their investment value will not be preserved despite disclosed, carefully negotiated agreements.”62
Regarding the Defendant Directors, the court held that appointment by a powerful stockholder does not automatically render a director’s decisions suspect, nor is it wrong for a director to buy or sell company shares absent evidence of unfair dealing.63The court observed, “if such conduct was actionable, directors of every Delaware corporation would be faced with the ever-present specter of suit for breach of their duty of loyalty if they sold stock in the company on whose board they sit.”64Nevertheless, although the court did consider the plaintiff’s argument that the board of directors should have delayed the offering because of the detriment to Molycorp, it found that, despite Molycorp’s budget issues (which were not unusual for a developing company), the factual allegations did not support a finding that, during the period from May 2011 (when the demand was first made) until September 2011 (when rare earth element prices fell), Molycorp had an urgent cash need or absence of financing alternatives that would have justified delaying the registration or otherwise interfering with the contractual rights of the Private Equity Investors.65
CONCLUSION
The decision in this case recognizes the important place that registration rights occupy within the business model of private equity and venture capital firms, which typically bargain for such rights at the outset to effect an exit through a public offering, whether in connection with or following an IPO. The decision demonstrates that, in the absence of factual allegations that a controller took advantage of the minority stockholders, a court will not find the exercise of those rights or the board’s facilitation of demand offerings to be a breach of fiduciary duty. At the same time, the court recognized that the outcome may have been different if the plaintiffs had challenged the validity or fairness of the terms of the registration rights agreement or alleged facts supporting an inference that the board of directors had reason to exercise its rights to delay the offering. Accordingly, care should be taken to ensure that the terms of registration rights agreements are negotiated at arm’s length and include customary safeguards, including delay rights. Although such delay rights are typically invoked to avoid the premature disclosure of material transactions (such as mergers and acquisitions), they provide the board of directors with important flexibility to consider the impact that changed circumstances may have on previously negotiated contractual rights (akin to a fiduciary out in a public merger agreement). In the exercise of their fiduciary duties, directors (particularly those appointed by one or more demanding stockholders) should be mindful of current market conditions and the company’s cash needs when facilitating a demand registration and deciding whether such circumstances would require the exercise of delay rights.
3. HALPIN V. RIVERSTONE NATIONAL, INC. (DRAG-ALONG RIGHTS AND WAIVERS OF APPRAISAL RIGHTS)
SUMMARY
In this case,66a statutory appraisal action, the Delaware Court of Chancery declined an issuer’s request to order minority common stockholders to consent to a merger agreement, with a resulting loss of appraisal rights, notwithstanding the stockholders’ prior agreement to vote in favor of a change in control of the issuer pursuant to a drag-along provision contained in a stockholders’ agreement. The court reasoned that the issuer waited until after the merger had closed to seek the stockholders’ consent to the merger agreement in contravention of the drag-along provision that required the stockholders to prospectively consent to a merger after advance notice of the merger had been given.67Thus, the issuer failed to comply with the terms of the drag-along provision and was limited to the benefit of its bargain, which, according to the express language of the dragalong provision, did not include the right to require the common stockholders to consent to a transaction that had already taken place.68
The court also queried in dictum whether common stockholders can,ex anteand by contract, waive the right to seek a statutory appraisal of their shares, but ultimately did not address the question.69The court noted that preferred stockholders may waive appraisal rightsex anteby contract because the rights of holders of preferred stock are largely contractual in nature, but that the same rationale did not necessarily apply to common stockholders.70
BACKGROUND
This action arose from the acquisition of Riverstone National, Inc. (“Riverstone”) by the private equity firm, Greystar Real Estate Partners, LLC (“Greystar”).71The merger agreement was adopted in an action by written consent of Riverstone’s 91 percent stockholder, CAS Capital Limited (“CAS”), and became effective on June 2, 2014.72Pursuant to the terms of the merger agreement, Riverstone’s minority common stockholders were cashed out for $4.44 per share plus a contingent right to receive potential earn-out payments.73
On June 9, 2014, subsequent to the effectiveness of the merger, Riverstone first informed the stockholder plaintiffs about the merger with Greystar.74Specifically, Riverstone sent a letter to its stockholders informing them that CAS had provided the necessary stockholder approval, in an action by written consent pursuant to section 228 of the General Corporation Law of the State of Delaware (the “DGCL”), to adopt the merger agreement (the “Information Statement”).75The Information Statement also informed the minority stockholders of (1) the effectiveness of the merger, (2) their right to receive a portion of the merger consideration, and (3) the availability of appraisal rights in connection with the merger.76However, the Information Statement also stated that the merger consideration would be available only to stockholders who executed a form of written consent attached to the Information Statement (the “Written Consent”), with a resulting loss of appraisal rights.77The Information Statement explained that a 2009 stockholders agreement (the “Stockholders Agreement”) required Riverstone’s common stockholders to execute the Written Consent.78The Information Statement warned: “Riverstone further has determined that if you fail to execute and return the Written Consent you will be in breach of the provisions of the Stockholders Agreement referred to above, in which event Riverstone reserves all of its rights at law or in equity.”79
Section 3 of the Stockholders Agreement (the “Drag-Along Provision”) stated, in relevant part:
[I]f at any time the Company and/or any Transferring Stockholders propose to enter into any such Change-in-Control Transaction, the Company may require the Minority Stockholders to vote in favor of such transaction, where approval of the shareholders is required by law or otherwise sought, by giving the Minority Stockholders notice thereof within the time prescribed by law and the Company’s Certificate of Incorporation and By-Laws for giving notice of a meeting of shareholders called for the purpose of approving such transaction. If the Company requires such vote, the Minority Stockholder agrees that he or she will, if requested, deliver his or her proxy to the person designated by the Company to vote his or her Shares in favor of such Change-in-Control Transaction.80
Notwithstanding Riverstone’s attempt to invoke the Drag-Along Provision, the petitioners declined to sign the Written Consent.81On the contrary, the petitioners initiated a statutory appraisal action, seeking an appraisal of the fair value of their shares by the Delaware Court of Chancery pursuant to section 262 of the DGCL.82Riverstone counterclaimed, seeking specific performance of the DragAlong Provision.83The ruling discussed below was on the parties’ cross-motions for summary judgment on a stipulated record.84
ANALYSIS
Riverstone sought specific performance of the petitioners’ alleged obligation under the Drag-Along Provision to execute the Written Consent and accept the merger consideration, with a resulting loss of appraisal rights.85The petitioners advanced several arguments as to why the Drag-Along Provision failed to prescribe the performance sought by Riverstone.86First, the petitioners argued that a common stockholder cannot waive its statutory right to appraisalex ante— here, in a stockholders’ agreement in return for consideration that is to be set later by a controlling stockholder.87The court ultimately determined that it was not required to decide whether common stockholders could waive their statutory rights to appraisal, but not before suggesting in dicta that, unlike the issue of whether preferred stockholders may waive appraisal rights, the issue of whether common stockholders may waive appraisal rights remains an open question:
The rights of holders of preferred stock are largely contractual, and this Court has found that such stockholders may waive appraisal rights ex ante by contract. . . . The question of whether common stockholders can, ex ante and by contract, waive the right to seek statutory appraisal in the case of a squeeze-out merger of the corporation is [] more nuanced than is the case with preferred stockholders. That question has not yet been answered by a court of this jurisdiction.88
However, the court agreed with the second argument advanced by the petitioners that the defendants were not entitled to specific performance of the Drag-Along Provision after the vote on the merger had already occurred.89According to the court, the Drag-Along Provision created a prospective scheme that required Riverstone’s common stockholders to adopt a merger agreement after receiving advance notice of a proposed merger in accordance with applicable law and Riverstone’s organizational documents, rather than to consent to a merger after it became effective.90The Drag-Along Provision also did not contain an express agreement by the petitioners to waive their appraisal rights under any circumstances.91Here, Riverstone bargained for a right that it failed to exercise and could not compel the petitioners to comply with the bargain Riverstone now wished that it had struck with the petitioners.92Relatedly, the court rejected Riverstone’s attempt to use the implied covenant of good faith and fair dealing to compel its desired outcome.93According to the court, the “Supreme Court has made clear that the gap-filling function of the implied covenant does not provide relief in a situation such as this, where the Company asks the Court to imply a right for which it did not contract and should have foreseen.”94
CONCLUSION
Preferred stock financings almost invariably involve significant stockholders negotiating for a right of the majority to force the minority to join in a sale of a company. Investors view such provisions as an important protection, particularly if they seek to exit their investment and sell the company for a price that does not allow all preferred stockholders to recover their liquidation preference or provide for any value to common stockholders. While the court does not question the enforceability of such provisions, except to the extent that the provisions force a loss of appraisal rights of common stockholders, the court’s decision makes clear that an issuer or other party seeking to invoke a drag-along right must have complied with the literal terms of the drag-along right to invoke the provision.
The court’s decision casts doubt on the enforceability of waivers of appraisal rights when given by common stockholders, while confirming the enforceability of such waivers when given by preferred stockholders. Notwithstanding the court’s dictum, waivers of appraisal rights by common stockholders when fully informed may be given effect. The Delaware courts have upheld contractual waivers of other statutory rights by holders of both common and preferred stock, including waivers of some of the most significant statutory rights of all stockholders, such as the right to vote in favor of the removal of directors without cause absent a staggered board structure or cumulative voting.95The stockholders’ agreement at issue inHalpindid not expressly require the stockholders to waive their appraisal rights in connection with a merger but rather to vote in favor of a prospective merger. Thus, the court was not faced with a scenario in which the stockholders had consented to an express waiver of appraisal rights.
4. TCV VI, L.P. V. TRADINGSCREEN, INC. (FUNDS AVAILABLE FOR REDEMPTION OF PREFERRED STOCK)
INTRODUCTION
In this case,96the Delaware Court of Chancery held that factual issues surrounding a corporation’s solvency at the time holders of the company’s preferred stock demanded redemption of their shares precluded the court from granting the plaintiffs’ motion for judgment on the pleadings. In so ruling, the court rejected the preferred stockholders’ argument that section 160 of the DGCL (“section 160”), requiring that redemption be made generally out of surplus, was the sole determinant of whether a corporation was legally permitted to redeem shares of its capital stock.97Rather, as discussed below, the court recognized that the long-standing, common-law principle prohibiting a corporation from purchasing its own shares when doing so would impair its obligations to the corporation’s creditors could also prevent the redemption of preferred stock.98Therefore, the court resolved the tension between a mandatory redemption provision in the company’s certificate of incorporation and Delaware’s statutory and common law restrictions on a corporation’s ability to redeem stock in the corporation’s favor.99
BACKGROUND
The plaintiffs owned more than a majority of the Series D Convertible Preferred Stock (the “Series D Preferred Stock”) of TradingScreen, Inc. (“TradingScreen”).100Section 7 of TradingScreen’s certificate of incorporation governed the plaintiffs’ redemption rights. Specifically, Section 7.1 granted holders of a majority of the Series D Preferred Stock the right, “beginning three months prior to the fifth anniversary of the issuance of the Preferred Stock,” to demand that the company assist them in the sale of their Series D Preferred Stock “on satisfactory terms and conditions.”101If after nine months such assistance failed to result in a third-party purchase of the stock, the holders of the Series D Preferred Stock could demand that TradingScreen redeem their shares.102If TradingScreen failed to redeem the Series D Preferred Stock, the holders were entitled to interest.103
In June 2012, the plaintiffs asked for TradingScreen’s assistance in the sale of all of their preferred stock pursuant to Section 7.1 of TradingScreen’s certificate of incorporation.104TradingScreen’s board of directors formed a special committee to address the request.105When efforts to find a purchaser for the plaintiffs’ Series D Preferred Stock were unsuccessful, the plaintiffs gave written notice to the company of its demand that the company purchase its Series D Preferred Stock.106
In response to the plaintiffs’ redemption demand, TradingScreen disclosed to the plaintiffs that its special committee had engaged a financial advisor to assist the special committee in its determination of the extent to which the company could effect a redemption of the Series D preferred stock without impairing the company’s ability to continue as a going concern.107The financial advisor provided the special committee with a fifty-two-page report finding that the company could legally redeem only a portion of the shares that were the subject of the plaintiffs’ redemption demand.108Based on this advice, the special committee determined to make a partial redemption of the Series D Preferred Stock based on the amount it had determined that the company had available for that purpose.109
The plaintiffs objected and filed its suit against TradingScreen.110
ANALYSIS
The plaintiffs’ suit alleged that TradingScreen breached the redemption terms of its certificate of incorporation by not honoring plaintiffs’ redemption demand in full.111The plaintiffs also contended that the only limitation on the company’s redemption obligation was the statutory prohibition that corporations may not purchase shares of their own capital stock unless they have a statutory surplus (which the plaintiffs contended the company possessed).112Finally, plaintiffs also claimed that even if TradingScreen were not obligated to make a full redemption, the interest provisions applied to the unpaid portions.113
TradingScreen countered by arguing that, in addition to the statutory prohibitions on redemptions found in section 160, the common law prohibits a corporation from redeeming its shares “if doing so would threaten its ability to continue operating as a going concern.”114The company argued that the special committee’s business judgment as to the level of funds TradingScreen had available for redeeming the Series D Preferred Stock was entitled to deference.115TradingScreen further argued that because Delaware law prohibited the redemption of the unredeemed shares, no interest could be due to the plaintiffs for its failure to effect a full redemption.116
The court rejected the plaintiffs’ primary argument that section 160 was the sole determinant of whether and how a corporation may redeem its capital stock.117In doing so, the court held that:
While Section 160 prohibits corporations that are balance-sheet insolvent from making redemptions, a corporation can satisfy Section 160’s test despite being cash-flow insolvent (or at risk of becoming cash-flow insolvent), i.e. unable to pay its debts as they come due. In such a case, law extraneous to Section 160 limits the scope of permissible redemptions.118
Given the court’s finding that the common law prohibits a corporation from making redemptions if the corporation would be rendered cash-flow insolvent, the primary question before the court was whether the special committee had validly determined that TradingScreen did not have sufficient financial resources to continue as a going concern if it honored the plaintiffs’ redemption demand.119The court found, however, that such an inquiry was fact-laden and not amenable to resolution on a motion for judgment on the pleadings.120According to the court,
Decisions regarding a corporation’s ability to continue as a going concern are necessarily made by a board as part of a “judgment-laden exercise.” To succeed in challenging such a decision, a plaintiff “must prove that in determining the amount of funds legally available, the board acted in bad faith, relied on methods and data that were unreliable, or made a determination so far off the mark as to constitute actual or constructive fraud.121
The court also held that it was premature at this stage in the proceedings to determine whether TradingScreen was in default of its redemption obligations such that the interest provisions of the redemption provision applied.122
CONCLUSION
This case highlights the dual role that preferred stock often plays as it straddles the fence separating equity from debt. Given that hybrid role, this opinion (as well as the related opinion of the Delaware Supreme Court) makes clear that while a Delaware court will look to the contractual nature of the relationship between a corporation and the holders of its preferred stock to determine the rights of preferred stockholders, that relationship will also be subject to a statutory and common law overlay. This opinion also makes clear that a board of directors will be given fairly wide deference in deciding whether the corporation has sufficient funds to make what might otherwise be an obligatory redemption. While it is difficult to determine the precise terms that might be added to certificates of designation to validly cabin a board’s discretion in making this determination, at least as highlighted in this opinion, a differently drafted redemption provision might have provided some protection for holders of preferred stock where the corporation cannot make a complete redemption. For example, the preferred stock terms might have required the corporation to seek financing or sell assets to fund the redemption. The validity of such a provision is an open question.
5. SIGA TECHNOLOGIES, INC. V. PHARMATHENE, INC. (EXPECTATION DAMAGES AS A REMEDY FOR BREACH OF AN EXPRESS CONTRACTUAL OBLIGATION TO NEGOTIATE A DEFINITIVE AGREEMENT IN GOOD FAITH)
INTRODUCTION
In this case,123the Delaware Supreme Court held that the Delaware Court of Chancery (1) could revisit a prior decision holding that expectation damages were too speculative to award for breach of an express contractual obligation to negotiate a definitive licensing agreement in good faith and (2) correctly found that lump-sum expectation damages were not too speculative to award for breach of the term sheet.124
This case was the second appeal in a long-standing dispute that arose from a failed collaboration between the two pharmaceutical companies.125InSIGA 2, the Delaware Supreme Court clarified that during the first appeal the court resolved open points on Delaware law with respect to expectation damages in the context of agreements such as term sheets that are not final definitive agreements like a merger agreement.126The court inSIGA 2also focused on expert testimony that proved that lump-sum expectation damages were not “speculative, uncertain, contingent or conjectural.”127
BACKGROUND
In 2004, when SIGA Technologies, Inc. (“SIGA”) acquired technology for ST246, a smallpox drug, ST-246’s viability and uses were unknown.128In 2005, SIGA faced a financing shortfall, lacked the experience and employees to bring a drug to market, and faced the threat of NASDAQ delisting its stock.129
In light of those business issues, PharmAthene, Inc. (“PharmAthene”) and SIGA negotiated and entered into a non-binding term sheet for a license agreement (the “LATS”).130Pursuant to the LATS, PharmAthene would get a worldwide, exclusive license to use, develop, sell, and sublicense ST-246 in exchange for $6 million spread out over three payments (one immediate cash payment and two milestone payments) and potential royalty payments.131
The parties also successfully negotiated and agreed to (1) $3 million in bridge financing on March 20, 2006, so that SIGA could continue developing ST-246 (the “Bridge Loan Agreement”) and (2) a merger agreement on June 8, 2006 (the “Merger Agreement”) that required the parties to close the merger by September 30.132Both agreements obligated the parties to negotiate in good faith a definitive license agreement based on the LATS.133
Through the summer and fall of 2006, after agreeing to the merger agreement, SIGA (1) was awarded $5.4 million from the National Institute of Allergy and Infectious Disease, (2) announced that it had completed the first human clinical trial, (3) made well-received presentations to the Department of Defense and the Department of Homeland Security, and (4) was awarded $16.5 million from the National Institutes of Health to fund ST-246 development.134
SIGA internal e-mails made clear that SIGA regretted the planned merger because, at that point, it was clear that SIGA could successfully complete development of and eventually sell ST-246.135SIGA’s board of directors considered its options and terminated the merger.136PharmAthene, unsurprisingly, sued SIGA in the Delaware Court of Chancery.137
In 2011, the Delaware Court of Chancery held that (1) SIGA breached its contractual obligation under the Bridge Loan Agreement and Merger Agreement to negotiate in good faith a definitive license agreement as required by the LATS, (2) the parties would have agreed to a license agreement but for SIGA’s badfaith breach, (3) SIGA was liable under promissory estoppel, and (4) equitable payments were the proper remedy.138However, the chancery court found that lump-sum expectation damages were unavailable because they were too speculative, uncertain, contingent, and conjectural.139
On appeal inSIGA 1,140the Delaware Supreme Court held that Delaware law permitted a plaintiff to recover expectation damages where (i) there was a Type II preliminary agreement to negotiate in good faith and (ii) the trial record proved that the parties would have reached an agreement but for the breaching party’s bad-faith negotiations.141
The Delaware Supreme Court also affirmed the court of chancery’s finding that SIGA, in bad faith, breached its contractual obligation to negotiate a license agreement consistent with the LATS.142Moreover, the Delaware Supreme Court directed the chancery court to revisit and redetermine the damages award and, in doing so, could reevaluate expert testimony.143
As the Delaware Supreme Court noted inSIGA 2, the Delaware Court of Chancery, on remand,144did as instructed and reevaluated the evidence, leading to a $113 million award in lump-sum expectation damages to PharmAthene.145As the Delaware Supreme Court later explained in the opinion, $113 million was less than 11 percent of the $1.07 billion figure in the expert’s damages model.146According to the chancery court, there was a reasonable certainty that PharmAthene would have earned profits from selling ST-246 but for bad-faith negotiations, and such damages were calculable.147
ANALYSIS
The parties again appealed, and inSIGA 2, SIGA argued that case law prevented the chancery court from reconsidering its prior holding that lump-sum expectation damages were too speculative, and, that even if it could revisit its holding, lump-sum expectation damages were too speculative or not reasonably certain.148
With respect to SIGA’s assertion that case law prevented the chancery court from revisiting its prior holding, the Delaware Supreme Court held that the chancery court was indeed able to revisit its prior decision—the court instructed it to do just that (and reevaluate the expert’s testimony).149According to the Delaware Supreme Court, the chancery court’s factual findings supported its new damages determination.150
As for damages, the chancery court did as instructed: it reconsidered the damages award and reevaluated the expert testimony.151In doing so, it applied the right legal remedy of expectation damages to cure the contract breach.152Expectation damages are based on reasonable expectations of the parties.153The damages are measured by using the amount of money the promisee in the same position would have received if the promisor had performed.154In other words, the remedy compensates a promisee for the value that the promisee reasonably expected had the contract been fulfilled.
The Delaware Supreme Court succinctly stated that “the Court of Chancery reasonably took into account that it was SIGA’s increasingly bullish view of ST-246’s prospects based on what was known in December 2006 that caused it to commit a breach to secure more of the drug’s future value for itself than it would have had from a deal consistent with the terms of the LATS.”155Expectation damages must be “establish[ed] . . . with sufficient certainty [and cannot] be uncertain, contingent, conjectural or speculative.”156Contrary to SIGA’s assertion, a court must incorporate presumptions when determining expectation damages.157There are two aspects of expectation damages awards: (1) the “fact” of damages (i.e., there would have been some profits), which must be “reasonably certain”; and (2) the actual amount of damages, which can be less certain but must be based on legitimate calculations.158
Here, PharmAthene was positioned to profit, and the core financial terms were never in dispute even if one party sought to renegotiate the terms.159SIGA’s internal e-mails questioned the need for collaboration, and SIGA made positive public announcements that, combined with other events, made clear that at the time of the breach the parties “had a reasonable expectation that ST-246 would be commercialized in the near future.”160SIGA also stated that postbreach evidence was improperly used because the post-breach evidence was used to resolve “fatal” issues with the speculative nature of the damages.161The Delaware Supreme Court disagreed, holding that the chancery court relied on post-breach evidence only to help determine damages, not to determine if damages were speculative.162For example, although SIGA did not get the government contract until after the 2011 court trial, there was a reasonable inference that parties knew the contract was imminent at the time of breach.163
As for whether the damages were speculative, the Delaware Supreme Court highlighted certain facts to show that damages were not speculative and that the expert conducted a proper and reasonable analysis.164For example, in July 2006 SIGA announced that ST-246 was “its lead smallpox drug candidate and it had successfully completed the first planned human clinical safety trial,” SIGA had met scientific milestones and sought bridge financing because of its confidence in the drug, and additional government funding in September 2006 to complete development challenged any assertion that damages were too speculative.165In short, “SIGA believed it was on the cusp of bringing ST-246 to market.”166
CONCLUSION
SIGA 2(the 2015 decision) demonstrates that care should be taken in drafting term sheets or other preliminary documents and that obligations to negotiate in good faith should be taken seriously. In particular, if parties to a preliminary agreement agree to negotiate the final agreement in good faith but intend the material terms agreed to to be merely preliminary in nature, language disclaiming the finality or binding nature of terms should be included. Seller’s remorse, particularly that which is spelled out in internal e-mails, is not helpful. Post-breach evidence can serve to fortify an argument that certain damages are not speculative.
6. FOX V. CDX HOLDINGS, INC. (TREATMENT OF STOCK OPTIONS IN A MERGER)
SUMMARY
In a recent case challenging the acquisition of a venture-backed company,167the Delaware Court of Chancery confirmed that Delaware’s merger statutes do not effect a statutory conversion of options at the effective time of a merger. Rather, the treatment of stock options in a merger is governed by the underlying stock option plan, which must be amended in connection with a merger if the merger’s treatment of options differs from the treatment the plan contemplates.168In this instance, the parties to the merger agreement sought to provide the option holders with an amount of consideration that was defined by reference to the consideration received by the holders of common stock less an escrow holdback, even though the plan required the holders of options to receive the full fair market value of their options less the options’ exercise price.169
The court also confirmed that a standard qualification in stock option plans, requiring a corporation’s board of directors to determine the fair market value of an option for purposes of cashing out the option, could not be satisfied by informal board action, a delegation to management, or a third party.170
BACKGROUND
This class action arose from a 2011 spin-off/merger transaction pursuant to which Miraca Holdings, Inc. (“Miraca”) acquired CDX Holdings, Inc. (formerly known as Caris Life Sciences, Inc.) (“Caris”) for $725 million (the “Merger”).171David Halbert, the founder of Caris, owned 70.4 percent of Caris’s fully diluted equity, largely held in the form of preferred stock.172JH Whitney VI, L.P., a private equity fund (“Fund VI”), owned another 26.7 percent of Caris’s fully diluted equity, whose holdings also largely consisted of preferred stock.173Most of the remaining approximately 2.9 percent of Caris’s fully diluted equity took the form of stock options held by employees of Caris.174
Immediately before the Merger, Caris spun off two of its three subsidiaries (“SpinCo”) to its stockholders (the “Spin-Off”).175In the Merger, Miraca paid $725 million for what was left of Caris (“RemainCo”), with Halbert and Fund VI receiving total proceeds of approximately $560 million, including the liquidation preference of their preferred stock.176Each share of common stock was converted into the right to receive $4.46 in cash.177Each option was terminated with the right to receive the difference between $5.07 per share and the exercise price of the option, minus 8 percent of the total option proceeds, which were held back to fund an escrow account from which Miraca could satisfy indemnification claims brought post-closing.178Of the $5.07, $4.46 was for RemainCo; the remaining $0.61 was for SpinCo.179
Under the terms of Caris’s 2007 Stock Incentive Plan (the “Plan”), in the event of a merger, each option holder was entitled to receive the amount by which the fair market value of the subject shares, as determined by the Caris board, exceeded the exercise price.180Caris was supposed to adjust the options to account for the Spin-Off.181The board’s good-faith determinations of fair market value were to be conclusive unless found to be arbitrary and capricious.182
In this action, plaintiff, a holder of Caris options, alleged that Caris breached the Plan in allocating merger consideration to the option holders in three respects: (1) members of management, rather than the company’s board of directors, determined the fair market value of the options; (2) the valuation per share attributed to the spun-off subsidiaries was made in bad faith and resulted from an arbitrary and capricious process; and (3) a portion of the option consideration was placed in an escrow holdback.183In this post-trial decision, the court found in favor of the plaintiff on all three claims.184
ANALYSIS
With respect to the first alleged breach of the Plan, the court found that the Caris board abdicated its responsibility to determine the fair market value of the options.185According to the court, the determination was made by a single officer working in conjunction with Caris’s tax advisor, PricewaterhouseCoopers, with a single director then giving perfunctory approval. At no point did the Caris board (or a duly authorized committee of the board) properly review or determine the options’ fair market value as required by the Plan. Accordingly, the court found that Caris had breached the Plan.186
With respect to the second alleged breach of the Plan, the court found that Caris’s determination as to the fair market value of the options was either made in bad faith or was arbitrary and capricious because Caris determined the fair market value using a figure manufactured by Caris to result in zero tax liability for the Spin-Off, which did not actually reflect the fair market value of the options.187
With respect to the third alleged breach of the Plan, the court found that the terms of the Plan governed Caris’s treatment of options in a merger, not the merger agreement.188According to the court, section 251(b)(5) of the DGCL permits a merger agreement to convert shares of a corporation into the right to receive consideration that incorporates the outcome of an indemnification mechanism.189However, “[o]ptions are not shares, and option holders are not stockholders.”190Instead, options are contractual rights granted under section 157 of the DGCL, and “the rights and obligations of the parties to the option are governed by the terms of their contract.”191Under the Plan, the Caris board was permitted to terminate the options in connection with a merger if it paid the option holders the difference between the fair market value of the common stock underlying the option and the exercise price of the option.192The Plan did not provide for an escrow holdback. Caris was therefore obligated to pay the class the full amount of the difference between the fair market value and the exercise price of the options at issue.193
The court found that plaintiff’s options had a value of $6.57 per share and awarded the plaintiff class total damages in an amount equal to $16,260,332.77, plus interest.194
CONCLUSION
Acquisitions of venture-backed companies, which are structured as mergers, frequently involve creating an escrow holdback to satisfy the buyer’s post-closing indemnification claims. Payments to option holders are often subject to the escrow. This decision confirms that payments to holders of options may not be subject to an escrow or otherwise differ from the consideration payable to the holders of options under the underlying stock option plan unless the plan expressly so provides.
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* Lisa R. Stark, of K&L Gates LLP, chairs the Working Group and the Jurisprudence Subcommittee. Contributors of written summaries in this year’s survey, in addition to Ms. Stark, are Richard Renck from Duane Morris LLP, Michael Moeddel from Keating Muething & Klekamp PLL, Lisa Murison from Stradling Yocca Carlson & Rauth, and Scott F. Rissmiller from Hogan Lovells US LLP.
1. To be included in the survey, cases must meet the following criteria: (a) the decision must address either a preferred stock financing or a change in control of a company that had previously issued preferred stock; or (b) the court must (i) interpret preferred stock terms, (ii) interpret a statute pertaining to a preferred stock financing, or (iii) address a breach of fiduciary duty claim brought in the context of a transaction described in (a) above.
2. Prairie Capital III, L.P. v. Double E Holding Corp., 132 A.3d 35 (Del. Ch. 2015).
95. Klaassen v. Allegro Dev. Corp., C.A. No. 8626-VCL, 2013 WL 5739680, at *26 (Del. Ch. Oct. 11, 2013) (enforcing a provision contained in a stockholders’ agreement pursuant to the terms of which certain stockholders of a Delaware corporation agreed not to vote in favor of the removal of directors except for cause notwithstanding the requirement, contained in section 141(k) of the DGCL, that all directors, serving on non-staggered boards without cumulative voting, be removable with or without cause),aff’d, 106 A.3d 1035 (Del. 2014).
96. TCV VI, L.P. v. TradingScreen, Inc., C.A. No. 10164-VCN, 2015 Del. Ch. LEXIS 108 (Feb. 26, 2015).
121.Id. at *22 (internal quotations omitted). The Delaware Supreme Court rejected an interlocutory appeal of this decision.SeeTCV VI, L.P. v. TradingScreen, Inc., 115 A.3d 1216 (Del. 2015). In the opinion rejecting the appeal, the supreme court reaffirmed that “when a board decides on the amount of surplus available to make redemptions, its decision is entitled to deference absent a showing that the board: (1) acted in bad faith, (2) relied on unreliable methods and data, or (3) made determinations so far off the mark as to constitute actual or constructive fraud.”Id.at 1217.
122.See TCV VI, L.P., 2015 Del. Ch. LEXIS, at *22–26.
123. SIGA Techs., Inc. v. PharmAthene, Inc., 132 A.3d 1108 (Del. 2015) (“SIGA 2”).
137.Id.at 1117–18; PharmAthene, Inc. v. SIGA Techs., Inc., No. 2627-VCP, 2011 WL 4390726, at *1–2, *8–13 (Del. Ch. Sept. 22, 2011) (this matter was heard after the 2008 ruling on a motion to dismiss).
140. SIGA Techs., Inc. v. PharmAthene, Inc., 67 A.3d 330 (Del. 2013).
141. The court borrowed the concept of “Type I” and “Type II” agreements from federal court decisions interpreting New York law. In a Type I agreement, the “parties agree on all the points that require negotiation (including whether to be bound) but agree to memorialize their agreement in a more formal document.”Id.at 349 n.82 (citing Adjustrite Sys., Inc. v. GAB Bus. Servs., Inc., 145 F.3d 543, 548 (2d Cir. 1998)). In a Type II agreement, the “parties agree on certain major terms but leave other terms open for further negotiation.”Id.at 349 (citingAdjustrite Systems, 145 F.3d at 548). In contrast to the fully binding nature of Type I agreements, Type II agreements bind the parties “to negotiate the open issues in good faith” but do not commit the parties to reaching a final contract.Id.(citing Teachers Ins. & Annuity Ass’n of Am. v. Tribune Co., 670 F. Supp. 491, 498 (S.D.N.Y. 1987)).
143.Id.at 333–34, 346, 353 (reversing the holding with respect to promissory estoppel because it does not apply when a fully integrated, enforceable contract already exists governing the promise at issue).
144. SIGA Techs., Inc. v. PharmAthene, Inc., 132 A.3d 1108, 1110–11 (Del. 2015); PharmAthene, Inc. V. SIGA Techs., Inc., No. 2627-VCP, 2015 WL 220445, at *1–2 (Del. Ch. Jan. 15, 2015) (final remand order).
152.Id.at 1130, 1136–39. In 2011, the chancery court ruled that expectation damages were not appropriate because damages were too speculative. PharmAthene, Inc. v. SIGA Techs., Inc., No. 2627-VCP, 2011 WL 4390726, at *31–33 (Del. Ch. Sept. 22, 2011).
153.SIGA 2, 132 A.3d at 1130 (quoting Duncan v. Theratx, Inc., 775 A.2d 1019, 1022 (Del. 2001)).
Over six years have passed since the creation of a class of investment advisers exempt from registered investment adviser requirements, or “exempt reporting advisers,” under the Dodd-Frank Act. In that time the U.S. Securities and Exchange Commission (SEC) has enhanced its examination and investigations of private investment funds and their investment advisers. For example, in the first half of 2016, a number of SEC cases focused on lack of adequate cybersecurity, investment advisers’ failure to disclose fees, misuse of investor funds, and the failure of fund administrators to appropriately respond to red flags. On May 12, 2016, Andrew Ceresney, the director of the SEC’s Division of Enforcement, stated that securities regulators should focus on private equity enforcement due to the “unique characteristics” of private equity funds, including restrictions on the ability of fund investors to withdraw their investments.
“Exempt reporting advisers” in particular are a topic of interest among the SEC’s Enforcement Division due to their growing popularity among the investment adviser community. In a 2011 release implementing the Dodd-Frank Act’s new rules for exempt reporting advisers, the SEC indicated that they would not be subject to routine SEC examinations, a position that corroborated a previous statement made by former SEC Chairman Mary Schapiro. However, on November 20, 2015, Marc Wyatt, the director of the SEC’s Office of Compliance, Inspections, and Examinations (OCIE), announced that OCIE would in fact begin examining exempt reporting advisers as part of its routine examination program.
Given the likely prospect of heightened scrutiny, current and aspiring exempt reporting advisers should be aware of applicable filing and compliance requirements and best practices to better serve their customers and avoid falling afoul of federal and state regulations.
What Is an Exempt Reporting Adviser?
Investment advisers must register with either federal or state securities authorities, depending on the amount of assets under management. “Small advisers” (with under $25 million in assets) may register only with state securities authorities. “Large advisers” (with over $110 million in assets) and certain “mid-sized advisers” (with $25 to $110 million in assets) must register with the SEC unless they fall under the “Private Fund Adviser Exemption” or “Venture Capital Adviser Exemption” to registration, each of which were created by amendments enacted under the Dodd-Frank Act to the Investment Advisers Act of 1940 (the Advisers Act).
The Private Fund Adviser Exemption is available to advisers based in the United States that solely manage private funds and have less than $150 million in assets under management. A “private fund” is an issuer of securities that would be an “investment company” but for the exceptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the Investment Company Act)—that is, an investment fund limited to 99 accredited investors or exclusively qualified purchasers, respectively. The Venture Capital Adviser Exemption is available to investment advisers that solely advise venture capital funds. A “venture capital fund,” as defined in the Advisers Act, is a private fund that: (i) invests no more than 20 percent of its total capital in assets other than qualifying investments (meaning equity securities issued by a nonreporting or foreign-traded portfolio company that are directly acquired by the venture capital fund) and short-term holdings (i.e., cash and cash equivalents, U.S. Treasuries with remaining maturities of 60 days or less, and shares of registered money-market funds); (ii) is not leveraged; (iii) does not offer its investors liquidity rights except in extraordinary circumstances; (iv) is not registered under the Investment Company Act; (v) has not elected to be treated as a business development company; and (vi) represents that it follows a venture capital strategy.
Investment advisers that meet either the Private Fund Adviser Exemption or the Venture Capital Adviser Exemption are known as “exempt reporting advisers” (ERAs). ERAs are not subject to the same federal or state registration procedures as other investment advisers, but must still register with and report to securities regulators and satisfy certain compliance requirements.
Federal Registration Process
An ERA is required to file with the SEC and does so by completing and filing Form ADV—the same registration document submitted by registered investment advisers (RIAs). However, instead of the entire form, ERAs complete only certain items in Part 1A, along with corresponding schedules. These items disclose, among other things, basic identifying information about the ERA (e.g., its legal name, principal office, and place of business), details about the size of any private funds it advises, other business interests of the ERA and its affiliates, and disciplinary history of the ERA and its employees. In particular, an ERA must identify “control persons” that directly or indirectly control it.
Form ADV is electronically filed, and the information provided on it is available to the public on the Investment Adviser Registration Depository, operated by the Financial Industry Regulatory Authority. An ERA must complete and file Form ADV with the SEC (and pay associated filing fees) within 60 days of the date on which the investment adviser commences an advisory relationship with its first fund. Form ADV must be updated at least annually within 90 days of the ERA’s fiscal year, and more frequently following any material developments described therein. ERAs relying on the Private Fund Adviser Exemption must include any updates to their valuation of the private fund assets under management to determine whether the exemption is still applicable. If an ERA determines that it no longer manages under $150 million in assets, it is given a 90-day grace period to file an application for registration with the SEC.
State Registration Process
A number of states require ERAs that have a place of business and a minimum number—typically five or six—of investment advisory clients (i.e., private or venture capital funds) in-state to make additional filings, to pay fees, and to report to state securities authorities when filing or amending their Form ADV. Although specific state requirements vary, as a general rule, SEC Rule 222-1(a) defines the term “place of business” as an office or other location held out to the public as a location in which the investment adviser regularly provides investment advisory services or solicits, meets with, or otherwise communicates with clients. These “notice filings” may be accomplished by the ERA selecting the relevant states on Item 2.C of Part 1A of the Form ADV, which will automatically send the form to those states. It is important for the ERA to determine whether it is subject to notice filing requirements in individual states. If required to register with one or more state securities authorities, an ERA must complete the entire Form ADV for the SEC registration.
Advisers who are exempt from investment adviser registration with the SEC must still comply with applicable state law. Many states have adopted exemptions for venture capital advisers and private fund advisers that are similar to the federal exemptions. An ERA should check with the state in which it conducts investment advisory activities to determine whether there is a state exemption and what, if any, compliance requirements exist at that level. The North American Securities Administrators Association (NASAA) provides information about state investment adviser laws and rules on its website (www.nasaa.org). NASAA has also issued model state ERA registration rules, modified versions of which have been or are being implemented by a number of states.
Compliance Requirements and Best Practices
ERAs are not subject to some of the Advisers Act provisions regarding registration, recordkeeping, or performance that apply to RIAs. However, ERAs have fiduciary responsibilities to their clients and must abide by certain other compliance requirements applicable to all investment advisers, including anti-fraud rules and pay-to-play provisions. Furthermore, adopting certain best practices as described below can help an ERA stay on the right track and protect itself and its clients.
1. Anti-Fraud Requirements
An ERA should be forthcoming and honest with clients about its services to avoid falling afoul of its fiduciary obligations, which are set forth in Sections 206(1) and 206(2) of the Advisers Act. It is unlawful for any investment adviser, whether an ERA or RIA, to use any device, scheme, or artifice in order to defraud a client or a prospective client. Investment advisers must also refrain from engaging in any transaction, practice, or course of business that operates as a fraud or deceit upon a client or a prospective client. Examples of practices that run afoul of the anti-fraud rules include promising clients a guaranteed return from an equity investment or making false statements about the ERA’s investment history (once a client loses her money, she is not going to be sympathetic to claims that the ERA was merely “puffing”). Advisers Act Rule 206(4)-8 makes it a fraudulent, deceptive, or manipulative act or practice for any investment adviser, whether an ERA or a RIA, to make any untrue statement of material fact or omit a material fact such that a statement to an investor or potential investor becomes misleading, or otherwise engages in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor. ERAs must be wary of conduct that poses conflicts of interest, such as tradeoffs between clients or tradeoffs between a client and other business dealings of the adviser, its affiliates, or their principals, officers, directors, employees, or other agents. Although ERAs are not subject to specific restrictions on advertising, general fiduciary obligations (as well as sound business practices) require avoiding misleading statements, such as through selectively cherry-picking performance information when soliciting investors. To prevent misuse of information regarding investments, ERAs should institute policies and procedures against insider trading.
2. Pay-to-Play Requirements
ERAs are subject to Advisers Act Rule 206(4)-5, which prohibits certain investment advisers from engaging in pay-to-play practices (i.e., being compensated for investment advisory services to a government entity or official after making political contributions to the same). Rule 206(4)-5, which is modeled after the Municipal Securities Rulemaking Board’s pay-to-play rules applicable to broker-dealers, imposes three main conditions on ERAs. First, investment advisers and their associates are subject to a two-year “cooling-off” period after making a contribution to an official of a government entity before the adviser can receive compensation for providing advice to the government entity. Second, investment advisers are not allowed to use third-party solicitors who themselves are not subject to pay-to-play restrictions. Finally, investment advisers may not solicit or coordinate campaign contributions from others (a practice known as “bundling”) for officials of a government entity to which the adviser provides or is seeking to provide services.
3. Anti-Money Laundering Requirements
Unlike broker-dealers and mutual funds, investment advisers are not subject to the anti-money laundering (AML) program requirements imposed by the USA PATRIOT Act, the Money Laundering Control Act of 1986, or the Bank Secrecy Act of 1970. However, due to counterparty risk management, investment funds often wisely refuse to do business with investment advisers that do not have AML programs of their own. Furthermore, U.S. investment advisers, including ERAs, are subject to the rules promulgated by the Office of Foreign Asset Control (OFAC) of the U.S. Treasury Department, which prohibits investment advisers from doing business with individuals and entities on OFAC’s list of “Specially Designated Nationals and Blocked Persons.” Investment advisers must ensure that they do not accept those individuals or entities as clients and must notify OFAC of any suspect clients or transactions.
Although not required by law, an investment adviser should conduct routine employee AML training to identify and report suspicious activity and should also implement a customer identification and due diligence program. The latter likely will involve obtaining appropriate AML documentation from prospective and existing investors. For example, an investment adviser may require natural persons with whom the adviser has not established a prior relationship to provide notarized signatures on his or her subscription agreement or a notarized copy of a driver’s license or passport.
4. Recordkeeping, Examinations, and Proxy Voting
Section 204 of the Advisers Act requires investment advisers to make and keep records and to make and disseminate such reports as the SEC may require. Although the SEC has yet to establish recordkeeping rules specific to ERAs, it is possible future ERAs could be subject to recordkeeping requirements.
The SEC has the legal authority to examine an ERA’s books and records. Historically, it has limited its examinations to those “for cause,” in which the SEC believed or had reason to believe there was wrongdoing (likely through tips, complaints, or referrals). However, as of November 20, 2016, the SEC has begun examining ERAs as part of its routine examination program. Thus, even ERAs without red flags could be subject to the scrutiny of the SEC’s Office of Examination and Compliance.
Given the SEC’s interest in this area (as well as for practical business reasons), it is advisable for ERAs to maintain most, if not all, of the records RIAs are required to maintain under Advisers Act Rule 204(2). These records include general and auxiliary ledgers, records of communications, financial records, purchases and sales, bank and custodial statements, evidence of political contributions, disciplinary records, policies and procedures, supervisory or operational procedures, and any other records one might expect an SEC examination team to request during an on-site inspection. Investment advisers should retain records for at least five years, and such records should be easily accessible for at least the first two years. Records may be maintained on paper or on micrographic or electronic media in accordance with Rule 204-2(g).
The SEC does not require ERAs to establish a written proxy voting policy, which RIAs usually file in Part 2A of Form ADV. However, certain states do require investment advisers doing business within their borders, including ERAs, to comply with recordkeeping requirements, including rules relating to proxy voting policies. ERAs should check the relevant states’ securities regulations to ensure they are in compliance with all applicable requirements.
5. Protecting Investor Privacy
ERAs and RIAs are both subject to rules promulgated under the Gramm-Leach Bliley Act that govern maintenance of investors’ personal information. Unlike RIAs, which are subject to privacy rules issued by the SEC, ERAs, along with broker-dealers and state-registered investment advisers, are subject to privacy rules issued by the Federal Trade Commission (FTC). The FTC privacy rules require ERAs to “develop, implement and maintain a comprehensive information security program that is written in one or more readily accessible parts.” In particular, ERAs must identify reasonably foreseeable risks to the security, confidentiality, and integrity of customer information, design and implement information safeguards, test and monitor these safeguards, and make adjustments as needed. Additionally, one or more employees must be appointed to coordinate the program, which could prove burdensome for ERAs that are individuals or smaller entities short on human resources.
ERAs are required to send initial privacy notices to investors along with standard fund documents describing their privacy policies and procedures. In addition, ERAs must send investors annual privacy disclosures, except when the ERA: (i) only shares investors’ nonpublic personal information with unaffiliated third parties that do not require an opt-out right be provided to investors under the Fixing America’s Surface Transportation Act (the FAST Act); and (ii) has not changed its privacy policies and procedures since its last privacy disclosure. Under the FAST Act, opt-out rights need not be provided to investors when information is shared with insurance rate advisory organizations, ratings agencies, consumer agencies, attorneys, accountants, auditors, and others determining industry standards; unaffiliated third parties providing services for or on behalf of the ERA; or for the purpose of fraud prevention or to comply with federal, state, or local laws.
6. Adoption of a Compliance Manual and Code of Ethics
Under Advisers Act Rule 206(4)-7, RIAs must adopt, review annually, and designate a chief compliance officer (CCO) to administer written policies and procedures to prevent violations of federal securities laws. Further, RIAs must adopt and enforce codes of ethics applicable to their “supervised persons,” which, as defined under the Advisers Act, include partners, officers, directors, employees, or other individuals who provide investment advice on behalf of the investment adviser and are subject to its supervision and control. Codes of ethics are meant to prevent misconduct by reinforcing fiduciary principles that govern the conduct of investment advisory firms and their personnel.
In contrast, ERAs are not required to adopt or implement compliance policies or procedures. However, doing so is considered a “best practice,” as internal compliance is the first line of defense against a violation of the securities laws to which ERAs are subject. If an ERA does decide to take this recommended route and adopt policies and procedures, these should be followed regardless of whether they are required by law. When the SEC conducts an examination, it will ask for—and will want to see evidence the ERA is complying with—all of an ERA’s policies and procedures.
Compliance policies often include an employee manual and code of ethics. These documents impose obligations on an ERA’s employees, contractors, and supervised persons to ensure that the ERA is in compliance with insider trading, pay-to-play, and privacy and confidentiality requirements, among others. For example, a compliance manual may require that an ERA’s supervised persons provide regular updates on the contractor’s equity or debt interests in any portfolio companies they recommend for investment by a fund the ERA advises. The documents may include other restrictions, such as limits on gifts an employee may accept, a conflicts-of-interest policy, and a catch-all provision for employee conduct.
It is important to note that the constraints imposed by an ERA compliance manual on supervised persons can be a major impediment to attracting talented investment professionals. For example, a small, recently formed ERA that is reliant on due diligence by supervised persons to advise investment funds may find it difficult to attract big-name investment or industry experts if the ERA’s compliance manual requires those supervised persons to attend quarterly, multiday training sessions on insider trading. An ERA should consult with counsel and take care to balance precautionary measures while maintaining a competitive edge against other investment advisers.
Codes of ethics typically designate a CCO, set forth the CCO’s responsibilities, and instruct employees to report to the CCO any potential violation of the investment adviser’s compliance manual or code of ethics, or other suspected wrongdoing. If an ERA appoints a CCO, the CCO’s name and contact information must be included in Form ADV along with the ERA’s basic identifying information. To the extent possible, a CCO should be a different individual than the manager, president, or chief executive officer of the ERA to avoid the appearance of conflicts of interest at the higher levels of the ERA’s organizational structure. Appearance of conflicts should not, however, hinder the relationship between a CCO and general counsel and outside general counsel, which is critical for a CCO to provide proper guidance and take corrective action. An ERA may even appoint its general counsel as CCO for economies of scale, although in such cases its general counsel/CCO must take care to remember which “hat” is being worn at a given moment to prevent any waivers of attorney-client privilege. Although an ERA that is a small entity, bereft of a general counsel, could theoretically engage outside counsel to serve as CCO, it would likely be very difficult for outside general counsel to enter into such a committed relationship while maintaining a separate law practice.
7. Other Investment Adviser Regular Updates
There are a number of other compliance obligations that all investment advisers, including ERAs, should bookmark in their calendars for review and possible action. This is not an exclusive list of an ERA’s recurring responsibilities, but they are important to note.
ERAs engaged in ongoing securities offerings should remember to ensure that information provided in their Form D and annual Form ADV filings is up to date, which may entail mandatory annual renewal of any state blue sky notice filings. These amendments should also be made when there have been any material changes to information previously provided.
ERAs may need to modify disclosures made in marketing materials and offering documents (e.g., partnership or operating agreements, private placement memoranda, and subscription agreements) to ensure that they remain consistent with and representative of the adviser’s business. For example, carried interest, fees, and expense allocations should conform to offering documents and communications with investors. Modifications to fund documents often are made through the use of side letters.
ERAs should conduct ongoing monitoring of equity participation by “benefit plan investors,” as defined under the Employee Retirement Income Security Act of 1974 (ERISA), to ensure that their investment funds are not deemed to include “plan assets” (thereby becoming subject to ERISA rules). ERAs should also send “venture capital operating company” or “real estate operating company” certifications to investors if so agreed upon in the fund documents, and may consider seeking an annual representation from all investors that there has been no change in their eligibility to participate in profits and losses from new issues.
ERAs, like investment funds and their general partners, should also obtain updated certifications and annually review their “bad actor” obligations under Rule 506(d) of Regulation D. Due diligence, including background checks and questionnaires, should be conducted on any service providers. ERAs should also monitor regulatory developments at the federal level and in the states in which they do business.
Conclusion
As evident by the rules and restrictions described in this article, “exempt reporting adviser” is somewhat of a misnomer. Although RIAs may have more onerous registration and reporting requirements, there are many regulatory pitfalls for ERAs at both the federal and state level. Adopting compliance policies and procedures to the extent practicable can help an ERA prevent securities laws violations, protect investors’ investments and privacy, instill investor confidence, and even help the ERA’s business run smoothly. Although it may seem like an administrative hassle initially, adopting a strong, yet flexible set of compliance policies and procedures will ultimately benefit new and up-and-coming ERAs.
On May 11, 2016, President Obama signed the Defend Trade Secrets Act (DTSA) into law. This important new legislation creates a federal, private, civil cause of action for trade-secret misappropriation in which “[a]n owner of a trade secret that is misappropriated may bring a civil action . . . if the trade secret is related to a product or service used in, or intended for use in, interstate or foreign commerce.” Defend Trade Secrets Act of 2016, S. 1890, 114th Cong. § 2 (2016). The DTSA enjoyed wide, bipartisan support leading up to its enactment, passing in the House by a vote of 410-2 and passing unanimously in the Senate. For the first time, the DTSA gives American companies the opportunity to protect against and remedy misappropriation of important propriety information in federal court. Businesses should be aware of the salient provisions of the DTSA discussed below in order to adequately prepare to employ the protections of the DTSA.
A Federal Cause of Action
Before the enactment of the DTSA, in the absence of diversity jurisdiction or an independent federal cause of action, companies seeking redress for trade-secret misappropriation had no choice but to sue in state court, where laws protecting against trade-secret misappropriation tend to differ from state to state both in the text of the laws themselves and in their application. For instance, the definition of “trade secret” differs from state to state, and different statutes of limitations may apply, and different remedies may be available for trade-secret misappropriation. The DTSA provides a uniform statute to be applied nationwide in federal court. Although the DTSA will not preempt existing state trade-secret laws, it gives companies the powerful option of filing suit in federal court, thus adding an important additional tool for American companies, especially those with a national footprint, to enforce their intellectual property rights.
Definition of Trade Secret and Misappropriation
The DTSA provides uniform definitions for the critical terms “trade secret” and “misappropriation.” The DTSA’s definition of trade secret is broad, allowing a wide range of proprietary information to fall within the purview of trade-secret protection under the statute. Specifically, trade secret is defined as: “all forms and types of financial, business, scientific, technical, economic, or engineering information, including patterns, plans, compilations, program devices, formulas, designs, prototypes, methods, techniques, processes, procedures, programs, or codes, whether tangible or intangible, and whether or how stored, compiled, or memorialized physically, electronically, graphically, photographically, or in writing if (A) the owner thereof has taken reasonable measures to keep such information secret; and (B) the information derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable through proper means by, another person who can obtain economic value from the disclosure or use of the information.”
The acts that constitute misappropriation are also described specifically, giving welcome guidance to litigants. Under the DTSA, misappropriation is defined as follows:
acquisition of a trade secret of another by a person who knows or has reason to know that the trade secret was acquired by improper means; or
disclosure or use of a trade secret of another without express or implied consent by a person who—
used improper means to acquire knowledge of the trade secret;
at the time of disclosure or use, knew or had reason to know that the knowledge of the trade secret was—
derived from or through a person who had used improper means to acquire the trade secret;
acquired under circumstances giving rise to a duty to maintain the secrecy of the trade secret or limit the use of the trade secret; or
derived from or through a person who owed a duty to the person seeking relief to maintain the secrecy of the trade secret or limit the use of the trade secret; or
before a material change of the position of the person, knew or had reason to know that—
the trade secret was a trade secret; and
knowledge of the trade secret had been acquired by accident or mistake.
Civil Seizure and Other Remedies
One provision of the new DTSA that has generated much commentary in the run up to its enactment is the new civil seizure mechanism established by the statute. The civil seizure mechanism is a preventative tool employed prior to a formal finding of misappropriation in which a court, on ex parte application by a trade-secret owner, may “issue an order providing for the seizure of property necessary to prevent the propagation or dissemination of the trade secret that is the subject of the action.” Using this tool, an American company aware of a potential misappropriation of its trade secrets may be able to quickly prevent further dissemination of that proprietary information during the pendency of a DTSA case. Following issuance of a seizure order, the court is required to hold a seizure hearing wherein the party who obtained the seizure order has the burden to prove the facts underlying the order. Civil seizure may be ordered only in “extraordinary circumstances” and requires a showing that:
an order pursuant to Fed. R. Civ. P. 65 or other equitable relief would be inadequate;
an immediate and irreparable injury will occur if seizure is not ordered;
harm to the applicant from denial of a seizure order: (1) outweighs the harm to the person against whom seizure is ordered; and (2) substantially outweighs the harm to any third parties by such seizure;
the applicant is likely to succeed in showing that the person against whom the order is issued misappropriated or conspired to misappropriate a trade secret through improper means;
the person against whom the order will be issued has possession of the trade secret and any property to be seized;
the application describes with reasonable particularity the property to be seized and, to the extent reasonable under the circumstances, the property’s location;
the person against whom seizure is ordered would destroy, move, hide, or otherwise make such property inaccessible to the court if put on notice; and
the applicant has not publicized the requested seizure.
Upon a finding of misappropriation of a trade secret, the statute provides for additional remedies. A court may grant an injunction to prevent any actual or threatened misappropriation, provided that the injunction does not “prevent a person from entering into an employment relationship,” and that any conditions placed on employment are based on “evidence of threatened misappropriation and not merely on the information the person knows.” Where appropriate, an injunction may require affirmative actions to protect the trade secret. Further, in “exceptional circumstances that render an injunction inequitable,” the court may condition future use of the trade secret on the payment of a reasonable royalty. Following a finding of misappropriation, a court may also award damages. Where the trade secret is “willfully and maliciously misappropriated,” a court may award exemplary damages double the damages amount already awarded. A court may also award attorney fees where the misappropriation or claim of misappropriation was in bad faith, or where a motion to terminate is made or opposed in bad faith.
Whistleblower Immunity
The DTSA includes a safe harbor for whistleblower employees that provides for immunity from any criminal or civil liability under any federal or state trade-secret law for disclosure of a trade secret that is made in confidence to an attorney or federal, state, or local governmental official “solely for the purpose of reporting or investigating a suspected violation of law,” or in a filing in a lawsuit made under seal. It is important that employers pay close attention to the notice provision within the whistleblower immunity section of the statute because compliance with this notice provision may affect whether an employer can seek certain remedies under the statute. The remedies for companies suing former employees for trade-secret misappropriation under the DTSA include punitive damages and attorney fees. In order to take advantage of these remedies, however, a company must advise its employees of the existence of the whistleblower immunity. As such, companies should strongly consider updating their employment policies and agreements going forward to include either the required notice, or a cross-reference to a policy document that includes a statement about the DTSA’s whistleblower immunity.
Other Notable Provisions
The DTSA additionally mandates that, within one year of enactment and every six months thereafter, the Attorney General submit a publicly available report on, inter alia: (1) the scope and breadth of theft of trade secrets of American companies occurring outside of the United States; (2) the extent to which theft outside the United States is sponsored by foreign governments or instrumentalities; (3) the ability of trade-secret owners to prevent misappropriation of trade secrets outside of the United States; and (4) recommendations for actions that may be undertaken to reduce the threat of misappropriation of trade secrets of American companies occurring outside of the United States.
Additionally, although the DTSA expressly indicates that “[n]othing in the amendments made by this section shall be construed . . . to preempt any other provision of law” and thus will not preempt existing state trade-secret laws, one remaining open question is what the result will be where the definition of trade secret within the DTSA conflicts with a state’s common-law definition, or where there is a different conflict between the DTSA and a state’s common-law requirements concerning keeping protected trade secrets confidential.
The DTSA’s broad definition of trade secret, together with the prophylactic provisions of the statute, will provide a robust additional tool for American companies to prevent unauthorized disclosure of propriety information. Although open questions certainly remain about the breadth of this statute given its recent enactment, it seems clear that this new law will provide an additional avenue through which American companies can ardently protect their intellectual property, thus providing enhanced value to their shareholders.
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