The Supreme Court recently answered the question of whether an issuer’s failure to disclose important information violated Rule 10b-5(b), an important anti-fraud prohibition in the federal securities laws. In addition, one AI program was not quite ready to uncover a key distinction in that case. It is worth considering both the case and the incipient AI analysis.[1]
The Supreme Court’s Opinion
In Macquarie Infrastructure Corp. et al. v. Moab Partners, L. P., et al.,[2] the court considered whether an issuer’s failure to say something in response to an express disclosure requirement violates Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5(b) thereunder. A unanimous Supreme Court said that those provisions “‘do not create an affirmative duty to disclose any and all material information.’”[3]
Moab Partners[4] claimed that Macquarie (the issuer) failed to disclose that new environmental restrictions would severely harm its business.[5] Moab asserted that this silence violated the disclosure requirements of Regulation S-K Item 303 (Management’s Discussion and Analysis of Financial Condition and Results of Operations).[6] Moab claimed that this failure served as a predicate for a violation of Section 10(b) and Rule 10b-5(b).
The court disagreed. Justice Sotomayor, writing for the court, observed that Rule 10b-5(b) makes it unlawful “to ‘make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.’”[7] The opinion contrasts saying nothing and telling a half-truth: “[T]he difference between a pure omission and a half-truth is the difference between a child not telling his parents he ate a whole cake and telling them he had dessert.”
The court found that:
Rule 10b–5(b) does not proscribe pure omissions. The Rule prohibits omitting material facts necessary to make the “statements made . . . not misleading.” Put differently, it requires disclosure of information necessary to ensure that statements already made are clear and complete (i.e., that the dessert was, in fact, a whole cake).[8]
The court found that failure to disclose alone was insufficient to constitute a violation of Rule 10b-5(b). “Today, this Court confirms that the failure to disclose information required by Item 303 can support a Rule 10b–5(b) claim only if the omission renders affirmative statements made misleading.”[9] Finding otherwise would read “the words ‘statements made’ out of Rule 10b–5(b) and shift[] the focus of that Rule and §10(b) from fraud to disclosure.”[10]
The court rejected Moab’s argument that were the court to find that Rule 10b-5(b) does not address omissions, it would create immunity for fraudulent omissions. The court disagreed, stating that Section 11(a) of the Securities Act of 1933 imposes liability for pure omissions. “By its terms, in addition to proscribing lies and half-truths, this section also creates liability for failure to speak on a subject at all.”[11] On the contrary, accepting Moab’s view “would also render §11(a)’s pure omission clause superfluous by making every omission of a fact ‘required to be stated’ a misleading half-truth.”[12] Further rejecting the immunity argument, the court noted that the SEC has authority to prosecute violations of its rules, including Item 303.[13]
Artificial Intelligence Analysis
Out of curiosity, I submitted the opinion to an AI program. The AI program said that it would help me read, understand, and work with documents more efficiently. It invited me to ask a question about this document. I asked, “what is the difference between Section 11 and Rule 10b-5?” The AI program’s conclusion was:
Unlike Section 11, Rule 10b-5 focuses on the overall misleading nature of statements made in connection with the purchase or sale of securities. In summary, Section 11 primarily deals with false statements or omissions in registration statements, while Rule 10b-5 addresses the broader issue of manipulative or deceptive practices in connection with the purchase or sale of securities.[14]
The AI response does not directly explain the key issue in the case, that is, whether Rule 10b-5(b) addresses omissions in comparison to Section 11. The response only obliquely discusses some differences between the provisions. The response’s disclaimer is all too accurate: “AI-generated responses may be inaccurate or misleading.”
Conclusion
Moab is a useful decision that further defines the scope of Section 10(b) and Rule 10b-5(b).
The AI analysis is interesting, but for different reasons. Perhaps one day, AI will be able to analyze questions much more complex than the one I posed. Should we fear that day? Not at all. What is past is prologue.[15] In the 1960s, IBM mainframe computers began to dominate the business world. Many feared that they would throw everyone out of work.[16] Of course, they did the opposite and allowed workers to focus on higher-level matters using better data than they had before.
In my view, AI never will replace human reasoning and judgment. In time, AI will become a great tool and provide many benefits to its users. Until AI can help a reader understand the nuances in new judicial opinions, I suggest reading those opinions carefully, including the footnotes.
“The Dog That Didn’t Bark” is a reference to Sir Arthur Conan Doyle, The Adventure of the Silver Blaze (1892) and the fictional detective Sherlock Holmes. ↑
621 U.S. ___ (2024), decided on April 12, 2024. References below are to the Slip Opinion. ↑
Id. at 6, citing Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44 (2011). ↑
The Supreme Court’s opinion does not identify the plaintiff, Moab Partners. It is a hedge fund manager managing a small fund. The Investment Adviser Public Disclosure website of the Securities and Exchange Commission (“SEC”) lists Moab Capital Partners LLC as an exempt reporting adviser as of July 19, 2021, with an effective date of July 30, 2021. Moab Capital Partners, LLC (CRD # 154855/SEC#:802-122208). Moab indicates that it qualifies for the exemption from registration because it acts solely as an adviser to private funds and has assets under management of less than $150 million. Moab Capital Partners, Form ADV, Item 2, March 12, 2024. ↑
Section 13(a) of the Exchange Act and 17 CFR §229.303 of Regulation S-K. ↑
Slip Opinion, at 4. At footnote 2, the court states that it granted certiorari only on the issue of omission, not half-truths. It also states that “[t]he Court does not opine on issues that are either tangential to the question presented or were not passed upon below, including what constitutes ‘statements made,’ when a statement is misleading as a half-truth, or whether Rules 10b–5(a) and 10b–5(c) support liability for pure omissions.”
In its entirety, Rule 10b-5 provides:
§ 240.10b-5 Employment of manipulative and deceptive devices.
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
To employ any device, scheme, or artifice to defraud,
To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security. ↑
The entire AI response is below, minus a link to provide feedback. For reasons of clarity, the author has removed the response’s odd paragraph numbering.
The difference between Section 11 and Rule 10b-5 is as follows:
Section 11 of the Securities Act of 1933 imposes liability for false statements or omissions in registration statements. It prohibits any registration statement that contains an untrue statement of a material fact or omits to state a material fact required to be stated therein or necessary to make the statements therein not misleading. In other words, Section 11 focuses on the accuracy and completeness of information provided in registration statements.
Rule 10b-5 is a regulation implemented under Section 10(b) of the Securities Exchange Act of 1934. It prohibits the use of any manipulative or deceptive device in connection with the purchase or sale of securities. Rule 10b-5(b) specifically makes it unlawful to make any untrue statement of a material fact or to omit to state a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading.
Unlike Section 11, Rule 10b-5 focuses on the overall misleading nature of statements made in connection with the purchase or sale of securities. In summary, Section 11 primarily deals with false statements or omissions in registration statements, while Rule 10b-5 addresses the broader issue of manipulative or deceptive practices in connection with the purchase or sale of securities.
AI-generated responses may be inaccurate or misleading. Be sure to double-check responses and sources. ↑
Class actions have taken the financial world by storm these past few years, capturing widespread investor, media, and regulatory attention and dominating many corporate governance and legal discussions.
Today, institutional investors are utilizing existing and new class action laws as a corporate governance tool for companies they invest in.[1] Now, these laws stand at the forefront, playing a pivotal role in shaping policies for asset recovery, steering shifts in investor behavior, and creating new focus on ESG policies, as well as influencing other critical factors.[2]
Indeed, total securities-related settlement values worldwide amounted to approximately $13 billion in the last two years alone, and there are over one thousand securities class actions remaining in litigation.[3]
And the rise of such class actions is no longer just a phenomenon in the United States. Significant opportunities now exist outside the U.S., as a wave of collective action litigation across the European Union (EU), the Asia–Pacific region (APAC), and other regions continues to pick up steam.
Growth in Securities Class Actions around the World
As the growing number of securities class action cases outside the U.S. mature and settle, multiple recent recoveries have eclipsed the $1 billion mark, with several high-profile opt-in litigations[4] underway, including claims against Wirecard AG[5] (Germany), Airbus SE[6] (the Netherlands), Glencore Plc[7] (United Kingdom), and Mitsubishi Motors[8] (Japan).
These actions are fueled by new laws and edicts, such as multiple countries’ implementation of the landmark EU Directive on Representative Actions, which was adopted in 2020.[9] Although several EU member states have yet to comply (and are subject to financial penalties in the meantime), prominent shareholder recovery jurisdictions, including the Netherlands and Germany, have already updated their procedures and laws to further improve access to courts and encourage resolution of disputes on a large scale.
Countries outside the EU have followed suit. Recent developments out of APAC include New Zealand, where in 2022 the country’s Law Commission recommended a statutory framework for class actions,[10] and Singapore, whose Monetary Authority highlighted that improving investors’ options to seek redress for losses arising from securities market misconduct is a key issue the country needs to address moving forward in 2023.[11]
This trend across European and APAC countries of enacting new and bolder class action laws ties back to the Supreme Court of the United States’s decision in Morrison v. National Australian Bank in 2010.[12] In that landmark decision in U.S. securities class action jurisprudence, the court held that § 10(b) of the Securities and Exchange Act only applies to U.S. securities or domestic transactions, ending its use for class action claims related to non-U.S. transactions in securities listed on foreign exchanges. Since then, out of necessity for injured parties outside of the United States, the quest for alternative venues has evolved in a full-fledged global movement. And over the last few years, the globalization of class action lawsuits has taken on a life of its own.
Today, business attorneys find themselves navigating a maelstrom of challenges, from the ever-expanding scope of these actions to emergence of new jurisdictions, heightened client interest, and advising financial services firms in their demanding and ever-changing global landscape.
Navigating this dynamic terrain is a challenge and vital responsibility for attorneys in the financial sector.
Complex Asset Classes and Antitrust Class Actions
Traditional equity investments have long dominated portfolios. Likewise, securities-related class actions have historically been dominated by holders of common stock or ordinary shares. This creates additional complexities as new laws emerge: (1) each country’s new class action laws have nuances that must be navigated, and (2) the complexity in recovery is compounded by new, innovative, and sophisticated asset classes.
Technological advancements and the swift flow of information have torn down barriers to entry in the investment world, fueling an appetite for new opportunities. Cryptocurrency, once considered incompatible with risk-tolerant investment strategies, is now capturing institutional attention. This transformation unfolds against a backdrop of maturing regulatory surroundings and evolving market infrastructure across the globe.
In the uncharted territory of cryptocurrency’s financial “Wild West,” asset managers are beginning to utilize class action laws when something has gone wrong.
However, the industry is also seeing an increase in the use of class action law globally to recover lost investments from other complex financial products. Often these cases are not brought on traditional securities laws, but rather antitrust or competition laws, further complicating the process. For example, 2023 set a record for the sheer number of antitrust settlements involving publicly traded securities or financial instruments. Indeed, there were nine such settlements collectively exceeding $650 million in aggregate. Two of the larger settlements include $187 million for investors in BBSW-based derivatives[13] and $155.5 million for investors who transacted in SIBOR- and/or SOR-based derivatives.[14]
Thus, the complexities in navigating these cases do not arise solely from novel financial products like cryptocurrencies; they extend to complex financial products such as asset swaps, bonds and floating rate notes, collateralized debt obligations, credit default swaps, forward rate agreements, inflation swaps, interest rate swaps, and total return swaps, just to name a few.[15]
Globetrotting Insights: Navigating International Class Action Trends
Embarking on an active process to reclaim international investments begins with recognizing the distinctive country-by-country demands inherent in such legal battles. The global stage of investment recovery is evolving, and strategic awareness of unique challenges and opportunities is the key to navigating this intricate terrain.
Since Morrison,[16] U.S. courts have not had jurisdiction over what is commonly known as “f-cubed cases.” These cases involve (1) foreign investors pursuing legal recourse against (2) foreign issuers for fraud that (3) transpired beyond U.S. borders. This restriction triggered a surge in foreign class actions, or collective actions, echoing beyond the U.S.
Yet only recently has this caused a wave of collective action litigations to increase across the EU and APAC, as well as other zones, prompting a noteworthy influx of litigation funders, U.S. litigation firms, and mass litigation units into these expanding markets. The driving force behind this expansion lies in evolving jurisdictional landscapes that render the pursuit of such actions legally more feasible.
The past few years have witnessed billion-dollar settlements in various corners of the globe, from Steinhoff[17] and Fortis[18] in the Netherlands to Royal Bank of Scotland[19] (RBS) in the UK. No longer are substantial recoveries confined to the Western Hemisphere, either. In the APAC region, securities class action dockets stand out as some of the busiest beyond U.S. borders, with settlements routinely surpassing the $100 million threshold. Australia spearheaded this trend, and a multitude of investor actions are filed in Taiwan.
The People’s Republic of China (PRC) has also made a notable entrance into this arena, introducing its own collective action legislation through the Provisions of the Supreme People’s Court on Issues Concerning Representative Litigation in Securities Disputes. In a mere twelve months, the PRC courts handed down a substantial $385 million verdict in the Kangmei Pharmaceutical investor action.[20] In December 2023, a securities settlement of 280 million yuan (about $40 million USD) was reached on behalf of 7,195 investors in Essence Information Technology Co., Ltd. in a case in the Shanghai Financial Court.[21]
While guiding clients through the intricacies of international class actions, a pivotal consideration arises—the prevalence of opt-in systems in the majority of jurisdictions. Under these systems, interested parties must actively choose to participate in the litigation, often backed by distinct teams and legal theories from the third-party litigation funders.
Navigating parallel opt-in claims is a common challenge, as seen in Germany, where six separate Wirecard actions demanded assessment. Business attorneys must be adept at steering their clients through nuances of different and competing litigations. In the example of the Wirecard case, a client may opt not to pursue a claim against auditor defendant Ernst and Young, while still seeking recovery against other defendants or taking part in one of several insolvency proceedings.
There are other material differences each investor must navigate as well, from relevant countries’ laws, to each case’s legal and economic damage theory.
For example, in the U.K., a claimant might need to demonstrate “reliance” on misrepresentations made by the company as a condition for certain claims,[22] a departure from the U.S., where there is a well-established presumption of reliance supported by the courts.[23]
Conclusion
As more countries embrace the idea of opening their courts to collective redress actions, it’s evident securities class actions are not just changing but will continue to boom, as institutional investors are keenly watching this wave, pulling the financial services industry along for this important ride. A notable shake up in broker-dealer services and a surge within the custodial business is emerging as they gear up to offer global, comprehensive support. Traditionally, attorneys advising broker dealers focused on notifying individual wealth customers about potential security settlements. But now, they’re stepping into a broader role, diving into holistic claim filing and client asset recovery services. This shift and the dynamic landscape of international class actions demands vigilance and adaptability from legal advisors and the financial services industry around the globe.
E.g., Verbandsklagenrichtlinienumsetzungsgesetz [VRUG] [Act Implementing Directive (EU) 2020/1828 on Representative Actions for the Protection of the Collective Interests of Consumers and Repealing Directive 2009/22/EC and Amending the Capital Investor Model Procedure Act (Collective Actions Directive Implementation Act], Oct. 8, 2023, Bundesgesetzblatt Teil I [BGBl I] at 272 2023 I (last visited Feb. 12, 2024) (Ger.) (Germany’s new law reorganizing the German collective redress system via the Verbraucherrechtedurchsetzungsgesetz, or Consumer Rights Enforcement Act (VDuG), including a third extension of Kapitalanleger-Musterverfahrensgesetz, or Capital Investor Model Procedure Act (KapMuG), which until the passing of VduG was Germany’s only procedure for shareholder asset recovery in a class-wide opt-in basis); Securities Law of the People’s Republic of China (promulgated by the Standing Comm. Nat’l People’s Cong., Dec. 28, 2019, effective Mar. 1, 2020) 2019 P.R.C. Laws (establishing new class action regime under China’s New Securities Law); Civil Litigation (Expenses and Group Proceedings) (Scotland) Act 2018, (ASP 10) (last visited Feb. 12, 2024) (Scotland’s implementation of a hybrid U.S.-style class action regime). ↑
2022 Global Class Action Annual Report, Broadridge Financial Solutions (last accessed Feb. 12, 2024); 2023 Global Class Action Annual Report,Broadridge Financial Solutions (last accessed Apr. 9, 2024) (together finding that settlements exceeded $7.4 billion in 2022 and $5.5 billion in 2023, and reporting more than one thousand pending securities and financial antitrust class and collective actions worldwide). ↑
Depending on the phase of opt-in litigation or the particular legal jurisdiction, court dockets might not be available to the public. Additionally, multiple opt-in claims may be progressing simultaneously, representing various groups ranging from a few individuals to tens of thousands. When possible, we include a non-exhaustive citation to the original case(s) filed for each litigation; otherwise, we cite to the firms or litigation funders bringing such claims. ↑
Landgericht München [Reg’l Ct. of Munich] Mar. 14, 2022, Wirecard AG/Ernst & Young: Order for Reference under the KapMuG, 3 OH 2767/22 KapMuG (3 O 5875/20) (order for reference pursuant to the Capital Investor Model Procedure Act (KapMuG), the first step under Germany’s collective redress regime for shareholder claims). ↑
Abduit 2002 Sicav SA and another v. Glencore plc and others, Case No. FL-2022-000027 (EWHC filed Sept. 28, 2022) (Eng.); Wirral Council as administering authority to Merseyside Pension Fund and another v. Glencore Plc, Case No. FL-2022-000029 (EWHC filed Sept. 29, 2022) (Eng.); abrdn OEIC I in relation to abrdn UK Equity Fund and others v. Glencore Plc, Case No. FL-2022-000026 (EWHC filed Sept. 28, 2022) (Eng.); Phoenix Life Ltd. and others v. Glencore Plc, Case No. FL-2022-000025 (EWHC filed Sept. 28, 2022) (Eng.). ↑
Directive (EU) 2020/1828 of the European Parliament and of the Council of 25 November 2020 on Representative Actions for the Protection of the Collective Interests of Consumers and Repealing Directive 2009/22/EC, 2020 O.J. (L 409) 1. ↑
Dennis v. JP Morgan Chase & Co., No. 1:16-cv-06496 (LAK) (S.D.N.Y. settlement approved Nov. 2, 2022). ↑
Fund Liquidation Holdings LLC. v. Citibank, N.A., No. 1:16-cv-5263 (AKH) (S.D.N.Y. settlement approved Nov. 29, 2022). ↑
See, e.g., Joint Declaration of Vincent Briganti and Christopher McGrath in Support of Plaintiffs’ Consolidated Motion for Conditional Class Certification for Purposes of Class Action Settlements at Ex. 1 (Stipulation and Agreement of Settlement as to Defendant Australia and New Zealand Banking Group Ltd.) 4–5, Dennis (No. 1:16-cv-06496 (LAK)), ECF No. 490-1 (“‘BBSW-Based Derivatives’ means any financial derivative instrument that is based or priced in whole or in part in any way on [the Bank Bill Swap Rate (]BBSW[)] or in any way includes BBSW as a component of price . . . including, but not limited to: (i) Australian dollar foreign exchange (‘FX’) derivatives,” forwards, Australian dollar FX swaps, Australian dollar currency options, Australian dollar futures contracts and options on such futures contracts; “(ii) BBSW-based interest rate derivatives, including interest rate swaps, swaptions, forward rate agreements (‘FRAs’), exchange-traded deliverable swap futures and options on those futures, 90-day bank accepted bill (‘BAB’) futures and options on those futures, and other over-the-counter (‘OTC’) contracts or publicly traded vehicles that reference BBSW; (iii) Australian dollar cross-currency swaps; and (iv) any other financial derivative instrument or transaction based in whole or in part on BBSW, or that in any way incorporates BBSW as a component of price.”). ↑
Morrison, 561 U.S. at 261–266 (finding that the antifraud provisions of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 do not extend to securities transactions outside the U.S.). ↑
Section 90A FSMA Claims: Who Can Bring Them?, Simmons & Simmons LLP (Oct. 21, 2020) (“Section 90A/Schedule 10A of FSMA holds issuers liable to a person who ‘acquires, continues to hold or disposes of the securities in reliance on’ the issuer’s misleading published information (paragraph 3(1)(a) of Schedule 10A).”). ↑
Basic v. Levinson, 485 U.S. 224 (1988) (finding a rebuttable presumption of reliance in securities fraud cases based off the “fraud-on-the-market” theory). ↑
Lawyers and clients have ample reasons to care about IRS Forms 1099, which allow computer matching of Social Security numbers and dollar amounts paid. In most cases, Forms 1099 report income, so if you receive a Form 1099, check the numbers. You may not be able to change it, but you’ll usually need to report it on your tax return.
Lawyers receive and send more Forms 1099 than most people, in part because of tax laws that single them out. Since 1997, most payments to lawyers must be reported on a Form 1099. The basic Form 1099 reporting rule (for lawyers and everyone else) is that each person engaged in business and making a payment of $600 or more for services must report it on a Form 1099. The rule is cumulative, so while one payment of $500 wouldn’t trigger the rule, two payments of $500 to a single payee during the year require a Form 1099 for the full $1,000.
Lawyers must issue Forms 1099 to expert witnesses, jury consultants, investigators, and co-counsel who received $600 or more. A notable exception to this $600 threshold rule is payments to corporations for services. However, the rule that payments to a lawyer require a Form 1099 overrides the rule that payments to a corporation are exempt. Any payment for services of $600 or more to a lawyer or law firm must be reported on a Form 1099. It doesn’t matter if the law firm is a corporation, limited liability company, limited liability partnership, or general partnership.
The size of the law firm also doesn’t matter; it might have one lawyer or thousands. This affects law firms as issuers, and as receivers, of Forms 1099. A lawyer or law firm paying fees to co-counsel or a referral fee to a lawyer must issue a Form 1099, regardless of how the lawyer or law firm is organized. Any client paying a law firm more than $600 in a year as part of the client’s business must issue a Form 1099.
Some businesses and law firms prefer to issue Forms 1099 at the time they issue checks, rather than in January of the following year. For example, if you are mailing out thousands of checks to class action recipients, you might prefer sending a single envelope that includes the check and Form 1099, rather than sending a check and later doing another mailing with a Form 1099.
Form 1099 Errors
Errors in reporting occur, and if you believe a Form 1099 is wrong, you may be able to get the issuer to correct or undo it.
Suppose that you receive a Form 1099 that says a company paid you $100,000, but you can prove that the company actually paid you only $10,000. If you cannot get the company to correct it, you must report the $100,000 and explain that you actually received only $10,000. Unfortunately, many “please fix my Form 1099” requests go ignored. The issuer of the form may believe it issued the form correctly, and many Form 1099 reporting issues that seem like errors really are not.
Say that a plaintiff nets $60,000 from a legal settlement when the lawyer collected $40,000, a 40 percent contingent fee. The plaintiff will usually receive a Form 1099 for the full $100,000, even if the lawyer was paid directly by the defendant and the plaintiff only received $60,000. Arguing about that after the fact is nearly always a waste of time. The only time you have any bargaining power about how Forms 1099 will be issued is before you sign a settlement agreement.
Failing to report (or at least explain) a Form 1099 on your tax return will get you an IRS notice. If you receive a Form 1099, report it, even if you are claiming that the money should be tax free. If you are a plaintiff or a lawyer, think about the forms before signing the settlement agreement. In some cases, you may be able to steer the defendant to completely avoid a Form 1099. That would be appropriate if a portion of a settlement is fairly attributable to physical injuries or physical sickness.
Form 1099-MISC vs. Form 1099-NEC
Even if it is certain that you will receive a Form 1099, there are different 1099s, and different boxes on the forms that signal different things to the IRS. The most common form is Form 1099-MISC, for miscellaneous income. But to discuss it, we must also talk about Form 1099-NEC.
Up until 2020, if you were paying an independent contractor, you reported it on Form 1099-MISC, in box 7, for non-employee compensation. But now, the old box 7 has morphed into its own form: Form 1099-NEC.
Form 1099-NEC reports a payment for services. Using that form tips the IRS off that the person should be paying not only income tax, but also self-employment tax. Self-employment tax is equivalent to both halves of the employer and employee payroll taxes that apply to wages, which are reported on Form W-2.
Self-employment tax can add a whopping 15.3 percent on top of income taxes. That 15.3 percent applies up to the wage base of $168,600, with 2.9 percent on any excess over the wage base. There’s no limit on that 2.9 percent, even if you earn millions. In short, self-employment tax is nothing to sneeze at.
Because of the self-employment tax, most payees would rather receive a Form 1099-MISC than a Form 1099-NEC. Sometimes you can specify, such as in a legal settlement agreement. Otherwise, the payer of the money generally picks whatever reporting they think is best and issues the 1099.
Gross Proceeds Paid to an Attorney
Most payments on Form 1099-MISC are recorded in Box 3, as other income. For lawyers settling cases, though, “gross proceeds paid to an attorney” is the most important category. Gross proceeds paid to an attorney are reported in Box 10 of Form 1099-MISC. This box is only for reporting payments to lawyers, such as legal settlement proceeds.
Notably, gross proceeds reporting for lawyers is not counted as income to the lawyer. Most payments to a lawyer are supposed to be reported on Form 1099-MISC, including settlement proceeds. Say that a lawyer settles a case for $1 million, with payment to the lawyer’s trust account. Assume that 60 percent is for the client and 40 percent is for the lawyer as a fee.
The lawyer will receive a Form 1099-MISC reporting the full $1 million as gross proceeds in Box 10. The lawyer need not report the full $1 million as income, because it is not. The lawyer can simply report the $400,000 fee as income without worrying about computer matching, since “gross proceeds” do not count as income.
The client isn’t so lucky. Unless the settlement is a non-income settlement (compensatory damage for personal physical injuries) or a capital recovery, the client in this example should receive a Form 1099-MISC in Box 3 for the full $1 million. The client must then figure out how to deduct the $400,000 in legal fees. Not all legal fees are deductible, and it is harder to find a way to claim them in many kinds of cases since 2018.
Joint Payees and Forms 1099
IRS regulations contain extensive provisions governing joint checks. Most of these rules mean that lawyers will be receiving the forms along with their clients when legal settlements are payable jointly to lawyer and client. In general, two Forms 1099, each listing the full amount, are required. Many lawyers receive funds that they pass along to their clients, with the law firm cutting checks to clients for a share of settlement proceeds.
When a plaintiff law firm disburses money to clients for legal settlements, should the law firm issue a Form 1099 to its own client? Some firms issue the forms routinely, but most payments to clients do not require them. In most cases, the settling defendant is considered the payer. Thus, the defendant generally has the obligation to issue any Form 1099 that is necessary. There are some exceptions, but just being a plaintiff’s lawyer and handling settlement money is not enough to trigger a Form 1099 obligation in this situation.
Every tax return must be signed under penalties of perjury. That makes tax returns the most important tax form of all. Yet it is hard to think of a tax form that is more important or pivotal to our tax system than Forms 1099. Whether you are paying money or receiving money, consider these forms at tax time and throughout the year. Not everyone is likely to agree on how and when the forms should be issued. That should not be a surprise, as there are hundreds of pages of IRS regulations about when and how they should be issued. Be careful out there!
Robert W. Wood is a tax lawyer and managing partner at Wood LLP. He can be reached at [email protected].
On March 25, 2024, the National Association of Industrial Bankers (“NAIB”), American Financial Services Association (“AFSA”), and American Fintech Council (“AFC”) (collectively, “Trade Associations”) filed a complaint in the United States District Court for the District of Colorado on behalf of their members. The Trade Associations seek declaratory judgment and preliminary and permanent injunctive relief against the Colorado Attorney General and Administrator of the Colorado Uniform Consumer Credit Code. The complaint challenges Colo. Rev. Stat. § 5-13-106, which opts Colorado out of Section 521 of the Depository Institutions Deregulation and Monetary Control Act of 1980 (“DIDMCA”). Colorado’s DIDMCA opt-out is set to go into effect on July 1, 2024.
Sections 521–523 of DIDMCA granted federal authority to insured, state-chartered banks and credit unions, authorizing them to contract for the interest rate permitted by the state where the bank is located and export that interest rate into other states. In June 2023, Colorado signed into law legislation exercising its right under Section 525 to opt out of DIDMCA, which it believes will require state-chartered banks and credit unions to adhere to Colorado laws regarding interest rate and fee limitations.
The Trade Associations assert that Colorado’s DIDMCA opt-out violates the Supremacy Clause and the Commerce Clause of the United States Constitution. The Trade Associations claim that Colorado’s opt-out is overly broad and facially invalid because Colorado’s definition of where a loan is “made” for purposes of its DIDMCA opt-out goes “far beyond” what is permitted by federal law. The Trade Associations noted that Congress allowed states to opt out with respect to loans “made in” a particular state as defined under federal law, but it did not intend to permit each state to independently define that term and where a particular loan is “made.”
Under federal law and long-standing prudential regulator commentary, a loan is “made” in the state where all key functions associated with originating or “making” the loan occur. These include the following nonministerial functions of the bank: the decision to lend, the communication of loan approval, and the disbursement of loan proceeds. Colorado seeks to define a loan as one that is “made” in Colorado whenever the loan is made to a Colorado resident, regardless of where the nonministerial functions occur.
The Trade Associations outline a series of arguments:
Colorado’s DIDMCA opt-out is disregarding the plain terms of DIDMCA, usurping federal authority, and intruding on the ability of other states to regulate loans made within their borders.
The opt-out violates the Commerce Clause because it impedes the flow of interstate commerce by subjecting state-chartered banks to inconsistent obligations across different states and, as a result, creates a significant burden on interstate commerce.
Although intended to combat high-cost payday lending, the opt-out actually has the converse effect because Colorado consumers will be harmed by the decreased range and availability of credit products.
Members of the Trade Associations are not payday lenders but rather mainstream, household names that offer a wide variety of useful and familiar credit products such as installment loans, store-branded credit cards, and point-of-sale loans offered by retailers (i.e., buy now, pay later loans). These members often fill the gap for a population that cannot be served by a traditional bank model due to credit risk and other factors.
The intent of Colorado’s DIDMCA opt-out to prevent high-cost lending and protect consumers is undermined because the same types of products will still be available to Colorado consumers through the national banks, due to the inability of states to opt out of the National Bank Act. This outcome will have a negative effect on the very consumers Colorado insists it is trying to protect with the opt-out.
Since the complaint was filed, the Colorado Attorney General and Colorado Uniform Consumer Credit Code Administrator filed a responsive brief objecting to the Trade Associations’ motion for preliminary injunction. The Federal Deposit Insurance Corporation (“FDIC”) also filed an amicus curiae brief siding with Colorado’s interpretation of the DIDMCA opt-out. The FDIC asserts that its position is consistent with historical interpretations, while others assert that the brief appears to contradict the plain language of the FDIC’s longstanding positions regarding where loans are made in the context of federal rate exportation authority. The Trade Associations filed a reply in support of their motion, and the American Bankers Association (“ABA”) and the Consumer Bankers Association (“CBA”) submitted an amicus brief in support of the trade groups.
As more states have introduced and continue to introduce DIDMCA opt-out legislation, Colorado’s DIDMCA opt-out case will be significant in the regulatory landscape across the country for the financial services industry.
The Corporate Transparency Act (“CTA”) is a landmark piece of legislation that went into effect on January 1, 2024. Under the CTA, millions of corporations, limited liability companies, and other entities are required to disclose their beneficial owners to the U.S. Treasury Department’s criminal-enforcement bureau, the Financial Crimes Enforcement Network (“FinCEN”).
In National Small Business United v. Yellen, the plaintiffs—National Small Business United d/b/a the National Small Business Association (“NSBA”), a nonprofit organization that represents the interests of small businesses and entrepreneurs, and one its members, Isaac Winkles—brought suit against the U.S. Treasury, Janet Yellen as secretary of the Treasury, and Himamauli Das as acting director of FinCEN, challenging the constitutionality of the CTA. On March 1, 2024, the U.S. District Court for the Northern District of Alabama issued its ruling in the case, finding in favor of the plaintiffs and prohibiting FinCEN from enforcing the CTA against them.[1]
This article will examine the court’s ruling, its immediate impact on CTA reporting companies, and its broader implications for the CTA.
National Small Business United v. Yellen
In its ruling in National Small Business United, the court found that the CTA, as currently drafted, exceeds the authority granted to Congress under the Constitution as it relates to each of Congress’s powers (i) over foreign affairs and national security, (ii) under the Constitution’s Commerce Clause, and (iii) over taxes. However, having found that the CTA is not within Congress’s constitutional authority, the court declined to address the plaintiffs’ additional arguments—that is, that the CTA also violates the First, Fourth, and Fifth Amendments.
With respect to Congress’s powers over foreign affairs and national security, the defendants argued that the CTA is necessary in order to protect national security interests, by enabling law enforcement to counter money laundering, terrorist financing, and other illicit activities. The court rejected this argument, stating, among other things, that the congressional findings connecting the CTA to national security interests are not sufficient to conclude that “a regulation in the purely domestic arena of incorporation is . . . ‘derivative of, and in service to’ Congress’ foreign affairs powers, especially in light of the States’ historically exclusive governance of incorporation.”[2]
With respect to Congress’s powers under the Commerce Clause, the court found, in part, that the CTA is not a valid regulation of the “channels and instrumentalities” of interstate commerce, nor is it within Congress’s power to regulate activities that have a substantial effect on interstate commerce, because the CTA, on its face, does not regulate entities that have engaged in interstate commerce. Rather, the CTA regulates entities upon their formation or registration to do business, regardless of whether or not they will engage in interstate commerce, and the act of formation or registration in and of itself is not an economic activity that affects interstate commerce.
Lastly, with respect to Congress’s taxing power, the court rejected the defendants’ argument that the CTA is necessary and proper to ensure the proper reporting and collection of taxes, finding that the relationship between such purposes and the CTA’s disclosure requirements is too attenuated.
Impact on Reporting Companies
The ruling in National Small Business United does not actually allow most entities affected by the CTA to refrain from complying with its requirements. Rather, the ruling is narrow in scope and applies only to the plaintiffs in the case, namely Isaac Winkles, the NSBA, and the NSBA’s members as of March 1, 2024. As such, all other entities that are reporting companies under the CTA are still required to report their beneficial owners to FinCEN within the required deadlines (i.e., ninety days for entities formed or registered to do business in 2024, and thirty days for entities formed or registered thereafter), as affirmed by FinCEN in an alert published on its website shortly after the ruling.[3] However, as a practical matter, entities in existence prior to the effective date of the CTA (which have until January 1, 2025, to file initial beneficial ownership reports with FinCEN) may want to consider postponing their filings until closer to the deadline while the legal challenges to the CTA continue to play out.
Implications for the CTA
The defendants in National Small Business United filed a notice of appeal on March 11, 2024, appealing the district court’s ruling to the U.S. Court of Appeals for the Eleventh Circuit. The appeals process is currently ongoing, with oral arguments scheduled for the week of September 16, 2024. While the ultimate impact of the case is thus still to be determined, the ruling has already had an impact on other legal challenges to the CTA.
In another case challenging the constitutionality of the CTA, Robert J. Gargasz Co. v. Yellen, the government defendants moved to hold that case in abeyance pending the outcome of the appeal in National Small Business United, on the grounds that the underlying issues in both cases are similar, which the court granted.[4] Furthermore, following the ruling in National Small Business United, additional lawsuits have been filed challenging the constitutionality of the CTA; these cases include many of the same arguments that the court found persuasive in National Small Business United and piggyback off the plaintiffs’ success. In one such case, Small Business Ass’n of Michigan v. Yellen, filed on March 26, 2024, plaintiff Small Business Association of Michigan argues that “because the CTA is triggered by the mere fact that an entity has been formed under state or tribal law, it applies to entities merely by virtue of their existence, not because they have engaged in any sort of commerce—interstate or otherwise.”[5] As such, the plaintiff argues that the CTA is not within Congress’s power under the Commerce Clause and cites to National Small Business United as precedent for its argument.[6] Thus, although the outcome in each of these actions is still uncertain, the ruling in National Small Business United called into question the constitutionality of the CTA and, depending on the outcome of these cases, may turn out to be the first domino to have fallen.
Lastly, in addition to the lawsuits challenging the CTA, legislation was recently introduced by Senator Tommy Tuberville (R-AL) and Representative Warren Davidson (R-OH) to repeal the CTA, posing additional uncertainty to the fate of the CTA in the wake of the ruling in National Small Business United.[7]
Nat’l Small Bus. United v. Yellen, No. 5:22-cv-01448-LCB, 2024 WL 899372 (N.D. Ala. Mar. 1, 2024). ↑
In a Fireside Chat event on April 2, 2024, sponsored by the Uniform Commercial Code Committee of the ABA Business Law Section (UCC Committee) and organized by the Committee’s Tokenized Payments Instrument Task Force, Assistant U.S. Attorney for the Southern District of New York Thane Rehn shared reflections on and lessons learned from the high-profile trial of Sam Bankman-Fried (SBF), founder of crypto exchange FTX Trading Ltd. (FTX). In a discussion moderated by Jess Cheng, partner at Wilson Sonsini, Rehn provided insight into the investigation of FTX’s collapse, the prosecution’s trial strategy, and key facets of the case that enabled the prosecution team to move quickly. The event, which attracted news coverage,[1] was especially timely, as it occurred only five days after SBF was sentenced to twenty-five years in prison for misappropriating billions of dollars of customer funds and defrauding investors and lenders.
Timeline of the Fall of FTX and SBF Trial
The chain of events that led to FTX’s collapse began in early November 2022 with the leak of what purported to be a balance sheet of Alameda Research LLC (Alameda), a crypto trading firm and FTX affiliate. Among other things, the leaked document revealed that a significant portion of Alameda’s assets consisted of FTT, an illiquid exchange token issued by FTX. Within days, rival crypto exchange Binance.com announced it would sell off its FTT holdings and initially offered to acquire FTX, but shortly thereafter, it withdrew from the deal, citing reports of mishandling of customer funds and alleged federal investigations. On November 11, 2022, FTX filed for Chapter 11 bankruptcy protection.
On December 12, 2022, SBF was arrested in the Bahamas, and the following day, the U.S. Attorney’s Office for the Southern District of New York unsealed the indictment charging him with wire fraud, commodities fraud, securities fraud, and money laundering. In parallel, the Securities and Exchange Commission charged SBF with orchestrating a scheme to defraud equity investors in FTX in violation of federal securities laws, and the Commodity Futures Trading Commission charged SBF, FTX, and Alameda with fraud and material misrepresentations in violation of federal commodities laws.
On November 2, 2023, after about one month of trial proceedings, the jury found SBF guilty on all seven counts of fraud and conspiracy. The U.S. Department of Justice issued the following statement from Attorney General Merrick B. Garland on the guilty verdict:
Sam Bankman-Fried thought that he was above the law. Today’s verdict proves he was wrong. This case should send a clear message to anyone who tries to hide their crimes behind a shiny new thing they claim no one else is smart enough to understand: the Justice Department will hold you accountable. I am grateful to the U.S. Attorney’s Office for the Southern District of New York and the FBI for their outstanding work in bringing Mr. Bankman-Fried to justice.
On March 28, 2024, U.S. District Court Judge Lewis Kaplan sentenced SBF to twenty-five years in prison and three years of supervised release, and he ordered the defendant to pay $11 billion in forfeiture for his orchestration of multiple fraudulent schemes.
Reflections on and Lessons Learned from the Trial
During the UCC Committee event on April 2, Rehn provided key insights into the trial strategy based on his experience as part of the prosecuting team, including preparing for the trial, delivering the prosecution’s opening statements, and cross-examining witnesses.
Sharing colorful examples and compelling visuals used at trial, Rehn illustrated how cooperating witnesses played an important role in the trial and efforts leading up to it. He discussed how the specialized knowledge of certain members of SBF’s inner circle at FTX and Alameda helped prosecutors piece together the billion-dollar theft of customer funds and the fraud on investors and lenders, enabling the team to move quickly to trial.
Rehn also shared how he used the opening statements to help the jury understand the narrative of FTX’s collapse, explain core financial and crypto concepts, and more generally preview the structure of the prosecution’s arguments. Interestingly, the aspects of crypto that tend to be more challenging to grasp—namely, blockchain, distributed ledgers, and technological innovation—arose less often than one might expect. Rather, the focus tended to be on explaining FTX’s role as a crypto exchange and dispelling misconceptions about its fall, particularly in the context of a highly volatile crypto market.
The defense sought to argue that SBF acted in good faith and that FTX was “building the plane as they were flying it,” with SBF taking the stand during his trial. Rehn walked through how the wealth of SBF’s tweets, interviews, and other public statements belied his testimony and those arguments. Sharing anecdotes, Rehn discussed the prosecution team’s approach to illustrating how SBF’s statements under cross-examination directly contradicted his prior statements, such as his claims to investors and the public that FTX segregated customer funds.
Takeaways
The Fireside Chat was a unique opportunity to learn about the strategies behind and lessons from a high-profile trial, directly from a key member of the prosecution team. Although the fraud occurred in the context of an innovative and volatile industry, at its core the case is a reminder across all industries that there are serious consequences for defrauding customers, investors, and lenders.
The views expressed by the writers are the writers’ own and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System, nor the views of Wilson Sonsini Goodrich & Rosati.
As global M&A activity faced significant headwinds throughout 2023, buyers and investors seeking opportunities in technology industries found refuge in critical technology subsectors—particularly artificial intelligence (“AI”). Despite global tech M&A volume falling roughly 50 percent in 2023 on a year-over-year basis, the aggregate value of global AI M&A transactions grew in 2023 by over 20 percent compared to the year prior. As fears of recession wane and expectations of interest rate decreases in 2024 grow, M&A activity in the AI sector is poised to continue its run with force.
In a variety of industries, organizations are rapidly investing in and acquiring AI software companies to enhance value and broaden their capabilities. AI companies offer notable advantages due to their ability to swiftly scale operations with minimal capital investment, ensuring operational efficiency. However, companies leveraging AI also present distinct challenges and unprecedented risks. These risks are particularly pronounced for AI companies employing cutting-edge technology or operating in highly regulated industries, such as FinTech, RegTech, biomedical solutions, digital health devices, or autonomous vehicles. Buyers, ranging from private equity funds to strategic and tech-savvy acquirers, must not only recognize these risks but also enlist the guidance of advisors experienced in acquiring companies with AI solutions (“AI companies”) to structure transactions in a manner that mitigates risk and maximizes value.
This article will highlight five key AI-specific issues to consider when acquiring an AI company and offer strategies to mitigate these risks. Screening for such AI-related concerns will supplement the standard considerations typical of ordinary acquisitions. As with any acquisition, buyers must thoroughly assess all aspects of the target company’s operations, encompassing employment practices, tax implications, commercial agreements, and any specific issues arising from the acquisition (e.g., regulatory scrutiny of the transaction).
1. Target Company IP Rights
In the realm of AI enterprises, having clear ownership or sufficient rights to utilize all critical intellectual property (“IP”) is imperative. IP forms the foundation of AI business activities. Without unequivocal ownership rights, a company faces the peril of third-party infringement assertions, posing existential threats to its business viability and profitability.
Buyers should initially identify the essential IP assets and AI solutions fundamental to the target company’s operations. Subsequently, they must ascertain whether the target holds exclusive ownership or possesses adequate rights to utilize the IP and AI solutions incorporated into its operations or offered in its products and services. This entails verifying that any entities involved in the development of the target company’s IP and AI—such as employees, contractors, service providers, or research institutions—have duly assigned and transferred all relevant rights to the target company. Buyers should meticulously scrutinize databases maintained by the relevant administrative bodies, such as the Canadian Intellectual Property Office, and conduct thorough IP searches. This diligence ensures that the target company is the rightful owner of any registered IP and that there are no encumbrances from third-party interests registered against the IP.
In instances where the target company does not possess outright ownership of the underlying IP, buyers must assess the extent of ownership and the terms governing the target company’s utilization of the IP. This includes evaluating any associated risks relating to potential IP infringement claims that could be levied against the target company.
In the context of AI companies utilizing employees or independent contractors to develop their AI solutions, it becomes imperative to ensure that the company has obtained waivers of moral rights and consents from these third-party contributors. Moral rights afford creators of original works that are protected under copyright laws specific rights to their creations, independent of formal registration. In Canada, moral rights cannot be transferred or licensed; rather, they must be explicitly waived.
Another consideration for buyers is whether the target company has incorporated open-source software into its AI solutions, which carries inherent risks. The use of open-source software can include obligations for the company to disclose, free of charge, the source code of any software or program integrating the open-source software. Given the substantial risks at hand, prospective buyers should contemplate enlisting a third-party evaluator to scrutinize the target company’s AI solution source code. Such an audit aids in comprehending any potential open-source challenges or infringements on third-party intellectual property associated with AI ventures.
2. Ownership and Voting Structure
During the launch and initial phases of growth, diverse investors may obtain equity in a company. Yet, early-stage enterprises often grapple with maintaining precise corporate records, which can pose challenges during the acquisition process. Hence, buyers must meticulously discern the identities of the target company’s shareholders and the attendant rights they hold, which could significantly influence the acquisition. These rights might encompass voting privileges or dissolution rights linked to specific share classes or investors.
Emerging and rapidly expanding firms frequently employ options or warrants to motivate both internal stakeholders (e.g., employees, board members, and contractors) and external counterparts (e.g., lenders, strategic allies, and key clients) to support their growth through investment endeavors. Consequently, buyers must scrutinize the terms and vesting schedules of any options, warrants, or convertible securities (if issued) by the target company, as these factors could impact future control and ownership.
The buyer must also ensure all appropriate shareholders approve of the share purchase transaction or agree to sell their shares (pursuant to the articles or shareholder’s agreement). A thorough examination of the target company’s minute books and relevant agreements, such as shareholder agreements, becomes imperative to grasp the company’s ownership and voting framework comprehensively. Additionally, scrutinizing the chain of share ownership is vital for buyers to ascertain the identity of each shareholder and confirm their authorization to transfer shares to the buyer.
3. Data Rights and Use of Personal Information
For AI companies, data and quantitative metrics often serve as pivotal value drivers. Prospective buyers must strive to gain a comprehensive understanding of how the target company leverages data and its corresponding data practices, with a particular focus on contractual obligations pertaining to data collection, usage, and transfer. This examination should encompass an assessment of the target company’s policies regarding personal information, ensuring adherence to relevant laws, including data protection and intellectual property regulations, and securing necessary consent for data transfer and utilization where applicable. Comprehensive scrutiny should extend to all privacy policies and internal data handling procedures employed by the target company. Verifying the adequacy of consents for data usage is essential in mitigating associated risks.
In scenarios where the target company’s data practices involve the handling and processing of personal data, buyers must ascertain the relevant legislation governing such activities and evaluate whether the target has established protocols that align with all applicable data protection and privacy laws, as well as any existing third-party agreements. Given the potential complexities and costs associated with rectifying data misuse issues, buyers must clearly comprehend the target company’s data practices. Noncompliance on the part of the target company could present significant challenges, potentially necessitating consent from relevant third parties to rectify.
In cases where the proposed transaction entails a transfer of data ownership, buyers must ensure that the target company possesses the requisite rights and consents for such transfer. Failure to secure appropriate consent could result in the target company breaching its contractual obligations and facing subsequent liability.
4. Regulatory Risk and Life Cycle Issues
During the initial phases of software development, AI companies typically concentrate on crafting products that fulfill specific functional criteria. However, in this pursuit, these entities may overlook the regulatory obligations that apply to them and their clientele. This oversight can occur when a solution initially tailored for a particular industry or jurisdiction is later offered to customers operating in different regulatory environments. Regulations are constantly evolving, and therefore products and services must be monitored and continually updated to reflect these changes to avoid regulatory offenses.
Buyers must verify that the target company’s AI aligns with the legal and regulatory requirements applicable to all involved parties, looking both to requirements regarding the technological aspects of the solution and to those related to the specific functions or industries it involves. Additionally, they should anticipate potential legal changes to ensure the longevity of the AI solution and prevent unforeseen regulatory breaches. Failure to meet regulatory standards could expose the target company to substantial liabilities from customers, third parties, and governmental entities.
Beyond regulatory compliance, the dynamic nature of disruptive AI solutions necessitates considering the life cycle of the target company’s AI solution. In conjunction with legal and financial due diligence, cyber diligence efforts should assess the scalability, functionalities, and growth potential of the AI solution slated for acquisition in the M&A transaction.
5. Cybersecurity
Ensuring data security is paramount in safeguarding an AI business’s assets and operations. A breach in data integrity can inflict severe damage on a company’s worth; unauthorized access to confidential business data or sensitive customer information has the potential to cause significant financial losses and tarnish the company’s reputation, thereby impacting credibility and revenue streams. Cybersecurity due diligence, commonly referred to as “cyber diligence,” serves as a proactive measure to mitigate the risk of future data breaches, regulatory penalties, and privacy infringement litigation.
Engaging in cyber diligence is advantageous for buyers because it allows for a comprehensive review of a target company’s cybersecurity practices, identification of potential vulnerabilities, and preemptive measures to address cybersecurity risks before they cause threats. Furthermore, cyber diligence should meticulously evaluate the sensitivity or value of stored data and monitor any gaps in data security protocols. Engaging cybersecurity experts may be necessary to assess the adequacy of security measures and identify vulnerabilities within the system. Buyers should also scrutinize the target company’s cybersecurity incident response plan to ascertain its readiness to manage, mitigate, or resolve cyber threats should they arise.
6. Addressing the Risks
Upon identifying issues, buyers should assess the feasibility of mitigating these risks and how they can be addressed. Depending on the gravity of the issue, the target company might have the capacity to rectify concerns before the closing of the deal. Buyers may opt to tackle identified issues pertaining to the AI solution through the representations and warranties outlined in the share purchase agreement.
In instances where issues cannot be rectified prior to closing, such as concerns surrounding the utilization of open-source software in the target company’s products or services, buyers are advised to negotiate a reduction in the purchase price to reflect the assumed risk and the anticipated cost of post-closing remedies. Additionally, buyers may contemplate securing a specific indemnity to address known issues or consider withholding a portion of the purchase price, which can be utilized to offset losses stemming from identified issues post-closing. The parties involved may also explore restructuring the transaction to alleviate associated risks.
Certain issues, such as significant infringement of third-party intellectual property or noncompliance with privacy laws, may not be possible to address prior to closing. Consequently, buyers must weigh the potential reputational risk of proceeding with the transaction without resolving such concerns.
Conclusion
The points discussed in this article are by no means an exhaustive list of all issues relating to M&A where the target has developed or incorporated AI solutions; the aim is to highlight certain unique challenges inherent in the AI landscape. The issues identified should be closely monitored and thoroughly assessed during the due diligence phase of any transaction. Based on the findings, issues may be able to be addressed in the purchase agreement. This will assist in protecting buyers and also in establishing a meaningful valuation for the target company, as the parties can seek to address the risk through a reduction in the purchase price.
Engagement of legal counsel well-versed in AI solutions and experienced in AI M&A transactions is crucial for both buyers and sellers. Such expertise ensures comprehensive protection of their respective interests throughout the transaction process.
An April 11, 2024, article in the Financial Times, “The inequity method of accounting: California family learns about private-equity hardball while selling supermarket chain,” has created a stir in the private equity deal community. The article details a dispute that arose between the prior owners of Save Mart, a California supermarket chain, and Kingswood Capital Management, a Los Angeles–based, lower-middle-market private equity firm. While the article is recent, the arbitration award detailed in the article was handed down on September 5, 2023, and confirmed by the Delaware Court of Chancery on February 28, 2024. Prior to the Financial Times article, the case received little attention. But the seeming harshness of the arbitration decision as detailed in the article (selling stockholders being required to pay the buyer approximately $70 million for the buyer to acquire the company), coupled with the Court of Chancery’s confirmation of it, has many in the deal community gobsmacked.
So, I decided to delve into it a bit more deeply and look at the actual provisions at issue to the extent obtainable. (Because the otherwise private arbitration ruling was posted by the Financial Times and is therefore publicly available, we have direct quotations from the purchase agreement to review.) What I have managed to learn from the available documents follows.
Save Mart Supermarkets, LLC operated over two hundred stores in California and Nevada. Save Mart also was a general partner in (and owned an equity interest of approximately 52 percent of) Super Store Industries (“SSI”), a separately run partnership with two other partners that operated a wholesale grocery distributor business. SSI had debt on its balance sheet of approximately $109 million. This debt was not on Save Mart’s balance sheet because SSI was an unconsolidated subsidiary, and Save Mart had elected to account for the SSI partnership using the equity investment method, meaning that Save Mart reflected on its balance sheet its net investment in SSI (SSI’s asset value less SSI’s debt, multiplied by Save Mart’s ownership interest). Save Mart’s latest balance sheet prior to its sale reflected its joint venture investment in SSI at a net $22.5 million. In other words, the SSI debt was well covered by the assets of SSI (and the SSI debt was current and had never been in default).
Kingswood Capital formed SM Buyer LLC (“Buyer”) to acquire Save Mart from its owners (“Sellers”). Buyer and Sellers entered into an Equity Purchase Agreement (“EPA”) on March 7, 2022. The deal was structured as a “cash free, debt free” deal, with an agreed “Base Value” of $245 million. Consistent with the “cash free” concept, the EPA permitted the Sellers to sweep all cash out of Save Mart prior to closing, and they in fact swept $205 million out of Save Mart prior to closing.
As is typical, the purchase price was determined by a formula that started with the base value and then subtracted closing date indebtedness and transaction expenses and added or subtracted other items, such as working capital excesses or deficiencies. The EPA contained a purchase price adjustment mechanism to address that calculation. It provided for (a) the Sellers to prepare an estimated closing statement a few days prior to closing (which the Buyer was entitled to comment upon and which provided the basis for the estimated purchase price to be paid at closing), (b) the Buyer to then, within ninety days after the closing, prepare its own closing statement consistent with the contractual guard rails, and (c) any dispute between the Sellers’ estimated and Buyer’s closing statements to be resolved by accountants or courts depending on the issue.
The definition of “Purchase Price” read as follows in the EPA (prior to an amendment that separated the sale of the SSI joint venture interest from the sale of the rest of Save Mart):
The aggregate consideration payable by Buyer in respect of the Company Membership Interests shall be an amount equal to (a) the Base Value, plus (b) the amount, if any, by which the Working Capital exceeds the Working Capital Target, minus (c) the amount, if any, by which the Working Capital Target exceeds the Working Capital, plus (d) the Closing Cash (which may be a negative number, in which case, Closing Cash shall reduce the Base Value), minus (e) Closing Date Indebtedness, minus (f) Transaction Expenses, minus (g) Deemed Accrual Amount (such resulting amount pursuant to clauses (a)-(g), and as such amount may be adjusted pursuant to the provisions of Section 1.4, the “Purchase Price”).
The key deduction from Base Value here was “Closing Date Indebtedness.” Closing Date Indebtedness was defined in the EPA as “the aggregate amount of all Indebtedness of the Group Companies as of the Adjustment Time.”
Indebtedness was defined very broadly to include:
among other things, “(i) the outstanding principal amount of and accrued or unpaid interest of (A) indebtedness of such Person or its Subsidiaries for borrowed money (including Debt Breakage Costs) and (B) indebtedness evidenced by notes, debentures, bonds or other similar instruments for the payment of which such Person or its Subsidiaries is responsible or liable,” and “(xi) all liabilities and obligations of the type referred to in clauses (i) – (x) of other Persons for the payment of which such Person or its Subsidiaries is responsible or liable, directly or indirectly, as obligor, guarantor or surety.”
Group Companies was defined to include Save Mart and its “Operating Subsidiaries.” Operating Subsidiaries was defined to include “all direct and indirect Subsidiaries of the Company [listed on Section 3.4(b) of the Company Disclosure Schedule].” SSI was in fact listed as an Operating Subsidiary on Schedule 3.4(b). Adjustment Time was defined as 11:59 p.m. PT on March 27, 2022, which was the day before the closing at 8:00 a.m. PT on March 28, 2022.
However absurd it may seem given the balance sheet accounting treatment of the SSI investment (net equity value), the strict language of the definition of Closing Date Indebtedness appears to cause all of the SSI debt (a revolver and a real estate loan, totaling $109 million) to be included.
At some point, the Buyer’s financing sources had apparently expressed concern about the potential for a creditor of SSI to directly sue Save Mart as a general partner of SSI. As a result, the Buyer asked the Sellers to restructure the deal so that Save Mart was no longer a direct partner of SSI immediately prior to the closing. They did this by amending the EPA (the “EPA Amendment”) to provide that immediately prior to the closing, Save Mart’s partnership interest in SSI would be distributed to the Sellers, who would then contribute that partnership interest to a newly formed entity (“SSI Holdco”). The Sellers would then sell the equity in SSI Holdco to a newly formed affiliate of the Buyer (“Topco”) for a fixed purchase price (not subject to any adjustment) of $90 million. As a result of the proposed pre-closing SSI spinoff required by the EPA Amendment, as of the closing date (a) Save Mart would no longer be a general partner of SSI, and (b) SSI would no longer be an Operating Subsidiary of Save Mart.
In the Amended EPA, the definition of Purchase Price was changed to read as follows (changes in bold):
The aggregate consideration payable by Buyer in respect of the Company Membership Interests shall be an amount equal to (a) the Base Value, plus (b) the amount, if any, by which the Working Capital exceeds the Working Capital Target, minus (c) the amount, if any, by which the Working Capital Target exceeds the Working Capital, plus (d) the Closing Cash (which may be a negative number, in which case, Closing Cash shall reduce the Base Value), minus (e) Closing Date Indebtedness, minus (f) Transaction Expenses, minus (g) Deemed Accrual Amount, minus (h) the SSI Purchase Price (such resulting amount pursuant to clauses (a)-(h), and as such amount may be adjusted pursuant to the provisions of Section 1.4, the “Purchase Price”), and the aggregate consideration payable by Topco in respect of the SSI Holdco Membership Interests shall be an amount equal to $90,000,000 (“SSI Purchase Price”).
But the definitions of Group Companies, Indebtedness, Closing Date Indebtedness, and Operating Subsidiary all remained unchanged. And notably, Schedule 3.4(b) continued to list SSI as an Operating Subsidiary, which was accurate pre-closing, but not post-closing when it mattered. Including all SSI debt in Closing Date Indebtedness made little sense before the SSI spinoff given the accounting treatment on Save Mart’s balance sheet, but it made no sense following the SSI spinoff because, post-closing, SSI was no longer a Group Company of Save Mart.
As required by the EPA, the Sellers prepared an estimated closing statement three days prior to the closing. The Buyer made several comments, and the Sellers made revisions to accommodate the Buyer’s comments. Notably, the Sellers did not include the SSI debt in the Closing Date Indebtedness for purposes of computing the estimated purchase price, and the Buyer did not object to the Sellers’ failure to do so. The estimated closing statement prepared by the Sellers reflected a purchase price to be paid by the Buyer to Sellers for Save Mart of approximately $39.5 million, of which approximately $7 million was to be deposited into an escrow account. The closing was then consummated based upon that estimated closing statement.
Pursuant to the terms of the EPA, the Buyer then prepared its own closing statement within ninety days after the closing; in that statement, the Buyer included the $109 million of SSI debt as a deduction from the Base Value for the purposes of determining the final purchase price. The provision in the EPA detailing how the Buyer was supposed to prepare its closing statement is set forth below in relevant part (emphasis added):
Closing Statement. No later than ninety (90) days after the Closing Date, Buyer shall cause to be prepared in good faith and delivered to Seller a statement (the “Closing Statement”) setting forth Buyer’s calculation of the Purchase Price (the “Closing Date Purchase Price”). The Closing Statement shall be prepared in a manner consistent with the definitions of the terms Working Capital, Closing Cash, Closing Date Indebtedness, Transaction Expenses, including, as applicable, the Accounting Rules (including as reflected on Exhibit A). The Parties agree that the purpose of preparing the Closing Statement and determining the Working Capital, Closing Cash, Closing Date Indebtedness, and Transaction Expenses is to measure the amount of the Working Capital, Closing Cash, Closing Date Indebtedness, and Transaction Expenses and such processes are not intended to (x) permit the introduction of accounting methods, policies, principles, practices, procedures, classifications or estimation methodologies for the purpose of determining the Working Capital, Closing Cash, Closing Date Indebtedness, or Transaction Expenses that are different than the Accounting Rules or (y) adjust for errors or omissions that may be found with respect to the Company Financial Statements or any inconsistencies between the Company Financial Statements and GAAP (except to the extent resulting from the application of the Accounting Rules in accordance with this Agreement).
There were disputes beyond whether the $109 million should have been included as part of Closing Date Indebtedness, and those disputes were referred to an accounting referee for resolution. But for reasons that are unknown (and must now be regretted by the Sellers), the parties agreed to submit the SSI debt inclusion dispute to binding arbitration before a retired former vice chancellor of the Delaware Court of Chancery (the “Arbitrator”), as opposed to litigating the dispute in court.
In the final arbitration award, the Arbitrator appears to concede that all of the extrinsic evidence suggests that the SSI debt was never intended to be a deduction to the purchase price. However, based upon Delaware’s strong contractarianism, he concludes early on that:
As explained below, the issues as framed by the parties distill down to a choice between two arguably unsatisfying outcomes: apply the clear and unambiguous terms of the operative contract and reach a result that is in tension with the extrinsic evidence; or follow that extrinsic evidence to a result that cannot be squared with the clear and unambiguous contract as written. That the resolution of the dispute, either way, will effect a material shift in the deal dynamics makes the choice between these outcomes all the more unsatisfying. But the choice, ultimately, is not difficult. The parties contractually invoked Delaware law and that election is consequential. Delaware law is more contractarian than most, and Delaware courts will enforce the letter of the parties’ contract without regard for whether they have struck a good deal or bad deal. Absent a contractual ambiguity, extrinsic evidence is inadmissible to construe the contract. The purchase agreement is not ambiguous. And the buyer has proffered the only reasonable construction of the contract’s operative provisions. Delaware law accordingly mandates that I adopt the buyer’s interpretation and ignore the extrinsic evidence.
The Sellers valiantly attempted to find places in the agreement (which after all must be read as a whole) to suggest that Buyer’s interpretation was not in fact the only reasonable interpretation, and that there was a perfectly valid interpretation that supported the Sellers’ view of the meaning of the term Closing Date Indebtedness in context of these other provisions (without necessarily relying on extrinsic evidence). Among those other provisions were the references to Accounting Rules and the fact that the EPA expressly forbade the “introduction of accounting methods, policies, principles, practices, procedures, classifications or estimation methodologies for the purpose of determining the Working Capital, Closing Cash, Closing Date Indebtedness, or Transaction Expenses that are different than the Accounting Rules.” The argument was that since the SSI debt had always been recorded under the net equity method of accounting, treating the entire SSI debt as if it were Indebtedness would be violating this provision. But after extensive analysis, the Arbitrator concluded that the Accounting Rules largely pertained to the calculation of Working Capital and could not overcome the clear definition of Closing Date Indebtedness. It is important to note here that the comparison was not to alternative balance sheets and differing methods of accounting for the debt, where the prohibition of changing methods of accounting may have had some applicability; instead this was a simple calculation of defined debt (which never mentioned applying accounting methods to determine the components of that defined debt).
There were other arguments based on isolated provisions of the EPA, including the fact that the SSI debt was listed as an Undisclosed Liability in the representations and warranties section of the EPA and, in context, Undisclosed Liabilities were stated as being in addition to Indebtedness that was otherwise included in calculation of the Purchase Price (emphasis added):
Undisclosed Liabilities. Except as set forth on Section 3.6 of the Company Disclosure Schedule [which listed the SSI debt only], neither the Company nor any of the Operating Subsidiaries have any material Liabilities, other than (a) as disclosed in, set forth on, or reflected and adequately reserved against in the Balance Sheet, (b) those incurred in the Ordinary Course of Business since the Balance Sheet Date (none of which arises from or relates to any violation of Law, tort, breach of Contract, environmental, health or safety matter or infringement or violation of Law or misappropriation or is otherwise material), and (c) those Transaction Expenses, Indebtedness, Working Capital and unpaid credit card processor’s fees, costs and expense items fully included in the calculation of the Closing Payments.
The argument was that if the scheduled SSI debt was intended to be included in the Indebtedness that was a part of the Closing Date Indebtedness deducted in determining the Purchase Price, then there was no reason to schedule it as an Undisclosed Liability in the first place. Again, the Arbitrator made short work of this argument (even though I kind of liked it) by simply noting that disclosures against representations and warranties are often broader than strictly necessary, and they don’t override the actual defined terms for purposes of calculating the Purchase Price.
The Sellers also tried to argue that SSI was not an Operating Subsidiary as of the Adjustment Time because the spinoff was supposed to happen one business day before the closing, which would have been prior to 11:59 PM PT on March 27, 2022. But the actual spinoff occurred immediately prior to the closing, which by definition was after the Adjustment Time. And the Sellers conceded at the arbitration hearing that the SSI spinoff, “without a novation from [the SSI lenders,] would not by itself discharge Save Mart’s theoretical general partner liability” on the SSI debt. With that concession, the Arbitrator was able to conclude that even if the SSI debt was not Indebtedness of an Operating Subsidiary as of the Adjustment Time, it could still qualify as Indebtedness for which Save Mart was otherwise liable (as a former general partner presumably) pursuant to clause (xi) of the definition of Indebtedness. If the spinoff did not eliminate the risk of the SSI lenders pursuing claims against Save Mart for the SSI debt, the Buyer’s financing sources must have been concerned about ongoing creditors other than the known SSI debt. In other words, the risk of Save Mart having to answer for the SSI debt directly did not appear to have been a driving concern for the Buyer or its financing sources, and there was no reason to expect that getting the benefit of a credit of $109 million against the Purchase Price (and the resulting payment of approximately $70 million to the Buyer by the Sellers) was going to result in the Buyer using that money to actually pay the SSI debt.
The Sellers also sought to reform the EPA based on unilateral or mutual mistake. Unfortunately, to prevail on these arguments, the Sellers were required to show “that the parties came to a specific prior understanding that differed materially from the written agreement.” And in this case the Arbitrator found that:
Seller fails to support this critical element. It has not produced clear and convincing evidence of a pre-existing agreement between the parties to exclude the SSI Debt from the definition of Indebtedness. To be sure, Kingswood’s original letter of intent did not include any SSI Debt in its sample Indebtedness calculation. But there is no evidence, never mind clear and convincing evidence, that the sample Indebtedness calculation caused the parties to reach a “specific prior understanding that differed materially from the written agreement.” In fact, witnesses from both sides repeatedly testified that the two sides simply never discussed the treatment of the SSI Debt in the Acquisition. This mutual silence is a far cry from the sort of clear and convincing evidence that could support a claim for reformation based on a mistake. Delaware law is clear that claims for mistake are not supported by “poor contract drafting” and “cannot save a party from its agreement to unambiguous contract provisions that later prove disadvantageous.”
The Sellers also argued that the “forthright negotiator principle” should result in a finding in favor of the Sellers. Application of the forthright negotiator principle, however, requires that there be an ambiguity in the contractual language that cannot be resolved by extrinsic evidence that leads “to a single, commonly held understanding of the contract’s meaning,” the Arbitrator noted. In such cases, “the court, in considering alternative reasonable interpretations of contract language, [may] resort to evidence of what one side in fact believed the obligation to be, coupled with evidence showing that the other party knew or should have known of such belief.” But here, according to the Arbitrator, “Buyer’s alleged lack of forthright negotiation [is] irrelevant because the EPA is unambiguous.”
Following the issuance of the final arbitration award in favor of the Buyer, the Buyer immediately sought to confirm the award in the Delaware Court of Chancery. Vice Chancellor J. Travis Laster, on February 28, 2024, in SM Buyer LLC v. RMP Seller Holdings, LLC, 2024 WL 8652024 (Del. Ch. (Trial Order) Feb. 28, 2024), granted the Buyer’s motion for summary judgment confirming the final arbitration award. In his order, Vice Chancellor Laster noted that “review of an arbitration award is one of the narrowest standards of judicial review in all of American jurisprudence.” To do so based on “manifest disregard of the law,” which was the ground asserted by the Sellers, requires “that the arbitrator (1) knew of the relevant legal principle, (2) appreciated that this principle controlled the outcome of the disputed issue, and (3) nonetheless willfully flouted the governing law by refusing to apply it.” Applying this standard, Vice Chancellor Laster concluded that:
[T]he Arbitrator strictly applied the literal words of the definition of Closing Date Indebtedness. The Arbitrator analyzed the Agreement as a whole and interpreted its language consistent with recent trends in Delaware law towards a highly contractarian jurisprudence. Given this record, it is not possible to find that the Arbitrator manifestly disregarded the law. He diligently applied the law.
But then Vice Chancellor Laster noted that even though he had to confirm the Arbitrator’s arbitration award in favor of the Buyer, he believed that “the outcome that the Buyer achieved in this case was . . . economically divorced from the intended transaction,” and that he “would have ruled differently than the Arbitrator” because:
I think the agreed-upon accounting principles and the mandate to prepare the reference statement and the final statement consistently meant that the Buyer’s adjustment was contrary to the plain meaning of the Agreement. At a minimum, I think the Agreement, read in conjunction with the Amendment and the separate treatment of the GP Interest [SSI], rendered the parties’ treatment of Closing Debt Indebtedness ambiguous.
Had the Sellers not agreed to submit this dispute to binding arbitration, they may still have had an appeal to the Delaware Supreme Court to right this apparent wrong, without the almost impossible burden of undoing the binding arbitration award. The appeal that is presumably in progress to the Delaware Supreme Court in the face of the final arbitration award is a much heavier lift than would have been the case had the final arbitration award simply been an opinion of the Delaware Court of Chancery.
This case raises some serious questions about deal-making ethics depending on who understood what and when about the potential inclusion of the SSI debt as a deduction to the Purchase Price. During my career I was once faced with a client pursuing a course of action that I believed was legally correct, but morally wrong, and my response was to refuse to represent them in the resulting dispute. Typically, sharp business practices will catch up with you eventually.
The obvious fix here, of course, was to amend the definition of Indebtedness to expressly exclude the SSI debt (and there were in fact a healthy list of exclusions to the definition of Indebtedness). That clearly should have happened. Another mitigating provision, which is often found in deals involving a private-equity-backed seller (which Save Mart was not), is to put a cap on any purchase price adjustment equal to the agreed escrow (which here was $7 million)—at least that would have resulted in a smaller ouch.
Deal lawyers tend to like Delaware’s strict contractarianism—it provides certainty that the documented deal is the deal. But that certainty can sometimes come at a cost in situations like this, particularly once an arbitrator applies that strict contractarianism.
In re Caremark Int’l Inc. Deriv. Litig., 698 A.2d 959 (Del. Ch. 1996) was a landmark decision from the Delaware Court of Chancery holding that a corporate board’s failure to assure a reasonable information and reporting system is an act of bad faith and in breach of the board members’ duty of loyalty.
Caremark articulated a two-prong standard for board member liability as follows:
The board must have utterly failed to implement any reporting information protocols over key corporate actions; and
even where such restrictions or controls are implemented, liability could nevertheless attach if the board failed to monitor or oversee relevant corporate operations.
These Caremark duties remain good law in Delaware and continue to provide shareholders with a powerful remedy in bringing derivative actions against a board, albeit one that many commentators and jurists have asserted is possibly the most difficult theory in corporate law upon which such plaintiffs might hope to win a judgment. That being said, there have been a few recent examples where plaintiffs have survived a motion to dismiss and a large derivative settlement followed.
Perhaps the most notorious of these instances resulted from In re The Boeing Company Deriv. Litig., No. 2019-0907-MTZ, 2021 WL 4059934 (Del. Ch. Sept. 7, 2021). The derivative litigation there flowed from two fatal crashes involving Boeing 737 Max aircraft. In denying the motion to dismiss, the court held that aircraft safety was a “mission critical” board oversight responsibility and that the Boeing board failed to satisfy the Caremark standards. Ultimately, the litigation settled for $237.5 million, one of the largest derivative settlements in history.
Boeing’s product safety issues remain the subject of almost daily commentary in the legal and business press. Indeed, Boeing and certain of its executives were sued earlier this year in a putative class action involving a different version of the 737 aircraft and issues apparently not related to the earlier 737 Max litigation. Without being privy to the scope of the releases the Boeing board may have obtained when the 2021 shareholder litigation was settled, it remains an open question to what extent Boeing’s current issues with 737 and other aircraft may become the subject of a new Caremark suit. To date there has been no such derivative suit.
Nonetheless, the Boeing derivative suit and a few others where board defendants were unable to prevail upon a motion to dismiss give support to the notion that Caremark theories may not be as difficult for plaintiffs as they once were. Although the success rate is still well below 50 percent, the authors estimate it is at about 30 percent. To use a baseball analogy, a .300 hitter is not considered to be a shabby foe.
It behooves a board to take cognizance of what may be the mission-critical activities of the corporation and take steps to implement and enforce protocols to ensure that those activities are properly monitored through use of executive committees or other mechanisms.
The authors, along with two other co-authors, have written in greater detail on these corporate governance issues in Corporate Governance: Understanding the Board-Management Relationship, recently published by the Business Law Section of the American Bar Association. The book provides an analysis of corporate management and the legal liability of directors and officers, and it examines how the corporate board has evolved and changed. It provides expansive discussion of shareholder derivative litigation against officers and board members at Boeing and McDonald’s Corporation, as well as other recent high-profile litigation in Delaware.
The preface of the book by Dave Gilfillan, chief claims officer at CRC Group, states, “The authors have provided a unique and focused lens in which to evaluate and understand the actions of directors and officers and their implications for corporate executives, legal counsel, business managers, stockholders, and consumers. CorporateGovernance offers a textural perspective of a complicated subject that is often misunderstood by both professionals and the public.”
Following Gilfillan’s comments, the book takes the reader into the fundamental issues of governance, oversight, and management. Chapter by chapter, it addresses economic fundamentals underlying organization governance; stress testing your organization governance structure; the evolution from tone at the top to checks and balances; why a company should consider using an executive committee of its board of directors; organization governance and information gaps: importance of internal reporting and internal information for board oversight; monitoring cash flows: the board, the CLO, and the CFO; the board, management, and the organization’s intellectual capital; and board member selection and board interaction.
Even though tender offers and other business combination transactions may involve only non-U.S. companies, such transactions may nonetheless be subject to various U.S. laws and regulations, including U.S. federal securities laws and regulations. The application of U.S. federal securities laws and regulations generally depends on how the transaction is structured, whether any of the companies is subject to U.S. securities law and reporting obligations, and whether any of the companies’ security holders are located or resident in the United States. U.S. federal securities laws and regulations are applicable to cross-border tender offers and other business combination transactions involving, in the case of a tender offer, a “target,” or, in the case of a business combination transaction not involving a tender offer, a “subject company” that is organized in a jurisdiction outside the United States.
“Tender offer” refers generally to an offer by a bidder to acquire shares of another company, whether for cash or securities or a combination of the two, that is made directly to security holders of the target company and may or may not be supported by management of the target company. References to a “business combination transaction” mean a combination of two entities’ businesses by means of a tender offer or otherwise.
A fundamental goal of the U.S. securities laws is the protection of U.S. investors. The SEC has historically taken the view that U.S. securities laws potentially apply to any transaction that is conducted in the United States or that employs U.S. jurisdictional means. Specifically, U.S. securities laws may be implicated as follows:
The general anti-fraud provisions of the U.S. Securities Exchange Act of 1934, as amended, may be violated where fraudulent conduct occurs in the United States or where the effects of the fraudulent conduct are felt in the United States.
If a tender offer is made for securities of a class that is registered under the Exchange Act, it is generally necessary for the bidder to comply with the tender offer provisions of the Exchange Act, subject to available exemptions, if any.
Even where the target company does not have a class of securities registered under the Exchange Act, the Exchange Act proscribes certain “fraudulent, deceptive, or manipulative” acts or practices in connection with tender offers that are potentially applicable.
If securities are to be offered to persons in the United States, it may be necessary to register such securities pursuant to the U.S. Securities Act of 1933, as amended, or to confirm the availability of an exemption from registration.
U.S. federal securities laws apply to a tender offer or other business combination transaction notwithstanding the nationality of the bidder or target or the protections afforded by their respective home market regulators if extended to holders in the United States. This approach contrasts with the approach taken in many European jurisdictions, where the jurisdiction of the organization of the target or the jurisdiction of its primary listing, rather than the residency of the investors or the means by which the offer is made, will determine the regulatory implications of the transaction. For instance, the United Kingdom’s City Code on Takeovers and Mergers applies to offers for all public companies, whether listed or unlisted, resident in the United Kingdom, the Channel Islands, or the Isle of Man; South African takeover regulations apply to companies that are deemed to be resident in South Africa; and in France, the rules relating to tender offers generally apply only where the target company is a French entity listed in France—the residency of the shareholders of the target is irrelevant.
Rule 802 is an exemption for the issuance of shares in an exchange offer. To qualify, the target must be a foreign private issuer with a U.S. shareholding of less than 10 percent. There are also exemptions for Canadian companies in the Multi-Jurisdictional Disclosure System. Section 3(a)(10) of the Securities Act provides an exemption for the issuance of shares in connection with a business combination pursuant to a court order.
There are two tiers of cross-border exemptions to U.S. tender offer rules. Tier I applies in the following circumstances:
The transaction is a tender offer for the equity securities of a target company that is a foreign private issuer.[1]
Fewer than 10 percent of the target company’s shares are held by U.S. residents.
In the case of a Tier I offer, the bidder is exempt from the following procedural requirements:
the rules governing the duration of the tender offer and extensions;
the prompt payment requirement;
restrictions on purchases outside of the tender offer; and
the rules governing the response of the target company.
Tier II applies in the following circumstances:
The offer is a tender offer for the equity securities of a target company that is a foreign private issuer.
More than 10 percent but less than 40 percent of the target company’s shares are held by U.S. residents.
In the case of a Tier II offer, the bidder is exempt from the following procedural requirements:
the rules governing notice of extensions;
the prompt payment requirement;
the prohibition on early termination of the tender offer period; and
the prohibition on purchases outside of the offer.
