Current Tax Issues with Captive Insurance Companies

Posted on February 18, 2014 by - Uncategorized

Large U.S. companies have been forming captive insurance companies (wholly owned insurance subsidiaries) since the 1950s. In general, such large captives are formed for one of three main reasons. First, some companies are unable to obtain necessary insurance coverage. For example, certain nuclear power companies formed a captive named Nuclear Electric Insurance Limited, because they could find no other insurance coverage. Second, some companies seek to obtain cheaper insurance. For example, the trucking market is currently “hardening” (premiums are increasing), leading to trucking companies forming captives. Third, some companies seek to gain more control over their current insurance program. 

The insurance code offers a small insurance company a strategic advantage: Internal Revenue Code (IRC) § 831(b) allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income. As a simple example, suppose a small insurance company had $500,000 in income but earned 5 percent on its total portfolio earning $25,000 for the year. The company would use the $25,000 figure as their gross income figure for the year. 

A captive can also be formed offshore and still be deemed a U.S. captive, provided it makes an IRC § 953(d) election agreeing to be taxed as a domestic company. For many large captives, forming offshore may provide a great deal of flexibility not found onshore. However, it should be noted that the Internal Revenue Service (IRS) is currently spending a great deal of time focused on offshore tax enforcement. Recently, the IRS refused to issue a positive private letter ruling to a number of foreign captives seeking 831(b) status, which may be an indication of tougher IRS scrutiny in this area. Thus, while a compliant captive should ultimately have nothing to fear from operating internationally, there is at least some chance that doing so may result in some additional compliance costs if it gets caught up in the IRS dragnet. 

This article will: (1) provide a brief history of captive insurance companies; (2) outline key requirements for captive insurance including insurance risks, risk shifting, risk distribution, and reinsurance; and (3) discuss certain IRS enforcement areas in captives, including excessive premiums and IRC § 831(b) tax shelter issues.

A Short History of Captive Insurance Companies

The IRS defines a captive insurance company as a “wholly owned insurance subsidiary.” According to the case law of that time, companies started forming captives in the 1950s because they couldn’t find insurance, could only find very expensive insurance, or simply decided that forming their own insurance company made more sense. The taxpayers in both United States v. Weber Paper Co., 320 F.2d 199 (8th Cir. Mo. 1963) and Consumer’s Oil Corp. of Trenton, NJ v. United States, 188 F. Supp. 796 (NJ 1960) owned property for which they could not procure flood insurance, leading both to form an insurance company. While the taxpayer in Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. Kan. 1986) did have an insurance policy, its carrier had complete control of its attorneys during litigation. When Beech was sued under a products liability claim in the early 1970s, it filed a motion to remove its insurer-appointed counsel several weeks before trial. The court denied this motion and Beech lost the case. Subsequently, Beech formed a captive to write its own insurance policy. Other cases provide similar examples. 

The IRS was concerned by the rise of captive insurance for two inter-related reasons. Their first concern was that the “captive insurer” was in fact a reserve account, defined as “an estimate of a definite liability of indefinite or uncertain amount.” While there is a certain amount of conceptual overlap between a reserve account and insurance (in both, a party is attempting to financially prepare for an anticipated contingency), contributions to a reserve account are non-deductible while premium payments are deductible. This leads to the IRS’ second concern – the rather uncertain nature of the legal definition of insurance. While the Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (U.S. 1941) defined insurance in 1943 as being comprised of both risk shifting and risk distribution, it provided no further guidance for either term. Hence, the IRS could legitimately argue that the captive insurance company was not in fact a bona fide insurance company but instead a reserve account, allowing the IRS to deny the deduction claimed by the parent company for the premium paid to the captive. 

Captive litigation can be broken down into pre- and post-Humana v. Commissioner, 88 T.C. 197 (1987). From the late 1970s to the late 1980s (pre-Humana) the IRS won a majority of their cases due to better preparation, weak taxpayer defenses, and a judiciary unaccustomed to dealing with the technical requirements of insurance. The Humana decision changed this, as the structure was well set-up and expertly defended and explained by counsel, leading to a partial taxpayer victory. Between Humana in the late 1980s and United Parcel Service of America v. Commissioner, 254 F.3d 1014 (11th Circuit 2001) in the early 2000s, the IRS lost most of its cases as taxpayers established better structures, these structures were better defended, and several states passed captive insurance-enabling legislation. The death knell for this initial wave of IRS captive litigation was the UPS decision, which the IRS won at trial based on an assignment of income argument, but which the appeals court disagreed with in a tersely worded decision, in which it reversed the tax court’s ruling and remanded for further action. Following the UPS case, the IRS largely ended its initial quest of litigating to prove the invalidity of captive insurance.&nbsp

Insurance Risks, Risk Shifting, and Risk Distribution

Counsel interested in recommending a captive to a client needs to be aware of several basic concepts, the first of which is derived from The Harper Group v. Commiss’r, 96 T.C. 45, 47 (1991), which states that all captives must comply with the following three factors: (1) the arrangement involves the existence of an “insurance risk”; (2) there is both risk shifting and risk distribution; and (3) the arrangement is for “insurance” in its commonly accepted sense. Points one and three can be reworded to simply say all captives must function as insurance companies; the insured must demonstrate it will be materially harmed (usually through financial loss derived from an ownership interest), and that the harm is “fortuitous” – one which is random and cannot be prevented. 

Risk shifting and risk distribution are a bit more complicated. Risk shifting is seen from the insured’s perspective and requires the risk of loss to “shift” from the insured to a third party. This is accomplished via an insurance policy (whose formation and terms are interpreted under basic contract law principles). Risk distribution is seen from the insurer’s perspective, and requires the insurer to pool risk from a sufficient number of resources such that losses smooth out over time. Non-compliance with either of these factors comprised the “economic family argument,” the IRS’ primary anti-captive weapon. 

Reinsurance or Safe Harbor IRS Revenue Rulings

One of the largest benefits of a captive is the ability to access the reinsurance market. Reinsurance is often called “insurance for insurance companies” as it allows insurers to spread out the risk of their own portfolios. For example, suppose an insurer was exposed to $5 million of potential claims for the year. The insurer could purchase reinsurance, thereby lowering its risk exposure. In our example, the insurer could purchase reinsurance that covered risks of about $2,000,000. Therefore, if the parent company had losses over $2,000,000, the reinsurer would be liable. 

The IRS has provided two safe harbors for captive insurance companies that decide not to use traditional reinsurance. All captives that wish to take advantage of a safe harbor must comply with one of two fact patterns outlined in specific IRS Revenue Rulings. In Rev. Rul. 2002-89, the captive insurer must derive at least 50 percent of its revenue and risk from a non-parent. For smaller captives, this is usually accomplished through the use of “risk pools” wherein a group of captives shares a portion of their risk with other captives, usually managed by the same captive management company. Participation is usually accomplished through a quota treaty retrocessional reinsurance arrangement. In Rev. Rul. 2002-90, a captive must underwrite risk for at least 12 different subsidiaries, with none comprising less that 5 percent nor more than 15 percent of the total risk underwritten by the captives. 

Excessive Premiums

One area that is currently being litigated by the IRS is excessive premium payments beyond what is reasonable for the claimed insurance risks. The IRS has a few cases in the U.S. Tax Court pipeline that address this issue, so it would not be unexpected that more such cases will follow. The IRS is concerned with transactions in which the tax deduction claimed is actually the reason for the existence of the policy. Treasury Regulation § 1.801-3(a) provides that an insurance company is “a company whose primary and predominant business activity . . . is the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies.” When the captive charges commercially unreasonable or non-arm’s length premiums, it may not be treated as bona fide insurance company. Thus, if the true purpose of an insurance company is to provide tax deductions, then the company may not qualify as an “insurance company” under the IRC. 

In the area of small captives, the existence of a $1.2 million maximum premium payment makes this type of analysis particularly relevant. The IRS requires that a captive operate as an actual insurance company in order for it to receive the economic benefit allowed under IRC § 831(b). It is important to remember that the $1.2 million can purchase a large amount of commercial insurance, so any small captive claiming policy premiums of that size may come under IRS scrutiny unless it has a very significant amount of provable potential claims.

IRC § 831(b) Tax Shelter Issues

The IRS is aware of certain questionable tax shelter practices in the captive world, especially in connection with small IRC § 831(b) captive insurance companies. While these arrangements are certainly a minority of the larger pool of compliant captives, it is worth noting some of the more prevalent IRS tax shelter issues here. 

Some IRC § 831(b) captive policies insure risks that are unrealistic with respect to the insured business. Specifically, certain insurance risk pools centered on terrorism are currently attracting increased IRS attention. The concern arises here because so few businesses may actually have the need for insuring against a terrorist act, making this coverage appear to be too remote to be justified for most insureds. While there are certainly business operations that involve terrorism risk, there are also many businesses that do not have this risk. 

The IRS has also become aware of the use of life insurance in IRC § 831(b) captives as a pre-ordained investment. Since life insurance is not generally a deductible business expense, the concern here is that the IRS may see a pre-planned use of an IRC § 831(b) captive as a conduit for life insurance as both undermining the business purpose of the captive, as well as a device for taking a deduction that the business could not otherwise take directly. The judicial doctrines and codified economic substance doctrine could be applicable here. 

Since an IRC § 831(b) captive may result in the deferral of realization of ordinary income, over a long period of time, this type of captive may accumulate a very large amount of retained resources. Because a captive is taxed as a C corporation, this type of large reserve could be subject to the Accumulated Earnings Tax (AET). The AET is a 15 percent penalty tax designed to prevent corporations from unreasonably retaining after-tax earnings and profits in lieu of paying current dividends to shareholders. Accumulated taxable income is reduced by a credit for an accumulation amount sufficient to satisfy reasonable current and future anticipated business needs. 

Conclusion

Captive insurance companies have been around since the 1950s and are currently a popular alternative vehicle for insuring risks associated with businesses. There are several key requirements that must be met for captive insurance to be deemed proper by the IRS. These include insuring real risks, shifting the risk from the insured business to the insuring captive, and the captive distributing the shifted risk among several other captive insurance companies. The IRS has raised specific tax issues that are currently the subject of IRS enforcement actions. These include the payment of excessive insurance premiums, as well as several IRC § 831(b) tax shelter issues. Overall, captive insurance may be an excellent insurance option for midsize and large businesses, provided that the professionals structuring the arrangements comply with IRS requirements in connection with the formation and maintenance of the captive insurance company.

 

 

 

 

Choice of Domicile in Captive Insurance Planning

Posted on February 18, 2014 by - Uncategorized

A captive insurance company in its most typical form is essentially a new subsidiary that is created by a parent company to underwrite the insurance needs of its operating subsidiaries. The basic idea of a captive is to bring in-house the purchasing of insurance that was previously done from unrelated commercial insurance companies, and retain the underwriting profits for the benefit of shareholders. But even beyond that, captive insurance companies fulfill a large role in making the entire enterprise focus on the management of its various risks of loss and incurring liabilities. 

The factors that go into the decision to form a captive insurance company, and the steps to do so, are beyond the scope of this article and are well-treated elsewhere. This article will focus upon a critical inquiry that is inherent in the captive creation process, which is the choice of the jurisdiction where the captive will be formed and domiciled. 

Captive insurance companies were originally formed outside the United States, usually in well-known debtors’ havens such as Bermuda, the Cayman Islands, and the British Virgin Islands. This is because of a perception that there were certain potential local tax benefits to being formed in those domiciles, but much more importantly, because the U.S. states did not have captive legislation, and instead treated captives like normal commercial carriers. Doing so made little practical sense, insofar as normal commercial carriers are subject to a wide swath of laws designed to protect the general public, such as requiring large amounts of capital and reserves, public filing of policies, and making premium rate requests. These requirements were, of course, nonsensical in the captive context where there is little need to protect the operating subsidiaries from the captive insurance company ultimately owned by the same parent. 

Vermont cracked open the door to captives in 1981, and through sheer persistence and aggressively changing its laws to match or exceed those of the offshore havens in favorability, was able to hold its own and grow its captive business against the likes of Bermuda. The IRS kicked the door wide open in 2002, following its landmark loss in United Parcel Service v. C.I.R., 254 F.3d 1014 (11th Cir. 2001), by issuing Revenue Rulings 2002-89, 2002-90, and 2002-91, that not only recognized the fundamental legitimacy of a properly structured and operated captive insurance arrangement, but also created safe-harbors in the confused area of risk distribution. Numerous states then flooded the captive marketplace – 37 states as of this writing – by passing captive insurance enabling legislation. 

It should be noted that for most tax purposes, there is little difference between an offshore captive (one formed outside the United States) or a domestic one, since the vast bulk of captives make the election under Tax Code § 953(d) to be treated as a domestic company. These days, the reasons for a captive to “go offshore” most often relate to those relatively few captives that for tax reasons do not make the § 953(d) election (captives owned by charitable organizations, for instance, have tax reasons for wanting to be taxed as a controlled foreign corporation instead), or captives where financial privacy or practical immunity to the enforcement of a domestic judgment is at a premium. 

The analysis and planning that goes into the formation of a captive insurance arrangement may be likened to the solving of a Rubic’s cube, where decisions must be made that will affect several or all sides, and some key issues must be resolved at once as if some juridical algebra problem. Most often, the question of where the captive should be domiciled is one of the last – not first – issues to be resolved. This is because the resolution of other issues, such as availability of capital, specialty lines of insurance to be written, and particular needs for flexibility in the investment of the captive’s assets, quite often lead to the choice of a particular domicile. There is rarely a need for prospective captive owner to choose the domicile as a first step, and indeed to do so can lead to missed opportunities if the captive arrangement could have been more efficient if formed elsewhere. 

But even beyond that, the issue of state taxation of premiums now most often resolves the issue – particularly if the captive owner is headquartered in one of the ever-increasing number of captive-friendly states. In the past, states paid little attention to their fiscal losses occasioned by captive insurance, mainly for the reasons that the very concept of captive insurance was little known to the state tax authorities, and payments to captives (as opposed to ordinary commercial insurance carriers) are inherently difficult for state field auditors to pick up. While some states have long been aggressive in taxing the premiums paid to captives (Texas is probably the best example of this), it has only been recently that other states have taken note of their own fiscal losses and have grown more aggressive in taxing the premiums paid to captives. Yet, at the same time, when a state passes new captive insurance legislation, in order to make that state’s laws more attractive to new captive formations, the state will usually exempt or substantially limit the taxes on premiums paid to its in-state captives. This creates a very powerful incentive for new captive owners to choose their own state (if it is friendly to captives) to form their captive, and puts pressure on existing captive owners to bring their captives back home. 

So, the default rule might be well be – if it isn’t already – the best domicile to form your captive is the one you are in. This disregards, however, that some states such as California and Washington do not yet have captive enabling legislation, while other states have either done little or nothing to implement their legislation, or have implemented it very poorly. The upshot of this is that many prospective captive owners will have to look beyond their state’s borders for a place to land their new insurance company. It is for these owners and their advisers that the factors discussed below will be of the most importance. 

It would be easy enough at this point to dive into a discussion of the technical nuances of the laws of various jurisdictions. That would not do the subject proper justice. Long experience has shown that the single most important factor in choice of domicile for a captive is not any specific statute or regulation, but that of the amenability of the insurance regulators in the domicile to working with captive owners to make the arrangement a success. Laws and regulations are only so good, or bad, as they are interpreted by their regulators, and in the case of captives this typically means the insurance commissioner’s office or equivalent. 

Very simply, a bad insurance commissioner’s office can make hash out of the best captive laws and regulations with the result that the captive owner becomes quite miserable. A good insurance commissioner’s office can, by contrast, work through mediocre laws and regulations to make captives in the state a happy success. Of course, no chart could adequately spell out the differences in how these regulators treat captives, and any such chart would be obsolete as quickly as the personnel changes occurred in the insurance commissioner’s office, which they do with some regularity. Suffice it to say that the best information about regulators must be obtained anecdotally from captive managers and other captive professionals who have done business in the state, while noting that the regulators of some states have a long and consistent history of favorable treatment of captives, while other states have undergone uncomfortable fluctuations dependent upon whomever is in charge at a given time. 

With that caveat firmly in mind, we turn to an examination of the statutory and regulatory factors that go into domicile selection for captives. What we will see is that the specific requirements of each jurisdiction are very similar. There is a good reason for that, which may be accurately expressed in a single word: competition. To vie for business, the various domiciles must offer regulations that are as, or more, favorable than that of competing jurisdictions. One may attribute Vermont’s long run of success to the fact that its state legislature, mindful that the captive sector is its second largest industry, has demonstrated a willingness to quickly consider and pass cutting-edge legislation so as to keep Vermont’s captive laws competitive with those of other jurisdictions. 

Minimum capitalization, i.e., how much cash the captive will need to qualify and stay qualified for its insurance license, is a significant factor of consideration in choosing a domicile. Obviously, the less money that a captive owner has to tie up in the captive, which moneys may be deployed to greater returns elsewhere, the more efficient the captive arrangement will be. Thus, captive domiciles compete for business by lowering their capital requirements to certain minimum amounts. 

It is here that our Rubic’s cube reappears, where we have to solve more than just one side of the puzzle at once. Although captive owners naturally desire to place as little capital as possible in their captive, the requirements of tax law must be taken into consideration. For tax purposes, one of the elements to establish the existence of an insurance contract is the requirement of “risk shifting,” which posits that the captive must have more risk of loss than simply the premium that it takes in from its insured. The captive must have, the slang goes, enough of its “own skin in the game” such that it can satisfy claims against a policy over and above the premium received. 

Thus, there are both actuarial and tax variables in the minimum capitalization equation. From the actuarial side, the limits on the maximum potential losses that the captive may underwrite – and thus policy limits – are limited by some combination of the total premiums to be received by the captive, loss expectancy, existing reserves, and capitalization. Plus, while the IRS has provided painfully little guidance on what constitutes minimum capital for tax purposes, it seems (largely anecdotally) that the captive’s capital should not be less than one-third of the premiums received in any given year, i.e., as it is usually articulated, premiums should not exceed capital by a ratio of greater than 3:1. 

There seems to be an accepted exception to this ratio for the first year of a captive’s existence, when the ratio of premiums to capitalization should not exceed 5:1, and which takes into consideration that relatively few claims are likely to have matured to where they will require payment in the first year. It is this 5:1 ratio that has worked to set the standard for minimum capitalization in most captive domiciles. The vast majority of captives start out as companies that make the Tax Code § 831(b) election, which means that the captive will not be taxed on its premium income so long as its premiums received do not exceed $1.2 million during the year. Applying the 5:1 ratio to $1.2 million results in a minimum capitalization requirement for tax purposes of $240,000 (which has been rounded up for statutory purposes to $250,000), which represents by far the most common minimum capitalization requirement of domestic domiciles. The states that have higher statutory minimum capital requirements are usually avoided by captive owners. 

However, not all new captives will take in the maximum amount of $1.2 million in premiums the first year, and this is where regulatory flexibility to lower the minimum capital for the first year only can be a very significant advantage for a captive domicile. These exceptions are created by the very practical recognition that by the second year, the premiums paid in the first year for the first year’s policies which have not expired, will be available to apply toward the statutory minimum. 

Offshore domiciles often have much lower minimum capital requirements (Nevis only requires $10,000 in capital for a single-owner captive) in consideration that many of the captives they form will not be subject to the minimum capitalization requirements for U.S. tax purposes, as their owners will often have little or no connection to the United States. But again, the statutory minimum capital requirements are but one side of the captive Rubic’s cube for U.S. taxpayers. 

Investment flexibility, i.e., the particular domicile’s rules about how the captive’s assets may be deployed, is a very significant factor in choosing a captive domicile – some might suggest the single most important factor. Non-captive commercial insurance companies are usually subject to “permitted asset” rules, which are an exhaustive list of the things that such insurance companies may invest in, so as to help protect the financial health of those companies from speculative investments (and also the state insurance fund from having to take over the liabilities of an insolvent carrier). The investment rules relating to captives can be much more flexible, and it is here that the domiciles have an opportunity to really compete against each other. 

Prior to the 2008 crash, which resulted in the liquidation of not just a few captives whose investments had failed, the investment rules relating to captives were typically very lax. The typical statement was that an investment was appropriate, “so long as it does not threaten the minimum liquidity of the company.” In application, this had an “almost anything goes” air, and led to captives making all sorts of creative, speculative, but often ill-advised investments, of their assets. 

After the 2008 market crash, many regulators started to the take back the reins over captive investments. This has been most commonly seen in how regulators view a large, single investment that comprises a large percentage of the captive’s overall assets, say over 30 percent – regulators now often cringe when so many of the captive’s eggs are be placed in one basket, and may either refuse to approve the investment or require additional capital to be infused into the company. But it is also seen in regulators occasionally requiring that certain captives abide by the very regimented investment restrictions for non-captive commercial carriers. 

As with so many things in the captive sector, the best information regarding a domicile’s investment flexibility is not necessarily found in its laws or regulations, so much as learned anecdotally from conversations with captive managers and owners of existing captives in that state. It should also be noted that investment flexibility in a particular domicile has the potential to change literally overnight as personnel changes in the insurance commissioner’s office bring different attitudes about how captives should be safely investing their assets. This issue can be a moving target, and more than a few captives have left particular domiciles and migrated elsewhere when they felt that investment restrictions had become too strict. 

Infrastructure support, i.e., the ability of the insurance commissioner’s office to effectively handle captives, is also a very important consideration. Newer domiciles in particular are often unwilling to extend adequate funding to the captive division within the insurance commissioner’s office until the economic benefits of captives within the state have been established. Indeed, while 37 states have passed captive enabling legislation, probably a third or so of these states could be said to have adequately funded their insurance commissioners to allocate resources for separate captive regulators; this is why captive development is stillborn in those states. 

On the other hand, the legislatures of the handful of states that lead the sector in the number of captives domiciled have seen the economic benefits of captives and have well-funded their insurance commissioners’ offices to properly administer them. These states have independent “captive deputy commissioners,” full time staffs, and quality financial analysts and examiners who are highly experienced with captives and their peculiar needs. 

But infrastructure support is not just limited to the insurance commissioner’s office. The best domiciles will have many quality captive managers who have been at least minimally vetted by the commissioner, and a cadre of other professionals such as accountants and attorneys who are likewise familiar with captives in that state. The availability of numerous of these captive service providers and professionals gives captive owners both the ability to choose between numerous competent providers and professionals, and the benefits of competition between them to drive down the pricing of their services.

In summary, there is quite a bit of analysis that goes into the selection of the domicile for a captive insurance company, and much of that analysis will be based on anecdotal information obtained from others who have practical experience in particular domiciles. The resolution of other considerations in the planning of the captive will quite often require the elimination from consideration of certain (if not many) domiciles, and make the choice of domicile in the end that much easier. But even if the grass appears greener on the other side of the fence, strong consideration to forming the captive in the state where the operating business is located now should always be made, even if that state’s captive laws and regulations are not the best.

 

Revisiting MAE MAC Clauses in M&A after Cooper T

Posted on February 18, 2014 by - Uncategorized

In what is now a familiar scenario, a megamerger unravels after post-signing events make the target less attractive to the acquirer, the acquirer develops considerable buyer’s remorse, and the target accuses the acquirer of delaying the deal.  If the acquirer has failed to negotiate a termination right triggered by the unforeseen events and also possesses an obligation to close, then the target may have a viable claim for breach of the merger agreement arising from the acquirer’s intentional delay. 

This fact pattern unfolded after Cooper Tire & Rubber Company announced a proposed $2.5 billion sale of the company to Apollo Tyres Limited (Apollo Tyres) in June 2013. The United Steelworkers (USW) asserted that the proposed merger required a renegotiation of the union’s contract with Cooper. After Apollo Tyres conditioned its participation in negotiations with the USW on Cooper accepting a $9 reduction in the deal price of $36, Cooper filed an action in Delaware. Cooper argued that Apollo Tyres breached a covenant to use its “reasonable best efforts” to obtain approvals required for closing. In Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd., C.A. No. 8980-VCG (Del. Ch. Nov. 8, 2013), the Delaware Court of Chancery rejected Cooper’s claims that Apollo Tyres breached the merger agreement, but cautioned Apollo Tyres against continuing to use the union issues to renegotiate the deal price. Cooper terminated the merger agreement in December 2013. 

The Cooper fact pattern was reminiscent of the events that unfolded after Hexion Specialty Chemicals, Inc., and its parent, Apollo Global Management, LLC (Apollo), agreed to acquire Huntsman Corp. in 2007. During the period between signing and closing, Huntsman reported disappointing earnings, and Hexion attempted to extricate itself from the transaction by claiming that Huntsman had suffered a material adverse effect and would be insolvent post-closing. In subsequent litigation, the Delaware Court of Chancery found that the changes in Huntsman’s financial performance did not constitute an MAE. Apollo Global Management, LLC v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008). 

More recently, the Delaware Court of Chancery found that short-term changes in financial results could conceivably constitute a material adverse effect under an acquisition agreement for purposes of a motion to dismiss against a backdrop of allegations of fraudulently misconduct by the sellers of a privately-held business. Osram Sylvania, Inc. v. Townsend Ventures, LLC, C.A. No. 8123-VCP (Del. Ch. Nov. 19, 2013). 

The acquirer’s typical protection against undesirable risks from significant changes in the target’s business between signing and closing is the material adverse effect or “MAE” clause. As more fully outlined below, these cases suggest that short-term, forward-looking elements of the MAE definition in merger agreements merit more attention by deal practitioners. 

Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd.

Background

This case arose after labor issues in both the United States and China threatened to unravel Apollo Tyres’ proposed $2.5 billion buyout of Cooper. Workers seized Cooper’s largest Chinese facility in July 2013, rendering it unlikely that Cooper could deliver timely, interim financial statements to Apollo Tyres. In addition, the USW filed an arbitration proceeding in Tennessee, alleging that the merger agreement violated the union’s collective bargaining agreements with Cooper. Thereafter, an arbitrator issued an order, preventing Cooper from consummating the merger absent renegotiation of its agreements with the USW. As a result, Apollo Tyres and Cooper agreed not to close the merger until the union contracts had been renegotiated. Subsequently, Cooper lowered its forecasted profits for 2013 by one-third, largely as a result of the labor issues. Thereafter, Apollo Tyres made some attempts to renegotiate the USW contracts (without Cooper’s input), but eventually halted negotiations because Cooper would not agree to a reduction in the merger price. Cooper estimated the cost of the USW developments to be about $10 million over six years, while Apollo Tyres argued that the economic effects would be more severe, warranting a $9 per share decrease in the merger consideration. 

In October 2013, Cooper initiated this action, alleging that Apollo Tyres breached Section 6.12 of the parties’ merger agreement by failing to use its “reasonable best efforts” to renegotiate the USW contracts. Cooper focused on Apollo Tyres’ decision to condition its participation in negotiations with the USW on a reduction in the merger price despite the parties’ exclusion of the impact of the announcement of the merger on Cooper’s relationship with its labor unions from the events that would constitute a material adverse effect. Cooper also had listed the possible renegotiation of the USW contracts on its disclosure schedules. 

The Court’s Decision 

Although the court found that Apollo Tyres did try to use the developments with the USW, the events at Cooper’s Chinese facility, and Cooper’s disappointing interim financials to reduce the merger consideration, it found no breach of Section 6.12. The court reasoned that Apollo Tyres possessed a good-faith but erroneous belief that the developments with the USW might constitute a material adverse effect under the merger agreement. The court also found no evidence that Apollo Tyres otherwise dragged its heels in violation of the reasonable best efforts covenant. Specifically, the court found persuasive evidence that Apollo Tyres’ executives and its hired experts immediately travelled to Tennessee to meet with the USW after learning of the arbitrator’s order and held meetings over the next several weeks with the USW. The court also found convincing the testimony of the experts hired by Apollo Tyres on the issue of whether Apollo Tyres had used its “reasonable best efforts” to reach the required agreement with the USW. 

However, in dicta, the court found unavailing Apollo Tyres’ position that it could continue to use the USW developments to renegotiate the deal price without breaching the reasonable best efforts provision given the parties specifically carved out union developments from the definition of an MAE. Subsequently, Apollo Tyres notified Cooper that financing was unavailable, and Cooper terminated the merger agreement. 

Apollo Global Management, LLC v. Huntsman Corp.

Background 

In July 2007, Hexion agreed to acquire all outstanding shares of Huntsman for $10.6 billion. Because Hexion had been eager to be the winner of a competitive bidding process, the merger agreement contained no financing contingency, and Hexion agreed to use its “reasonable best efforts” to consummate the financing, which was being provided by Credit Suisse and Deutsche Bank. In addition, the merger agreement entitled Huntsman to uncapped damages if Hexion “knowingly and intentionally breached” its covenants under the merger agreement. An MAE/MAC clause permitted Hexion to terminate the merger agreement upon the “occurrence, condition, change, event or effect that is materially adverse to the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole.” 

During the period between signing and closing, Huntsman reported several disappointing quarterly results, missing the numbers it projected at the time the deal was signed. Huntsman’s first-half 2008 EBITDA was down 19.9 percent year-over-year from its first-half 2007 EBITDA, and its second-half 2007 EBITDA was 22 percent below the projections Huntsman presented to bidders in June 2007 for the rest of the year. After receiving these financials, Hexion and Apollo began exploring options for extricating Hexion from the transaction. Initially, Hexion focused on arguing that Huntsman had suffered a material adverse effect. Subsequently, Hexion explored ways to disrupt the financing. Hexion (through Apollo) sought a written opinion of Duff and Phelps of the likely insolvency of the combined companies post-closing. After obtaining such an opinion, without any input from, or the knowledge, of Huntsman’s management, Hexion forwarded it to Credit Suisse and attached the opinion to the complaint that the company filed in Delaware. Plaintiffs sought a declaration that: (1) Hexion possessed no obligation to consummate the merger if the combined companies were insolvent, and (2) Huntsman had suffered a material adverse effect. Huntsman counterclaimed and sought, among other things, specific performance of the merger agreement. After the filing of the Delaware litigation, Credit Suisse and Deutsche Bank pulled their financing. 

The Court’s Decision 

In reviewing the parties’ claims, the court began with Hexion’s argument that its obligation to close was excused as a result of Huntsman suffering a material adverse effect. As quoted above, the definition of a “material adverse effect” did not specifically cover changes in short-term prospects. Accordingly, under Delaware law, the court was required to presume that Hexion was purchasing Huntsman as part of a long-term strategy. While Huntsman’s interim performance may have been “disappointing,” the court was unable to conclude that a change “consequential to the company’s long-term earnings over a period of years” had occurred. According to the court, at best, Hexion’s projections predicated Huntsman’s 2009 EBITDA to be 3.6 percent lower than expected at the time of the execution of the merger agreement. 

The court found that Hexion intentionally breached its covenant to use its “reasonable best efforts” to consummate the financing for the following reasons. First, the court found the mere fact that Hexion failed to approach Huntsman about the possible insolvency of the combined entity before engaging Duff and Phelps to render an insolvency opinion constituted an intentional breach of the merger agreement. Second, the court found Hexion intentionally breached the merger agreement by publishing the solvency opinion (both by filing it with a complaint and by sending it to Credit Suisse). The court also confirmed that the solvency of the combined entity was not a condition precedent to any of Hexion’s obligations under the merger agreement. However, the court found that it could not order Hexion to close. The merger agreement provided that, in circumstances where Hexion was obligated to consummate the merger, but had not: “Huntsman shall not be entitled to enforce specifically the obligations of [Hexion] to consummate the Merger.” The court therefore ordered Hexion to perform its obligations under the merger agreement, other than the obligation to close. 

In December 2008, Apollo and Hexion agreed to pay Huntsman $425 million to settle the litigation, in addition to a $325 million breakup fee. 

Osram Sylvania, Inc. v. Townsend Ventures, LLC

Background 

In September 2011, plaintiff Osram Sylvania Inc. (OSI), a preferred stockholder of Encelium Holdings, Inc. (Encelium), agreed to purchase all of Encelium’s common stock from Townsend Ventures, LLC, and members of Encelium’s management (Townsend) for $47 million pursuant to a stock purchase agreement (the SPA). In the months leading up to the execution of the SPA, Townsend provided OSI with a management presentation which included Encelium’s historical financials and some forecasts. The management presentation revealed that Encelium had a negative EBITDA for calendar year 2010, but projected sales for the calendar year 2011 of approximately $18 million. The management presentation also disclosed that two of Encelium’s employees were responsible for approximately 32 percent of the forecasted sales for 2011. In early July 2011, Townsend reported to OSI that Encelium’s actual sales for the second quarter of 2011 were consistent with the forecasted sales numbers contained in the management presentation. Further, Townsend forecasted sales of approximately $4 million for the third quarter of 2011. In October 2011, the stock sale closed. 

After the closing, OSI learned that Encelium’s sales for the third quarter of 2011 were only $2 million, or approximately one-half of defendants’ estimates. According to OSI, Townsend knew Encelium’s actual sales results for this period prior to closing, but concealed the company’s underperformance. OSI also alleged that defendants manipulated the second quarter 2011 numbers to conceal underperformance. Specifically, OSI contended that defendants: (1) held invoices for payment, (2) billed and shipping excess product to create reportable revenue (without disclosing the credits to be applied), and (3) failed to disclose discount policies to inflate revenues. Encelium also allegedly failed to disclose that its top two salespeople resigned during the summer of 2011. OSI supported its allegations with an Encelium internal e-mail, in which one of the defendants stated: “[G]iven where sales are going the distraction with senior management is far too great to keep up any charade on the chance that a deal does happen.” 

Based on the foregoing, OSI contended that Townsend breached numerous provisions of the SPA, including representations relating to the accuracy of Encelium’s financial statements and the absence of a material adverse effect or change. OSI also claimed that Townsend breached Section 6.4 of the SPA, which required defendants to notify OSI of any fact or circumstance that occurred during the period between signing and closing, which had or would reasonably be expected to have, individually or in the aggregate, a material adverse effect. OSI also included counts of fraud in its complaint. 

The Court’s Decision 

In reviewing OSI’s claims, the court found that OSI adequately pleaded breaches of a number of Townsend’s representations and warranties under the SPA, including Sections 3.5(c) (warranting that the company had been run in the ordinary course of business and that there had been no MAC/MAE since the end of the second quarter of 2011), Section 3.7 (warranting that there had been no event or change since December 31, 2010, that resulted in, or would reasonably be expected to result in an MAC/MAE), and 3.5(b) (warranting the accuracy of the financial statements from 2008 through the second quarter of 2011). 

The SPA defined an MAE/MAC as “any effect or change . . . that would be materially adverse to the Business, assets, condition (financial or otherwise), results or operations of [Encelium].” Here, the court found that it was reasonably conceivable that certain of Encelium’s business practices, such as the billing and shipping of excess product during the months preceding the signing of the SPA, could have a material adverse effect on the company’s “long-term performance.” Furthermore, the court found it reasonably conceivable that Encelium’s achievement of only one-half of projected revenues for the third quarter of 2011, constituted an MAC or MAE, requiring notification under Section 6.4 of the SPA. The court also found that OSI stated a claim for fraud by alleging that defendants misrepresented the financial condition of the company to induce OSI to purchase Encelium’s common stock at an inflated price. 

Looking Forward: Lessons from Recent MAE/MAC Decisions

The lessons from Osram, Cooper Tire, and its predecessors are clear: the definition of an “MAE” in any merger agreement deserves a second look. In public company agreements, the failure of a target to meet earnings or revenue projections is commonly excluded from the list of events than could constitute a MAE, as are developments which result from the announcement of the merger. Further, changes in “prospects” are rarely included in the MAE clause as an event that could constitute an MAE. The elimination or retooling of these exceptions to the MAE definition, coupled with the introduction of more short-term, forward-looking features may give acquirers greater flexibility in responding to events that occur during signing and closing. While the introduction of these definitional elements may not be appropriate or realistically obtainable in most deals, the foregoing decisions make the case for their consideration. 

On the other hand, targets should focus on whether they have the ability to force a buyer to close upon the satisfaction of all conditions precedent to closing and/or to pay a significant reverse termination fee. As the foregoing cases show, targets may enter into agreements with the expectation that they have the ability to force the acquirer to close if all closing conditions are met, but are later disappointed. 

Privacy and Social Media

Posted on January 23, 2014 by - Uncategorized

From every angle, social media is anathema to privacy. The very founding concept of paleolithic AOL chatrooms and Usenet newsgroups, and later Facebook, MySpace, and the earliest blogging sites was to provide a forum for people to share with each other. People shared ideas, humor, emotions, preferences, prejudices, priorities, and often misguided attempts at profundity. Newer sites simply broadened and deepened the sharing – Twitter users share commute times and coffee temperatures, Tumblers share memes galore, and Instagramites share a wealth of doctored photographs. 

We learned things about the people in our world, and they about us. Thanks to social media, we now know that if our nearest coworker were a tree, she would be a willow, and the celebrity she believes that she most resembles is Angelina Jolie. We also know that Shirley’s kids are honor students and that Tom’s brother was just released from prison (early, for good behavior), that Jeffrey lives and dies with his Eagles and that Sandra is so, so, so sad at the plight of shelter animals. Importantly, we know when people are leaving town and how long they will be gone. We know if they come into money. We learn about their families and their vulnerabilities. We learn about drinking and drug use, sexual promiscuity, and even crimes like DWI or hit and run. We see pictures of their kids, their cars, their vacations, and their homes. 

All of this sharing may help create communities, but it also destroys privacy. The bikini-clad body that is perfectly appropriate on the beach at St. John or Captiva may undermine the respect an employee has worked hard to earn from superiors, subordinates, and peers at the office who may view the vacation pictures on Facebook. The same may be true for pictures of a drinking party among friends. Too much published information can and will present obstacles when circumstances change and a spouse sues for divorce, or a rival is seeking an edge for a promotion at work. We all know that kids can be the cruel, and your insistence on wearing mouse ears at a Disney theme park may reach the attention of your children’s classmates, and their parents. Criminals trawl social media constantly, looking for vulnerabilities and vacations, pinpointing easy targets. 

Operators of various social media outlets are well aware that their profits may increase as we expand our willingness to share personal information about ourselves, and much of the business model development for social media sites is designed to coerce, cajole, trick, taunt, or tease us into revealing more information about our lives and our thoughts and opinions. Who are your friends? What discounts interest you? You “liked” the last Vin Diesel movie, will you like the next one? What is your relationship status? Who do you write to? Who do you poke? Won’t you download the mobile app so we can see where you are when you access our site? Your friends have downloaded our app. Why won’t you? We will ask you again in two hours. 

Every bit of information we disclose is another databite to be mined and measured, sorted and sold. Online transactions provide even more opportunities, because a purchase through a social media site hits the trifecta for the site owner. With a purchase, the site registers our activity, our expenditure, our degree of interest in a good or service and an entire category of goods or services (opening our wallet demonstrates significant interest), our bank, our credit card information, our shipping address, our online ID, and our passwords. In addition, the social media site may trumpet the sale to our friends attempting to induce additional transactions. And beyond this extraordinary information bounty, the social media site likely received a financial kickback from a sale made from its platform. Moreover, the data mining industry attempts to review every transaction and every posting in which we engage in order to be able to maximize the profit potential of every piece of information disclosed by that transaction or posting. 

For this reason, social media is not simply a collection of online places that allow private information to escape, but social media sites are organized to draw as much participation and information out of us as possible. Like casinos built without sunlight or clocks so as to encourage your further play, the social media sites and data mining industry study online behavior and build manipulation machines designed to entice you to remain engaged and to divulge information. A search engine site may not care whether you own a particular make or model of car or that you baked cookies last night, but it cares that you told them about your car and your cookies. They make money from aggregating car owners and cookie bakers and selling information to companies who can exploit that information. 

Until recently, there has been very little counterbalance to the siren’s call of revealing everything on social media or to the tricks and manipulations that the online media companies employ to make sharing easy, satisfying, and seemingly so necessary. Certainly there are authors writing jeremiads both in and out of the mainstream media who will despair about the morality of kids today, or about the solipsistic adults who believe that each workout or restaurant meal is worth recording for posterity and circulating to wide circle of “friends.” There seems to be an absence of concerted opposition to this kind of activity. Schools and workplaces do not appear to actively discourage sharing in social media, except to prevent a student from bullying another, or to caution workers not to release company trade secrets. Governmental restrictions are spotty at best, except for the intelligence services, judiciary, and some government agencies. 

In short, prior to 2013, legislatures and regulators in the United States appeared to be more concerned about the data they could glean from social media than protecting privacy of the average citizen in the online world. Much of the rest of the industrialized world has a very different viewpoint about personal information than that we experience in the United States. In Europe, Canada, and other countries across the world, protection of each citizen’s private information is considered to be a human right, secured by statute and enforced by government and private causes of action. In the United States, by contrast, only certain classes of information are protected under federal law – financial transactions, health care transactions, and information regarding children under the age of 13 – while nearly all other data is considered to be fair game for any business or government agency that chooses to collect, store, and use the information. 

The Federal Trade Commission (FTC) and state attorneys general have been the traditional protectors of online privacy for lightly-regulated industries like social media. But through much of the development of social media and socially-oriented Internet sites, these enforcement agencies have tended only to enforce the privacy policies that a site chose to publicize. If a social media site had claimed not to gather certain information, but it indeed gathered that information, then the FTC would assert claims upon that site. However, if the social media site had a vague privacy policy that never clearly disclosed all of the information it gathered, or if the site gathered and sold massive amounts of personal data from its users, and the site revealed its behavior in its privacy policy, then no enforcement action would be initiated because the site was not breaking any known laws. (The exception to this rule seemed to be the 2006 ruling against Choicepoint, costing the company $10 million in civil penalties for providing personal information to identity thieves.) In other words, for most personal data about people, their activities, and their transactions, it seems that a social media site would not be regulated for use or abuse of this data, only for misrepresenting what data was collected and how such data was used. Deep intrusions of privacy may be allowed, as long as the site doesn’t directly misrepresent what it is doing. 

The FTC has moved beyond this position during the past three years by using its powers to enforce privacy policies on social media sites to sue transgressors, and then to force the transgressive sites into settlements that include a long-term consent order permitting the FTC to have a tighter grip on the site’s policies. For example, in November 2011, the FTC claimed that Facebook had lied to consumers by repeatedly stating that personal information would be kept private, while repeatedly allowing that personal information to be shared and made public. In settling this claim, Facebook agreed to a 20-year consent order protecting its member’s privacy in more specific ways. That agreement mandates that Facebook receive explicit consent of its users before disclosing private information. Following up on this, in September 2013, the FTC announced an inquiry into whether Facebook’s proposed new privacy policies, disclosed in August 2013, violated the 20-year consent agreement. In its proposed new policies, Facebook was planning to use its members’ names and pictures in advertising products the members had “liked” or for which they had given a favorable comment, and the new policy provided that Facebook automatically assumed that the parents of teenage Facebook users had granted permission for their children’s names to be used in advertising. The original FTC claim relating to an allegedly misleading privacy policy has thereby enabled the FTC to exercise much greater influence into Facebook’s future treatment of consumer data. The FTC also has obtained similar 20-year consent orders in place with Twitter, MySpace, and Google. 

State breach notice laws affecting social media privacy have some relatively consistent elements and some experimental elements. These laws address the way that a social media company must behave after a breach of security relating to a site-user’s personal information. Over 45 U.S. jurisdictions have some sort of data breach notice law. While these statutes come in a variety of flavors – some include obligations triggered by simple exposure of personal data while others are not triggered until the exposed data is at risk of theft and misuse – their basic function is the same: if a company exposes/loses certain kinds of data relating to individuals, then the company must provide notice of the loss to the data subjects (and often to law enforcement and credit services). Nearly all of these laws would apply to companies collecting personal data about their users and failing to appropriately guard the data from unauthorized breach or disclosure. However, social media sites are considered to provide a special class of service where the essential purpose of the enterprise is to enable people to provide information about themselves to a larger public. The social media companies only facilitate this exercise. Therefore, in the regular course of using social media, people are exposing their own private data, even health-care data, financial information, and information about their children, and self-exposure will not trigger the state breach notice laws. It is, however, likely that a failure by a social media company to protect a user’s private data beyond that company’s privacy settings would trigger these laws. For example, if a Texas social media user had set her account to “friends only,” and the social media site exposed her account more broadly, then the site would be subject to state law breach notice requirements. 

A social media site might have trouble meeting its obligations with respect to breaches because for each user whose account was compromised, the site must determine if the exposure included private and legally protected subject matter as defined in each applicable statute. Rather than undertake this Herculean task, the site may determine simply to notify all its members about the mistake, whether or not such notice is mandated by a particular state law. Of course, as with other enterprises, social media companies that accept credit card payments or otherwise keep customer financial account data are expected to protect this data and are obligated to notify customers where financial data was compromised. 

As social media grows in importance in many American lives, states are tackling specific aspects of privacy intrusions that are raised in the news and that capture the imagination of legislatures and the public. For example, the concern about disclosure of personal information on social media sites has manifest in the field of worksite protections. In the past two years, a new wave of privacy laws has been sweeping state legislatures; at this writing, 12 states currently have laws specifically restricting employers from demanding access to their employees’ social media sites when those sites are not fully public. (The states that have passed these laws are Arkansas, California, Colorado, Illinois, Maryland, Michigan, New Jersey, New Mexico, Nevada, Oregon, Utah, and Washington.) Nearly all of these laws were passed in 2013, and other legislatures are currently considering legislating similar employer restrictions. One of the newest and broadest of these laws, passed in September 2013 and signed into law in New Jersey, prohibits employers from seeking access to “a person account,” such as a friends-only account at Facebook. Further, the law prohibits employers from “shoulder surfing” or making an employee access a personal account while management watches, from requiring an applicant or employee to change the privacy settings on a restricted account to a less-restrictive setting so that the employer can access it, or by forcing the employee to accept an employer’s “friend” request. The law also prohibits an employer from retaliating or discriminating against a job applicant or employee for refusing to provide log-in information to the employer, for reporting violations of this law to the New Jersey Commissioner of Labor, or from testifying or participating in an investigation into a violation of the law. 

The New Jersey law contains exceptions for financial service firms that are required by statute to monitor employees’ social media communications. Similarly, in September of 2013, Illinois amended its social media password law to exempt the financial services sector, because many companies in this sector – banking, securities sales, and insurance – are required to monitor certain employee’s correspondence of all types with customers or prospective customers. Most states with laws in this space have broad definitions of the type of sites protected. For example, the recently passed Nevada statute classifies a social media account as “any electronic service or account or electronic content, including, without limitation, videos, photographs, blogs, video blogs, podcasts, instant and text messages, electronic mail programs or service, online services or Internet website profiles.” The penalties for these laws vary widely, with California, Colorado, Illinois, New Jersey, and Oregon creating administrative remedies; Illinois, Maryland, Michigan, Oregon, Utah, and Washington providing a private right of action (some with penalty caps); and Arkansas, Nevada, and New Mexico not addressing remedies at all in their statutes. Other aspects of the laws vary by state. Oregon bans colleges from asking for social media passwords. Washington allows employers to be granted access to social media sites when making factual determinations in the course of conducting an investigation. New Mexico’s restrictions only apply to job applicants and not to employees. 

Despite these laws, employers are still allowed to review social media pages that are available to the general public, and employees may volunteer access to their social media accounts or may choose to “friend” work associates, including their superiors. Taking advantage of these voluntary actions does not violate any of the new social media forced access laws. However, because of the recent trend toward increasing the protection accorded to personal online accounts and communications, employers should document how they obtained any social media information regarding employees how they obtained access to it. The trend toward increased protection is not uniform, though, and highlights uncertainty in a number of jurisdictions as to the degree to which privacy in social media should be protected. Most states have not approved such protections, and those that have passed a password protection law are inconsistent with respect to penalties, definitions, and the scope of protections. 

California is taking steps to protect the privacy of some social media users from users’ own poor judgments. In autumn 2013, California enacted a law that would require social media sites to allow young registered users to erase their own comments from the sites. This is a first step in the United States toward the “right to be forgotten” that has been debated in Europe over the past decade. Teens who may have posted embarrassing statements will now have the right to clear those statements from the site’s memory banks. The mechanism for enforcement has not as yet been determined, but we do know some of the limitations of the law. The statute only covers the teen’s own posts and not posts made by others. A child can only erase his or her own statements, not the comments, “like” buttons, or other posts surrounding those statements. (A new case has ruled that use of the “like” button on social media is constitutionally protected speech. Bland v. Roberts, Case No. 12 – 1671, 4th Cir., September 18, 2013.) A teen cannot erase pictures of him or herself that others have posted, or statements about that teen that third parties posted, no matter how embarrassing or offensive those pictures or statements may be. The Library of Congress is currently archiving public tweets on Twitter, and other third-party sites archive social media data. These archive sites are not covered by the California law. And from a policy standpoint, is there a downside to permitting young bullies, racists, and fraudsters to eliminate the evidence of their statements? Although some of this speech may have legal implications and may be required in court proceedings, under the new California law these statements may be required to be deleted. 

In an equally bold move, in 2013 the California legislature also addressed the broad concern of consumers who are being silently tracked by software over the Internet. Tracking tools used by social media are one of the ways these sites derive revenues, capturing user’s behavior and then selling targeted advertising designed to match or appeal to the type of behavior a specific user exhibits. Many sites use persistent beacons, cookies, and other tools that follow a person’s web usage and send information about that user’s visits and habits to the site or other third parties. Some Internet browser programs are now including anti-tracking technology, permitting a user to attempt to reject these monitoring tools or at least to advise sites that use the tools that this user does not wish to be tracked in this way. California’s new law will not force sites to stop tracking consumers, and it will not even force those sites to acknowledge and follow “do not track” instructions received by consumer’s browser. Instead, the California law requires companies to disclose whether the sites will honor “do not track” instructions from their users. Presumably, it is thought that Internet surfers will avoid sites that do not honor such requests. It is also likely that the California attorney general’s office, which fought for this law, will be posting a “naughty and nice” list of companies which will and won’t respect their user’s wishes not to be tracked. This law follows several years of failure by Internet sites (including social media) and privacy advocates to agree on a method permitting people to opt-out of being tracked online. It is unlikely that the California law will itself cause major changes in social media company behavior, but this is the first statute to advance the conversation on tracking of private online movements, and it could lead to further action by legislatures across the country.

Led by the states, the United States is developing laws and regulations to protect certain aspects of people’s information on social media. As social media sites evolve to make the dissemination of information easier, our society is beginning to recognize the problems inherent in such dissemination, and the use and protections to which such information is entitled. Both the FTC and state legislatures are taking steps to protect the American public from inappropriate intrusions on their privacy through social media – even if they are only protecting us from our own poor judgment.

U.S. Supreme Court Reaffirms that Forum-Selection Clauses Are Presumptively Enforceable

Posted on January 22, 2014 by - Uncategorized

Forum-selection clauses are common and highly useful features of commercial contracts because they help make any future litigation on a contract more predictable for the parties and, in some cases, less expensive. But what procedure should a defendant use to enforce a forum-selection clause when the defendant is sued in a court that is not the contractually selected forum? On December 3, 2013, the U.S. Supreme Court issued a decision in Atlantic Marine Construction Co. v. United States District Court for the Western District of Texas (__ S.Ct. __, 2013 WL 6231157 (Dec. 3, 2013)) that answers this question. The Court held that, if the parties’ contract specifies one federal district court as the forum for litigating any disputes between the parties, but the plaintiff files suit in a different federal district court that lawfully has venue (and therefore could be a proper place for the parties to litigate), the defendant should seek to transfer the case to the court specified in the forum-selection clause by invoking the federal statute that permits transfers of venue “[f]or the convenience of the parties and witnesses, in the interest of justice.” If the contract’s forum-selection clause instead specifies a state court as the forum for litigating disputes, the defendant may invoke a different federal statute that requires dismissal or transfer of the case. Importantly, the Court held that the parties’ contractual choice of forum should be enforced except in the most unusual cases, and that the party resisting the forum-selection clause (i.e., the plaintiff who filed in a different court) has the burden of establishing that public interests disfavoring transfer outweigh the parties’ choice. Atlantic Marine is significant for the business community because it provides greater certainty regarding the enforceability of forum-selection clauses, giving commercial parties that employ such clauses in their contracts greater predictability about where they will face future litigation. The Court in Atlantic Marine reinforced the strong federal policy favoring the enforcement of such clauses, and clarified the mechanism for their enforcement. As the Court explained,

[w]hen parties have contracted in advance to litigate disputes in a particular forum, courts should not unnecessarily disrupt the parties’ settled expectations. A forum-selection clause, after all, may have figured centrally in the parties’ negotiations and may have affected how they set monetary and other contractual terms; it may, in fact, have been a critical factor in their agreement to do business together in the first place. In all but the most unusual cases, therefore, ‘the interest of justice’ is served by holding parties to their bargain.

In Atlantic Marine, the U.S. Army Corps of Engineers hired Atlantic Marine Construction to build a child-development center on a military base in Texas. Atlantic Marine subcontracted with another construction company, J-Crew Management, to provide labor and materials. That contract called for all disputes between Atlantic Marine and J-Crew Management to be resolved in the state or federal court in Norfolk, Virginia, where Atlantic Marine is based. But J-Crew Management sued Atlantic Marine in federal court in Texas over Atlantic Marine’s alleged failure to pay for construction work. Preferring to litigate in Virginia, as the parties had agreed to do, Atlantic Marine asked the federal district court in Texas to enforce the forum-selection clause. It argued that there were two ways that the district court might enforce that clause: under a federal statute that requires the dismissal or transfer of a case brought in the “wrong” venue, or under another federal statute that authorizes a transfer to a more convenient location. (The federal venue statute specifies which federal district or districts are permissible locations for a civil action to be brought, based on the residency of the defendants, the location of the events that are the subject of the suit, or the existence of personal jurisdiction over the defendant.) The district court denied Atlantic Marine’s request under both theories, reasoning that venue was proper in Texas despite the contract’s forum-selection clause, and that a convenience transfer was not warranted based on the balance of public and private interests. Atlantic Marine then asked the Fifth Circuit for a writ of mandamus to require the district court to transfer or dismiss the case. Over a dissent that noted the presumptive enforceability of forum-selection clauses, the court of appeals rejected that request. The Supreme Court granted Atlantic Marine’s request for review to resolve a circuit split over how to enforce a contract provision that selects a federal forum other than the one in which the case was filed. In a unanimous opinion by Justice Alito, the Supreme Court reversed and remanded. In doing so, it effectively disagreed with both sides of that dispute among the courts of appeals. The Court first rejected the argument that a forum-selection clause affects whether venue in a given district is “wrong” or “improper,” because the venue statute does not address forum-selection clauses. Accordingly, when a case is filed in a district in which venue is authorized by law, a party seeking to enforce a forum-selection clause must seek transfer to a more convenient forum. A clause selecting a federal forum may be enforced using the statutory convenience transfer, while a clause selecting a state forum may be enforced under the forum non conveniens doctrine. The Court then described the appropriate standard for transfer. In ordinary cases not involving forum-selection clauses, courts must balance “the convenience of the parties and various public-interest considerations” to determine whether transfer would promote “the interest of justice.” But that analysis shifts in three important ways, the Court explained, in cases involving forum-selection clauses. First, in balancing interests, the court may not consider “the plaintiff’s choice of forum,” because the plaintiff already agreed by contract that another forum is more appropriate. Although “plaintiffs are ordinarily allowed to select whatever forum they consider most advantageous,” when the parties have agreed in advance to a forum-selection clause, “the plaintiff has effectively exercised its ‘venue privilege’ before a dispute arises. Only that initial choice deserves deference.” Second, because forum-selection clauses “waive” the parties’ “right to challenge the preselected forum as inconvenient,” the courts are limited to “consider[ing] arguments about public-interest factors only.” And the parties’ contractual choice of forum will outweigh public-interest factors “‘in all but the most exceptional cases.’” Finally, the court should apply the choice-of-law rules of the state in which the parties selected their forum, so that the plaintiff does not gain an unfair advantage by ignoring the forum-selection clause. Ordinarily, plaintiffs may affect the substantive law that applies to their case by choosing where to file suit, because a federal court typically applies “the choice-of-law rules of the State in which it sits.” Although the Supreme Court has recognized an exception for cases transferred because of convenience – under which the court applies the choice-of-law rules of the district where the plaintiff first filed suit – the Court rejected that approach in Atlantic Marine. The transferee court in the contractually selected forum will apply that forum’s choice-of-law rules as if the case had been filed there initially, in order to avoid privileging a party that “flouts its contractual obligation and files suit in a different forum.” The Court also noted that the same revised analysis would apply regardless of whether the forum specified in the forum-selection clause is a federal, state, or foreign court. Because the federal transfer statute codifies the forum non conveniens doctrine, the Court explained, the statute and the doctrine function exactly the same way for these purposes, except that the remedy under the latter is dismissal (allowing the plaintiff to refile in a state or foreign court) rather than transfer. The Supreme Court did not ultimately decide which forum was proper in Atlantic Marine, however. Instead, it rejected the lower courts’ balancing of public and private interests, because the private interests cannot weigh against enforcing the forum-selection clause, and remanded to allow the lower courts to consider in the first instance whether any public-interest factors preclude enforcement of the clause in this case.

Discovery and Preservation of Social Media Evidence

Posted on January 22, 2014 by - Uncategorized

The ubiquitous nature of social media has made it an unrivaled source of evidence. Particularly in the areas of criminal, personal-injury, employment, and family law, social media evidence has played a key role in countless cases. But the use of social media is not limited to these practice areas. Businesses of every size can be affected by social media – both in the duty to preserve social media content and in the desire to access relevant social media evidence in litigation. 

The Duty to Preserve Social Media Evidence 

Data residing on social media platforms is subject to the same duty to preserve as other types of electronically stored information (ESI). The duty to preserve is triggered when a party reasonably foresees that evidence may be relevant to issues in litigation. All evidence in a party’s “possession, custody, or control” is subject to the duty to preserve. Evidence generally is considered to be within a party’s “control” when the party has the legal authority or practical ability to access it. 

As an initial matter, social media content should be included in litigation-hold notices instructing the preservation of all relevant evidence. Once the litigation-hold notice has been issued, parties have available to them a number of ways to preserve social media data, depending on the particular platform or application at issue. 

Methods of Preservation 

Facebook offers the ability to “Download Your Info.” With just one click of the mouse, users can download a zip file containing timeline information, posts, messages, and photos. Information that is not available by merely logging into an account also is included, such as the ads on which the user has clicked, IP addresses that are logged when the user accesses his or her Facebook account, as well as other potentially relevant information. 

Twitter offers a similar, although somewhat limited, option. Twitter users can download all Tweets posted to an account by requesting a copy of the user’s Twitter “archive.” Twitter does not, however, offer users a self-serve method of obtaining other, non-public information, such as IP logs. To obtain this additional information, users must request it directly from Twitter by sending an e-mail to [email protected] with the subject line, “Request for Own Account Information.” Twitter will respond to the e-mail with further instructions. 

Although these self-help methods can be an excellent start, they do not address all possible data. Therefore, it may be prudent to employ the assistance of a third-party vendor in order to ensure complete preservation. CloudPreservation and X1 Social Discovery are two examples of commercially available tools that are specifically designed for archiving and collecting social media content. 

Consequences of Failing to Preserve 

Regardless of the method employed, preservation of social media evidence is critically important and the consequences of failing to preserve can be significant. In the worst case, both counsel and client may be subject to sanctions for a failure to preserve relevant evidence. In the first reported decision involving sanctions in the social media context, Lester v. Allied Concrete Co., No. CL08-150 (Va. Cir. Ct. Sept. 01, 2011), aff’d, No. 120074 (Va. Ct. App. Jan. 10, 2013), the court sanctioned both the plaintiff and his counsel based, in large part, on its determination that they had engaged in spoliation of social media evidence. In that case, the lawyer told his paralegal to make sure the plaintiff “cleaned up” his Facebook page. The paralegal helped the plaintiff to deactivate his page and delete 16 pictures from his account. Although the pictures were later recovered by forensic experts, the court found that sanctions were warranted based on the misconduct. 

In contrast to Lester, a federal court in New Jersey imposed a significantly less severe remedy for the removal of Facebook posts. In Katiroll Company, Inc. v. Kati Roll and Platters, Inc., No. 10-3620 (GEB) (D.N.J. Aug. 3, 2011), the court determined that the defendant committed technical spoliation when he changed his Facebook profile picture, where the picture at issue was alleged to show infringing trade dress. Because the defendant had “control” over his Facebook page, he had the duty to preserve the photos. 

Because the photos were relevant to the litigation, their removal was “somewhat prejudicial” to the plaintiff. Instead of harsh monetary or evidentiary sanctions though, the court ordered a more practical-driven resolution. Specifically, the court ordered the defendant to coordinate with the plaintiff’s counsel to change the picture back to the allegedly infringing picture for a brief time during which the plaintiff could print whatever posts it believed to be relevant. 

Critical to the court’s decision not to award sanctions was its finding that the plaintiff had not explicitly requested that the defendant preserve his Facebook account as evidence. The court concluded, instead, that it would not have been immediately clear to the defendant that changing his Facebook profile picture would constitute the destruction of evidence. Thus, any spoliation was unintentional. This decision supports the idea that counsel should consider issuing a litigation-hold notice to opposing parties, as well as to one’s own client. 

Even inadvertent negligence for which sanctions are not warranted, can result in the loss of potentially relevant social media evidence. For example, in In re Pfizer, Inc. Securities Litigation, 288 F.R.D. 297 (S.D.N.Y. Jan. 8, 2013), the plaintiff-shareholders sought sanctions against Pfizer for failing to preserve data from “e-rooms.” The “e-rooms” were internal collaboration applications maintained by the company for use by employees in sharing documents and calendars, archiving e-mails, and communicating via discussion boards and instant messaging. Although the company had preserved (and produced) a tremendous amount of ESI, it had failed to preserve the data associated with the relevant e-rooms. 

The court took issue with the scope of Pfizer’s litigation-hold measures because they did not include e-rooms. Although documents and information included in the e-rooms were likely also maintained elsewhere and had likely been preserved and produced, the deletion of the e-rooms had resulted in the loss of discoverable information concerning the manner in which the employees internally organized information. 

The court found that this information was relevant because it would allow the plaintiffs to draw connections and understand the narrative of events in a way “not necessarily afforded by custodial production.” Thus, the court concluded, the company breached its duty to preserve because the scope of its litigation hold did not include the e-rooms. Sanctions, however, were not warranted because the conduct was merely negligent and the plaintiffs had not shown that any lost data was, indeed, relevant to their claims. 

Preservation in a “BYOD” World 

One question that remains unanswered relates to the obligation of a company to preserve the potentially relevant social media content of its employees. In Cotton v. Costco Wholesale Corp., No. 12-2731 (D. Kan. July 24, 2013), the court denied the employee-plaintiff’s motion to compel text messages sent or received by employees on their personal cell phones, finding that the employee had failed to show that the employer had any legal right to obtain the text messages. In other words, the phones and the data they contained were not in the “possession, custody, or control” of the employer. This recent discussion is one of the first of its kind and observers will have to wait to see whether the approach is adopted by other courts in cases to come. 

The Discoverability of Social Media

Preservation of social media evidence, of course, is only one part of the process. Parties will want to obtain relevant social media evidence as part of their informal and formal discovery efforts. Although some courts continue to struggle with disputes involving such efforts, discovery of social media merely requires the application of basic discovery principles in a somewhat novel context. 

No Reasonable Expectation of Privacy 

The user’s right to privacy is commonly an issue in discovery disputes involving social media. Litigants continue to believe that messages sent and posts made on their Facebook pages are “private” and should not be subject to discovery during litigation. In support of this, litigants claim that their Facebook pages are not publicly available but, instead, are available only to a limited number of designated Facebook “friends.” 

Courts consistently reject this argument, however. Instead, courts generally find that “private” is not necessarily the same as “not public.” By sharing the content with others – even if only a limited number of specially selected friends – the litigant has no reasonable expectation of privacy with respect to the shared content. Thus, the very purpose of social media – to share content with others – precludes the finding of an objectively reasonable expectation that content will remain “private.” Consequently, discoverability of social media is governed by the standard analysis and is not subject to any “social media” or “privacy” privilege. 

Relevancy as the Threshold Analysis 

Relevancy, therefore, becomes the focus of the discoverability analysis. Courts are wary about granting discovery of social media content where the requesting party has not identified some specific evidence tending to show that relevant information exists. However, a requesting party is only able to satisfy this burden if at least some part of producing party’s social media content is publicly available. Thus, when a litigant’s social-networking account is not publicly available, the likelihood of its discovery diminishes significantly. As more and more users understand the importance of privacy settings, the burden on the requesting party becomes more and more difficult to satisfy. 

Methods of Access to Social Media Evidence 

Assuming a litigant is able to meet its burden to establish the relevancy of social-networking content, the question becomes a practical one – how to obtain the sought-after information? Currently, this question has no good answer. There have been a variety of methods requested by litigants and ordered by the courts, with mixed degrees of success. 

Direct Access to Social Media Accounts

One of the most intrusive methods of discovery is to permit the requesting party access to the entire account. If analogized to traditional discovery, this would be the equivalent of granting access to a litigant’s entire office merely because a relevant file is stored there. Not surprisingly, this method of “production” has not been popular with parties or with courts. 

Nevertheless, there now are several decisions in which a court has ordered a party to produce his or her login and password information to the other side in response to a discovery request. One of these decisions, Largent v. Reed, No. 2009-1823 (Pa. C.C.P. Nov. 8, 2011), illustrates some of the procedural challenges that can result. 

In Largent, the court ordered the plaintiff to turn over her Facebook login information to defense counsel within 14 days of the date of the order. Defense counsel then would have 21 days to “inspect [the plaintiff’s] profile.” After that period, the plaintiff could change her password to prevent any further access to her account by defense counsel. Although the order specifically identified the defendant’s lawyer as the only party who would be given the login information, it did not specify whether the defendant was permitted to view the account’s contents once the attorney had logged in. 

Another case involving the exchange of login information resulted in more serious and permanent harm. In Gatto v. United Airlines, Inc., No. 10-1090-ES-SCM (D.N.J. Mar. 25, 2013), the plaintiff voluntarily provided his Facebook password to the defendants’ counsel during a settlement conference facilitated by the court. When the defendants’ attorney later logged into the account and printed portions of the plaintiff’s profile page as previously agreed, Facebook sent an automated message to the plaintiff, alerting him that his account had been accessed from an unauthorized ISP address. 

The plaintiff attempted to deactivate the account but deleted it instead. As a result, all of the data associated with the account was automatically and permanently deleted 14 days later. The court found that the plaintiff had failed to preserve relevant evidence and granted the defendants’ request for an adverse-inference instruction as a sanction. 

Not all courts have endorsed the idea of direct access to a party’s social media account. One court went so far as to hold that a blanket request for login information is per se unreasonable. In Trail v. Lesko, No. GD-10-017249 (Pa. C.C.P. July 3, 2012), both sides sought to obtain Facebook posts and pictures from the other. Neither complied and both parties filed motions seeking to compel the other to turn over its Facebook password and username. 

The court explained that a party is not entitled to free-reign access to the non-public social-networking posts of an opposing party merely because he asks the court for it. “To enable a party to roam around in an adversary’s Facebook account would result in the party to gain access to a great deal of information that has nothing to do with the litigation and [] cause embarrassment if viewed by persons who are not ‘Friends.’” 

One court went even further. In Chauvin v. State Farm Mutual Automobile Insurance Company, No. 10-11735, 2011 U.S. Dist. LEXIS 121600 (S.D. Mich. Oct. 20, 2011), the court affirmed an award of sanctions against the defendant due to its motion to compel production of the plaintiff’s Facebook password. The court upheld the decision of the magistrate judge, who had concluded that the content the defendant sought to discover was available “through less intrusive, less annoying and less speculative means,” even if relevant. Furthermore, there was no indication that granting access to the account would be reasonably calculated to lead to discovery of admissible information. Thus, the motion to compel warranted an award of sanctions. 

In Camera Review

In an effort to guard against overly broad disclosure of a party’s social media information, some courts have conducted an in camera review prior to production. For example, in Offenback v. Bowman, a No. 1:10-cv-1789, 2011 U.S. Dist. LEXIS 66432 (M.D. Pa. June 22, 2011), the magistrate judge conducted an in camera review of the plaintiff’s Facebook account and ordered the production of a “small segment” of the account as relevant to the plaintiff’s physical condition. 

In Douglas v. Riverwalk Grill, LLC, No. 11-15230, 2012 U.S. Dist. LEXIS 120538 (E.D. Mich. Aug. 24, 2012), the court ordered the plaintiff to provide the contents for in camera review. After conducting its review of “literally thousands of entries,” the court noted that “majority of the issues bear absolutely no relevance” to the case. In particular, the court found that the only entries that could be considered discoverable were those written by the plaintiff, which could be in the form of “comments” he made on another’s post or updates to his own “status.” The court identified the specific entries it had determined were discoverable. 

Many courts, understandably, have been less than enthusiastic about the idea of doing the parties’ burdensome discovery work. For example, in Tomkins v. Detroit Metropolitan Airport, 278 F.R.D. 387 (E.D. Mich. 2012), the court declined the parties’ suggestion that it conduct an in camera review, explaining that “such review is ordinarily utilized only when necessary to resolve disputes concerning privilege; it is rarely used to determine relevance.” 

At least one court has agreed to “friend” a litigant for the purpose of conducting an in camera review of the litigant’s Facebook page. In Barnes v. CUS Nashville, LLC, No. 3:09-cv-00764, 2011 U.S. Dist. LEXIS 143892 (M.D. Tenn. June 3, 2010), the magistrate judge offered to expedite the parties’ discovery dispute by creating a Facebook account and then “friending” two individuals “for the sole purpose of reviewing photographs and related comments in camera.” The judge then would “properly review and disseminate any relevant information to the parties . . . [and would] then close Facebook account.” 

Attorneys’ Eyes Only

In Thompson v. Autoliv ASP, Inc., No. 2:09-cv-01375 (D. Nev. June 20, 2012), the defendant obtained information from the plaintiff’s publicly available social-networking profiles that was relevant to the case, but asserted that the plaintiff had since changed her account settings to prevent the defendant from further access and had failed to produce (or had produced in overly-redacted form) information from these profiles in response to the defendant’s formal discovery requests. 

The defendant sought to have the court conduct an in camera review of the profiles in their entirety to determine whether the plaintiff’s discovery responses were complete. Instead, the court ordered the plaintiff to provide the requested information to the defendant’s counsel for an attorney’s-eyes-only review for the limited purpose of identifying whether information had been improperly withheld from production. The defendant’s counsel was instructed that it could not use the information for any other purpose without a further ruling by the court. 

Third-Party Subpoenas

While the discoverability analysis is a product of the common law, there is at least one statute relevant to the discussion. The Stored Communications Act (SCA) limits the ability of Internet-service providers to voluntarily disclose information about their customers and subscribers. Although providers may disclose electronic communications with the consent of the subscriber, the SCA does not contain an exception for disclosure pursuant to civil discovery subpoena. The application of the SCA to discovery of communications stored on social-networking sites has produced mixed results. 

Providers, including Facebook, take the position that the SCA prohibits them from disclosing social media contents, even by subpoena. From Facebook’s website: 

Federal law prohibits Facebook from disclosing “user content (such as messages, Wall (timeline) posts, photos, etc.), in response to a civil subpoena. Specifically, the Stored Communications Act, 18 U.S.C. § 2701 et seq., prohibits Facebook from disclosing the contents of an account to any non-governmental entity pursuant to a subpoena or court order. 

One of the earliest cases to address the issue, Crispin v. Christian Audigier, Inc., 717 F. Supp. 2d 965 (C.D. Cal. 2010), concluded that the SCA prohibited a social-networking site from producing a user’s account contents in response to a civil discovery subpoena. In that case, the defendants served subpoenas on several third parties, including Facebook and MySpace, seeking communications between the plaintiff and another individual. The plaintiff moved to quash the subpoenas. 

The court held that plaintiff had standing to bring the motion, explaining that “an individual has a personal right in information in his or her profile and inbox on a social-networking site and his or her webmail inbox in the same way that an individual has a personal right in employment and bank records.” Moreover, the court determined that the providers were electronic communication service (ECS) providers under the SCA and were thus prohibited from disclosing information contained in “electronic storage.” 

The SCA does not override a party’s obligation to produce relevant ESI, though. To the contrary, a party must produce information that is within its possession, custody, or control. Thus, a court can compel a party to execute an authorization for the release of social media content. With an executed authorization, a properly issued subpoena, and, in most cases, a reasonably small payment for associated costs, litigants can obtain all information related to a user’s social media account. 

Lessons Learned 

Although the world of social media and other new technology continues to present novel questions, the answers are often derived by applying a “pre-Facebook” analysis. For example, businesses understand that they have an obligation to preserve potentially relevant evidence. Social media evidence is no different and should be preserved in the same way as paper documents and emails. 

Similarly, parties in litigation are entitled to discovery of all relevant, non-privileged information. Thus, social media content is subject to discovery, despite the privacy settings imposed by the account user. Nevertheless, only relevant information must be produced and it is the responsibility of counsel to make the relevancy determination.

Parties and counsel are well advised to adjust their thinking so that social media becomes just another type of ESI. And, like emails and other forms of electronic data, social media must be preserved and is subject to discovery if relevant to the dispute.

 

 

 

 

Canada’s Tough New Anti-Spam Legislation: Beware Its Extra-Territorial Reach

Posted on January 22, 2014 by - Uncategorized

 

Canada’s new anti-spam laws (CASL), (S.C. 2010, c. 23), will come into force on July 1, 2014, and is the toughest anti-spam law in the world.  Whether or not your client is located in Canada, CASL may affect your client. Even if your client isn’t a spammer, CASL will affect your client’s business operations in and from Canada. 

Why should U.S. lawyers and their clients care about CASL?  The answer is that CASL has considerable extra-territorial reach. CASL applies where “a computer system located in Canada is used to send or access” an electronic message.  So, by way of example, CASL will apply if an e-mail is sent from the United States to a Canadian who receives and opens it on a computer located in Canada. In light of the long statutory reach outside of Canada and because of the unprecedented toughness of CASL, anyone involved in online commercial communications flowing into Canada needs to consider compliance with CASL. 

A violation of CASL attracts significant administrative monetary penalties of up to $1 million for individuals and $10 million for others. Corporate directors and officers may be personally liable if they direct, authorize, or assent to, or acquiesce or participate in, a contravention of CASL, subject to a due diligence defense.  Employers may be vicariously liable for violations of CASL by their employees, subject to a due diligence defense.  It is also an offense under CASL to aid, induce, procure, or cause to be procured the doing of any acts contrary to certain sections of CASL, including the sections relating to CEM’s. 

CASL regulates “commercial electronic messages” (CEM) which are defined broadly and includes any electronic message that has as its purpose, or as one of its purposes, the encouragement of participation in a commercial activity. An electronic message would include e-mail, text messages, and social media messaging and text, sound, voice, or image messages.  Even if the electronic message itself is not related to a commercial activity, it may still be a CEM, having regard to the hyperlinks to other content or websites or the contact information contained in the message. Commercial activity is defined in CASL to mean any transaction, act, or conduct or any regular course of conduct that is of a commercial character, whether or not the person who carries it out does so with the expectation of profit.  Common business activities, including sending e-mail messages to customers, operating a website, or making an application available for download, will therefore be subject to CASL. 

CASL is fundamentally different than the U.S. Can-Spam Act of 2003, (15 U.S.C. ch. 103, Public Law No. 108-187, was S. 877 of the 108th United States Congress), because, unlike the Can-Spam Act, which is based on an “opt-out” model which assumes that recipients of unsolicited electronic messages have implicitly consented to their receipt until and unless they take steps to opt-out of the receipt of such messages, Canada is moving to an “opt-in” consent regime.  This will prohibit the sending of CEM’s unless the recipient has given his or her express or implied consent, subject to limited exceptions.  Problematically, a CEM cannot be used to request this consent which means companies will need to obtain express consent without using e-mail. 

In addition to the obligation to obtain express or implicit consent to the sending of CEM’s,  CASL also regulates the content and form of CEM’s.  Every CEM must identify the sender, include prescribed contact information for the sender, and provide a specific unsubscribe mechanism which must permit the recipient to indicate, at no cost, that the recipient no longer wishes to receive CEM’s from the sender.  The sender must comply with requests to unsubscribe to CEM’s “without delay,” and in any event within 10 business days. Prescribed contact information for each CEM includes the name and mailing address of the person sending the CEM, and a telephone number, e-mail address, or web address of the person sending the CEM.  Where the CEM is being sent on behalf of another person, such as by a third-party service provider, the name of the third party as well as the name of the person on whose behalf the CEM is being sent must also be included. 

CASL establishes a right of private civil action which may be commenced by any individual or organization affected by a contravention of CASL; however, this private right of action will not come into force until July 1, 2017.  Class actions are also possible.  These actions are of significant concern for anyone doing business in Canada or communicating online with Canadians.  CASL also regulates the unsolicited installation of computer programs or software; however, these provisions will not come into force until January 15, 2015. 

As a result of consultation with many different stakeholders, the three sets of regulations to CASL include many important exceptions that have to be assessed carefully by clients when implementing a compliance program.  It is also important to consider Industry Canada’s Regulatory Impact Analysis Statement (RIAS) which clarifies questions raised during the consultation process, although the RIAS is not legally binding.  Given the complexity and novelty of CASL, compliance with CASL will be complex and must be tailored for each client’s specific operations and processes. 

The first phase of CASL’s implementation commences July 1, 2014, with the balance of its provisions being phased in over the following three-year period.  U.S. lawyers and their clients will want to act quickly to assess whether the client needs to comply with CASL and if so, the process for compliance with CASL.  Given the extremely high administrative monetary penalties, it is critical to act now.

10 Tips for Avoiding Ethical Lapses When Using Social Media

Posted on January 22, 2014 by - Uncategorized

You may be among the thousands of legal professionals flocking to social media sites like LinkedIn, Facebook, Twitter, or Google+ to expand your professional presence in the emerging digital frontier. If so, have you paused to consider how the ethics rules apply to your online activities? You should. Some of the ethical constraints that apply to your social media usage as a legal professional may surprise you. Moreover, legal ethics regulators across the country are beginning to pay close attention to what legal professionals are doing with social media, how they are doing it, and why they are doing it. The result is a patchwork quilt of ethics opinions and rule changes intended to clarify how the rules of professional conduct apply to social media activities. 

This article provides 10 tips for avoiding ethical lapses while using social media as a legal professional. The authors cite primarily to the ABA Model Rules of Professional Conduct (RPC) and select ethics opinions from various states. In addition to considering the general information in this article, you should carefully review the ethics rules and ethics opinions adopted by the specific jurisdiction(s) in which you are licensed and in which your law firm maintains an office. 

1. Social Media Profiles and Posts May Constitute Legal Advertising

Many lawyers – including judges and in-house counsel – may not think of their social media profiles and posts as constituting legal advertisements. After all, legal advertising is limited to glossy brochures, highway billboards, bus benches, late-night television commercials, and the back of the phonebook, right? Wrong. In many jurisdictions, lawyer and law firm websites are deemed to be advertisements. Because social media profiles (including blogs, Facebook pages, and LinkedIn profiles) are by their nature websites, they too may constitute advertisements. 

For example, the Florida Supreme Court recently overhauled that state’s advertising rules to make clear that lawyer and law firm websites (including social networking and video sharing sites) are subject to many of the restrictions applicable to other traditional forms of lawyer advertising. Similarly, California Ethics Opinion 2012-186 concluded that the lawyer advertising rules in that state applied to social media posts, depending on the nature of the posted statement or content. 

2. Avoid Making False or Misleading Statements

The ethical prohibition against making false or misleading statements pervades many of the ABA Model Rules, including RPC 4.1 (Truthfulness in Statements to Others), 4.3 (Dealing with Unrepresented Person), 4.4 (Respect for Rights of Third Persons), 7.1 (Communication Concerning a Lawyer’s Services), 7.4 (Communication of Fields of Practice and Specialization), and 8.4 (Misconduct), as well as the analogous state ethics rules. ABA Formal Opinion 10-457 concluded that lawyer websites must comply with the ABA Model Rules that prohibit false or misleading statements. The same obligation extends to social media websites. 

South Carolina Ethics Opinion 12-03, for example, concluded that lawyers may not participate in websites designed to allow non-lawyer users to post legal questions where the website describes the attorneys answering those questions as “experts.” Similarly, New York State Ethics Opinion 972 concluded that a lawyer may not list his or her practice areas under the heading “specialties” on a social media site unless the lawyer is appropriately certified as a specialist – and law firms may not do so at all. 

Although most legal professionals are already appropriately sensitive to these restrictions, some social media activities may nevertheless give rise to unanticipated ethical lapses. A common example occurs when a lawyer creates a social media account and completes a profile without realizing that the social media platform will brand the lawyer to the public as an “expert” or a “specialist” or as having legal “expertise” or “specialties.” Under RPC 7.4 and equivalent state ethics rules, lawyers are generally prohibited from claiming to be a “specialist” in the law. The ethics rules in many states extend this restriction to use of terms like “expert” or “expertise.” Nevertheless, many professional social networking platforms (e.g., LinkedIn and Avvo) may invite lawyers to identify “specialties” or “expertise” in their profiles, or the sites may by default identify and actively promote a lawyer to other users as an “expert” or “specialist” in the law. This is problematic because the lawyer completing his or her profile cannot always remove or avoid these labels. 

3. Avoid Making Prohibited Solicitations

Solicitations by a lawyer or a law firm offering to provide legal services and motivated by pecuniary gain are restricted under RPC 7.3 and equivalent state ethics rules. Some, but not all, state analogues recognize limited exceptions for communications to other lawyers, family members, close personal friends, persons with whom the lawyer has a prior professional relationship, and/or persons who have specifically requested information from the lawyer. 

By its very design, social media allows users to communicate with each other or the public at-large through one or more means. The rules prohibiting solicitations force legal professionals to evaluate – before sending any public or private social media communication to any other user – whom the intended recipient is and why the lawyer or law firm is communicating with that particular person. For example, a Facebook “friend request” or LinkedIn “invitation” that offers to provide legal services to a non-lawyer with whom the sending lawyer does not have an existing relationship may very well rise to the level of a prohibited solicitation. 

Legal professionals may also unintentionally send prohibited solicitations merely by using certain automatic features of some social media sites that are designed to facilitate convenient connections between users. For instance, LinkedIn provides an option to import e-mail address books to LinkedIn for purposes of sending automatic or batch invitations. This may seem like an efficient option to minimize the time required to locate and connect with everyone you know on LinkedIn. However, sending automatic or batch invitations to everyone identified in your e-mail address book could result in networking invitations being sent to persons who are not lawyers, family members, close personal friends, current or former clients, or others with whom a lawyer may ethically communicate. Moreover, if these recipients do not accept the initial networking invitation, LinkedIn will automatically send two follow up reminders unless the initial invitation is affirmatively withdrawn. Each such reminder would conceivably constitute a separate violation of the rules prohibiting solicitations. 

4. Do Not Disclose Privileged or Confidential Information

Social media also creates a potential risk of disclosing (inadvertently or otherwise) privileged or confidential information, including the identities of current or former clients. The duty to protect privileged and confidential client information extends to current clients (RPC 1.6), former clients (RPC 1.9), and prospective clients (RPC 1.18). Consistent with these rules, ABA Formal Opinion 10-457 provides that lawyers must obtain client consent before posting information about clients on websites. In a content-driven environment like social media where users are accustomed to casually commenting on day-to-day activities, including work-related activities, lawyers must be especially careful to avoid posting any information that could conceivably violate confidentiality obligations. This includes the casual use of geo-tagging in social media posts or photos that may inadvertently reveal your geographic location when traveling on confidential client business. 

There are a few examples of lawyers who found themselves in ethical crosshairs after posting client information online. For example, in In re Skinner, 740 S.E.2d 171 (Ga. 2013), the Georgia Supreme Court rejected a petition for voluntary reprimand (the mildest form of public discipline permitted under that state’s rules) where a lawyer admitted to disclosing information online about a former client in response to negative reviews on consumer websites. In a more extreme example, the Illinois Supreme Court in In re Peshek, M.R. 23794 (Ill. May 18, 2010) suspended an assistant public defender from practice for 60 days for, among other things, blogging about clients and implying in at least one such post that a client may have committed perjury. The Wisconsin Supreme Court imposed reciprocal discipline on the same attorney for the same misconduct. In re Disciplinary Proceedings Against Peshek, 798 N.W.2d 879 (Wis. 2011). 

Interestingly, the Virginia Supreme Court held in Hunter v. Virginia State Bar, 744 S.E.2d 611 (Va. 2013), that confidentiality obligations have limits when weighed against a lawyer’s First Amendment protections. Specifically, the court held that although a lawyer’s blog posts were commercial speech, the Virginia State Bar could not prohibit the lawyer from posting non-privileged information about clients and former clients without the clients’ consent where (1) the information related to closed cases and (2) the information was publicly available from court records and, therefore, the lawyer was free, like any other citizen, to disclose what actually transpired in the courtroom. 

5. Do Not Assume You Can “Friend” Judges

In the offline world, it is inevitable that lawyers and judges will meet, network, and sometimes even become personal friends. These real-world professional and personal relationships are, of course, subject to ethical constraints. So, too, are online interactions between lawyers and judges through social media (e.g., becoming Facebook “friends” or LinkedIn connections) subject to ethical constraints. 

Different jurisdictions have adopted different standards for judges to follow. ABA Formal Opinion 462 recently concluded that a judge may participate in online social networking, but in doing so must comply with the Code of Judicial Conduct and consider his or her ethical obligations on a case-by-case (and connection-by-connection) basis. Several states have adopted similar views, including Connecticut (Op. 2013-06), Kentucky (Op. JE-119), Maryland (Op. 2012-07), New York (Op. 13-39, 08-176), Ohio (Op. 2010-7), South Carolina (Op. 17-2009), and Tennessee (Op. 12-01). 

In contrast, states like California (Op. 66), Florida, Massachusetts (Op. 2011-6), and Oklahoma (Op. 2011-3) have adopted a more restrictive view. Florida Ethics Opinion 2009-20, for example, concluded that a judge cannot friend lawyers on Facebook who may appear before the judge because doing so suggests that the lawyer is in a special position to influence the judge. Florida Ethics Opinion 2012-12 subsequently extended the same rationale to judges using LinkedIn and the more recent Opinion 2013-14 further cautioned judges about the risks of using Twitter. Consistent with these ethics opinions, a Florida court held that a trial judge presiding over a criminal case was required to recuse himself because the judge was Facebook friends with the prosecutor. See Domville v. State, 103 So. 3d 184 (Fla. 4th DCA 2012). 

6. Avoid Communications with Represented Parties

Under RPC 4.2 and equivalent state ethics rules, a lawyer is forbidden from communicating with a person whom the lawyer knows to be represented by counsel without first obtaining consent from the represented person’s lawyer. Under RPC 8.4(a) and similar state rules, this prohibition extends to any agents (secretaries, paralegals, private investigators, etc.) who may act on the lawyer’s behalf. 

These bright-line restrictions effectively prohibit lawyers and their agents from engaging in social media communications with persons whom the lawyer knows to be represented by counsel. This means that a lawyer may not send Facebook friend requests or LinkedIn invitations to opposing parties known to be represented by counsel in order to gain access to those parties’ private social media content. In the corporate context, San Diego County Bar Association Opinion 2011-2 concluded that high-ranking employees of a corporation should be treated as represented parties and, therefore, a lawyer could not send a Facebook friend request to those employees to gain access to their Facebook content. 

On the other hand, viewing publicly accessible social media content that does not precipitate communication with a represented party (e.g., viewing public blog posts or Tweets) is generally considered fair game. That was the conclusion reached by Oregon Ethics Opinions 2013-189 and 2005-164, which analogized viewing public social media content to reading a magazine article or a published book. 

7. Be Cautious When Communicating with Unrepresented Third Parties

Underlying RPC 3.4 (Fairness to Opposing Party and Counsel), 4.1 (Truthfulness in Statements to Others), 4.3 (Dealing with Unrepresented Person), 4.4 (Respect for Rights of Third Persons), and 8.4 (Misconduct), and similar state ethics rules is concern for protecting third parties against abusive lawyer conduct. In a social media context, these rules require lawyers to be cautious in online interactions with unrepresented third parties. Issues commonly arise when lawyers use social media to obtain information from third-party witnesses that may be useful in a litigation matter. As with represented parties, publicly viewable social media content is generally fair game. If, however, the information sought is safely nestled behind the third party’s privacy settings, ethical constraints may limit the lawyer’s options for obtaining it. 

Of the jurisdictions that have addressed this issue, the consensus appears to be that a lawyer may not attempt to gain access to non-public social media content by using subterfuge, trickery, dishonesty, deception, pretext, false pretenses, or an alias. For example, ethics opinions in Oregon (Op. 2013-189), Kentucky (Op. KBA E-434), New York State (Op. 843), and New York City (Op. 2010-2) concluded that lawyers are not permitted (either themselves or through agents) to engage in false or deceptive tactics to circumvent social media users’ privacy settings to reach non-public information. Ethics opinions by other bar associations, including the Philadelphia Bar Association (Op. 2009-02) and the San Diego County Bar Association (Op. 2011-2), have gone one step further and concluded that lawyers must affirmatively disclose their reasons for communicating with the third party. 

8. Beware of Inadvertently Creating Attorney-Client Relationships

An attorney-client relationship may be formed through electronic communications, including social media communications. ABA Formal Opinion 10-457 recognized that by enabling communications between prospective clients and lawyers, websites may give rise to inadvertent lawyer-client relationships and trigger ethical obligations to prospective clients under RPC 1.18. The interactive nature of social media (e.g., inviting and responding to comments to a blog post, engaging in Twitter conversations, or responding to legal questions posted by users on a message board or a law firm’s Facebook page) creates a real risk of inadvertently forming attorney-client relationships with non-lawyers, especially when the objective purpose of the communication from the consumer’s perspective is to consult with the lawyer about the possibility of forming a lawyer-client relationship regarding a specific matter or legal need. Of course, if an attorney-client relationship attaches, so, too, do the attendant obligations to maintain the confidentiality of client information and to avoid conflicts of interest. 

Depending upon the ethics rules in the jurisdiction(s) where the communication takes place, use of appropriate disclaimers in a lawyer’s or a law firm’s social media profile or in connection with specific posts may help avoid inadvertently creating attorney-client relationships, so long as the lawyer’s or law firm’s online conduct is consistent with the disclaimer. In that respect, South Carolina Ethics Opinion 12-03 concluded that “[a]ttempting to disclaim (through buried language) an attorney-client relationship in advance of providing specific legal advice in a specific matter, and using similarly buried language to advise against reliance on the advice is patently unfair and misleading to laypersons.” 

9. Beware of Potential Unauthorized Practice Violations

A public social media post (like a public Tweet) knows no geographic boundaries. Public social media content is accessible to everyone on the planet who has an Internet connection. If legal professionals elect to interact with non-lawyer social media users, then they must be mindful that their activities may be subject not only to the ethics rules of the jurisdictions in which they are licensed, but also potentially the ethics rules in any jurisdiction where the recipient(s) of any communication is(are) located. Under RPC 5.5 and similar state ethics rules, lawyers are not permitted to practice law in jurisdictions where they are not admitted to practice. Moreover, under RPC 8.5 and analogous state rules, a lawyer may be disciplined in any jurisdiction where he or she is admitted to practice (irrespective of where the conduct at issue takes place) or in any jurisdiction where he or she provides or offers to provide legal services. It is prudent, therefore, for lawyers to avoid online activities that could be construed as the unauthorized practice of law in any jurisdiction(s) where the lawyer is not admitted to practice. 

10. Tread Cautiously with Testimonials, Endorsements, and Ratings

Many social media platforms like LinkedIn and Avvo heavily promote the use of testimonials, endorsements, and ratings (either by peers or consumers). These features are typically designed by social media companies with one-size-fits-all functionality and little or no attention given to variations in state ethics rules. Some jurisdictions prohibit or severely restrict lawyers’ use of testimonials and endorsements. They may also require testimonials and endorsements to be accompanied by specific disclaimers. South Carolina Ethics Opinion 09-10, for example, provides that (1) lawyers cannot solicit or allow publication of testimonials on websites and (2) lawyers cannot solicit or allow publication of endorsements unless presented in a way that would not be misleading or likely to create unjustified expectations. The opinion also concluded that lawyers who claim their profiles on social media sites like LinkedIn and Avvo (which include functions for endorsements, testimonials, and ratings) are responsible for conforming all of the information on their profiles to the ethics rules. 

Lawyers must, therefore, pay careful attention to whether their use of any endorsement, testimonial, or rating features of a social networking site is capable of complying with the ethics rules that apply in the state(s) where they are licensed. If not, then the lawyer may have no choice but to remove that content from his or her profile. 

Conclusion

Despite the risks associated with using social media as a legal professional, the unprecedented opportunities this revolutionary technology brings to the legal profession to, among other things, promote greater competency, foster community, and educate the public about the law and the availability of legal services justify the effort necessary to learn how to use the technology in an ethical manner. E-mail technology likely had its early detractors and, yet, virtually all lawyers are now highly dependent on e-mail in their daily law practice. Ten years from now, we may similarly view social media as an essential tool for the practice of law.

 

Words that Matter: Considerations in Drafting Preferred Stock Provisions

Posted on January 22, 2014 by - Uncategorized

Pursuant to Delaware law, all capital stock, by default, is created equal unless the company’s certificate of incorporation provides for certain classes or series of preferred stock that enjoy special contractual rights, powers, and preferences over shares of another class or series of capital stock. While the General Corporation Law of the State of Delaware (the DGCL) permits a company to create preferred stock, it provides drafters of preferred stock provisions with no specific guidance as to the nature or form of the preferred stock’s rights and obligations. Similarly, Delaware case law imposes few express mandates other than to require that shares of preferred stock have preference over shares of common stock (which typically takes the form of a preference as to dividends and/or distributions upon liquidation of the company). 

With few requirements from the DGCL and Delaware case law, it is up to the drafter to set forth the particular terms, including the rights, powers, and preferences of the preferred stock. The terms of the preferred stock, particularly the economic rights, powers, and preferences, will be influenced by the context in which the preferred stock is being issued and the relative bargaining power of the company and its investors. The special rights, powers, and preferences typically associated with preferred stock consist of some combination of special dividends, liquidation, voting, redemption and/or conversion rights, and such rights, powers, and preferences must be clearly and specifically set forth in the company’s certificate of incorporation or in a certificate of designation (which has the effect of amending the company’s certificate of incorporation). For purposes of this article, a certificate of incorporation and a certificate of designation are referred to collectively as a “certificate of incorporation.” 

The interpretation of the special contractual preferences of preferred stock is primarily governed by the principles of contract law. In addition, preferred stock provisions must be interpreted in the context of the DGCL and the case law interpreting it. Drafters of preferred stock provisions are deemed to have been aware of and have an understanding of such applicable laws. If a preferred stockholder asserts a claim related to a contractual right, power, or preference of the preferred stock, Delaware courts will interpret such rights, powers, and preferences as contractual rather than fiduciary in nature. 

On the other hand, preferred stockholders have rights that are separate from those created by their contractual preferences. These separate rights are shared equally with the common stockholders and are fiduciary in nature. If a preferred stockholder asserts a claim related to a right that is not a preference, but instead is shared equally with the common stockholders, Delaware courts have suggested that both the preferred and common stockholders are owed fiduciary duties. For example, if preferred and common stockholders are entitled to vote on a certain matter, the directors’ duty to disclose all material information related to the matter extends to all of the company’s stockholders. If there is a divergence of interests between the holders of the preferred stock and common stock, however, it will generally be the duty of board of directors to prefer the interests of the common stockholders to those of the preferred stockholders. As a result, directors could be found to have breached their fiduciary duties if they favor the interests of the preferred stockholders under these circumstances. 

Accordingly, precise legal drafting is the key to ensuring that a preferred stockholder’s investment is adequately protected. The special rights, powers, and preferences of the preferred stock must be expressed clearly and will not be presumed. This article sets forth common drafting pitfalls of which drafters of preferred stock provisions should be cognizant. Most of these pitfalls can be avoided by remembering one simple concept when drafting preferred stock provisions: the special rights, powers, or preferences of preferred stock must be expressed clearly and will not be presumed or implied. 

Protecting Protective Provisions

Among the most highly negotiated contractual provisions related to preferred stock are the so-called “protective provisions,” which are contained in the certificate of incorporation and set forth a list of actions that the company cannot take without the prior consent of a specified percentage of the outstanding preferred stock. As its name implies, these provisions seek to protect the investment of the preferred stockholders from actions by the company that may dilute or diminish their investment. As some holders of preferred stock learned the hard way, however, the absence of a single phrase or the reliance on a general, catch-all provision can result in the elimination or circumvention of some or all of these highly negotiated protective provisions. 

Being “Benchmarked” 

The absence of the simple phrase “including by merger or otherwise” could ultimately result in the inapplicability of all of the preferred stock protective provisions through amendments effected by merger rather than through a direct amendment to the certificate of incorporation. In Benchmark Capital Partners, IV, L.P. v. Vague, 2002 WL 1732423 (Del. Ch. July 15, 2002), aff’d, 822 A.2d 396 (Del. 2003), Benchmark Capital Partners (Benchmark) purchased shares of preferred stock of Juniper Financial Corp. (Juniper) in exchange for certain provisions in Juniper’s certificate of incorporation to protect Benchmark’s investment. These protective provisions included the requirement that Juniper obtain Benchmark’s consent prior to taking any action that would “materially adversely change the rights, preferences and privileges” of Benchmark’s preferred stock. 

Several years later, when Juniper was in need of additional financing, Juniper and its potential investor proposed a transaction that would involve an investment of $50 million in financing in Juniper in exchange for shares of a new series of preferred stock of Juniper. In connection with the proposed transaction, Juniper initially considered amending its certificate of incorporation to permit the issuance of the new series of preferred stock, but reconsidered when it realized that Benchmark could invoke its protective provisions to block such action. Instead, to avoid Benchmark’s protective provisions, Juniper merged a wholly owned subsidiary with and into itself and, by virtue of the merger, amended and restated its certificate of incorporation. The amendments to the certificate of incorporation included the creation of a new series of preferred stock and the conversion of Benchmark’s existing preferred stock into a new series of junior preferred stock with diminished rights. 

In response, Benchmark filed suit in the Delaware Court of Chancery seeking to preliminarily enjoin the merger on the basis that Juniper failed to obtain the votes required by two of its protective provisions – a series vote of the holders of each series of existing preferred stock on the merger because the amendments would “materially adversely change the rights, preferences and privileges” of such series, and a class vote of the holders of existing preferred stock because Juniper “authorize[d] or issue[d], or obligate[d] itself to issue, any other equity security . . . senior to or on a parity with” the existing preferred stock. Juniper responded that Benchmark was not entitled to a series or class vote related to the merger because the adverse change to Benchmark’s rights was the result of a merger, as opposed to a direct amendment to the certificate of incorporation, and Benchmark’s protective provisions did not expressly apply to mergers. 

The court agreed with Juniper and held that protective provisions drafted to track Section 242(b)(2) of the DGCL (which provides holders of any class of capital stock with a class vote on an amendment to a certificate of incorporation that would “alter or change the powers, preferences, or special rights of the shares of such class so as to affect them adversely”) do not provide a class vote on a merger including one in which the certificate of incorporation of the surviving corporation is amended in the merger, absent an express provision of the certificate of incorporation to the contrary. Thus, because the protective provisions covering amendments to the certificate of incorporation did not include the phrase “including by merger or otherwise,” Juniper was able to amend its certificate of incorporation by virtue of merger to severely diminish Benchmark’s rights without Benchmark’s consent. 

Benchmark is consistent with decisions of the Delaware Supreme Court, including Elliott Associates, L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998), that provided a “path” for future drafters of preferred stock provisions. The Supreme Court noted that when a charter “grants only the right to vote on an amendment, alteration or repeal, the preferred have no class vote in a merger,” but when a charter “adds the terms ‘whether by merger, consolidation or otherwise’ and a merger results in an amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote.” As a result, drafters of preferred stock provisions should be cognizant of this “path” and draft protective provisions accordingly. 

Being “Crackered” 

Preferred stock provisions frequently provide that all shares of convertible preferred stock will convert automatically into shares of common stock upon the consent of the holders of a majority of the preferred stock. Where different series of preferred stock have different economic rights or protective provisions, holders of a series of preferred stock that do not own enough shares to block such an automatic conversion may lose their special economic rights or protective provisions if the holders of a majority of the preferred stock determine to convert the preferred stock into common stock. In Greenmont Capital Partners I, L.P. v. Mary’s Gone Crackers, Inc., 2012 WL 4479999 (Del. Ch. Sept. 28, 2012), the Delaware Court of Chancery considered whether, under Delaware law and the terms of the company’s certificate of incorporation, Mary’s Gone Crackers had the power to implement an automatic conversion of all of the shares of its Series A and Series B preferred stock into shares of common stock and subsequently to amend the certificate of incorporation to remove all references to the preferred stock (including its rights, powers, and preferences) without the consent of the holders of the Series B preferred stock. 

Under the company’s certificate of incorporation, a vote of the majority of the holders of the outstanding shares of Series A and Series B preferred stock (voting together) had the right to automatically convert their shares into shares of common stock. Because the holders of the Series A preferred stock (who enjoyed fewer benefits under the certificate of incorporation than the holders of the Series B preferred stock) owned a majority of the total shares of preferred stock, the holders of the Series A preferred stock had the ability to automatically convert all of the shares of the outstanding Series A and Series B preferred stock into common stock without the consent of the holders of the Series B preferred stock. In early 2012, Mary’s Gone Crackers solicited and received consents from a sufficient number of holders of the Series A preferred stock to effect the automatic conversion of all the shares of the company’s preferred stock into shares of common stock. 

A holder of the Series B preferred stock filed suit in the Delaware Court of Chancery claiming that the consent of the holders of the Series B preferred stock was required to effect the automatic conversion (and subsequently to amend the charter) based on certain protective provisions contained in the company’s certificate of incorporation, including consent rights over the company’s ability to take any action that would alter or change the powers, preferences, and rights of the Series B preferred stock. The court disagreed and held that the automatic conversion provision in the certificate of incorporation is a right of the holders of the preferred stock. Accordingly, the automatic conversion by the holders of a majority of the preferred stock to common stock was an effectuation of that right and was not an alteration or change to a right of the Series B preferred stock. The court noted that had the drafters of the preferred stock provisions intended for an automatic conversion to be subject to the consent rights of the holders of the Series B preferred stock, they could have expressly listed that right among the other consent rights of the holders of the Series B preferred stock. Because the holders of Series B preferred stock did not expressly bargain for the right to consent to any automatic conversion of the preferred stock, the holders of the Series A preferred stock were able to exercise the automatic conversion right and convert all of the shares of the preferred stock into common stock without the consent of the holders of the Series B preferred stock. 

What About Subsidiaries? 

When drafting preferred stock protective provisions that prevent the company from taking certain actions without the vote or consent of the holders of the company’s existing preferred stock, drafters should be aware that such provisions will not necessarily apply to any subsidiary of the company. Unless subsidiaries are specifically included within the scope of this protective provision, a subsidiary of the company could take actions that the company would otherwise be prevented from taking without the prior consent or vote of the preferred stockholders. For example, in In re Sunstates Corp. Shareholder Litigation, 788 A.2d 530 (Del. Ch. 2001), the Delaware Court of Chancery considered whether a preferred stock protective provision prohibiting the company from repurchasing its own shares when dividends were in arrears applied to purchases of the company’s stock by its subsidiaries. Consistent with prior decisions holding that the special rights of preferred stock must be expressed clearly, the court held that the relevant protective provision, which did not expressly provide that it applied to any subsidiary of the company, did not apply to purchases of the company’s stock by its subsidiaries. Further, the court noted that if the investors wished to prevent subsidiaries of the company from making such repurchases, they could have done so by including of the phrase “or permit any subsidiary of the company to take any such action.” 

“No Impairment” Clauses 

Protective provisions often include a “no impairment” clause, which typically provides that a company will not take any action that would impair the rights, powers, and preferences of the holders of the company’s existing preferred stock. In WatchMark Corp. v. ArgoGlobal Capital, LLC, 2004 WL 2694894 (Del. Ch. Nov. 4, 2004), the Delaware Court of Chancery rejected an argument that a “no impairment” clause operated as a gap filler to confer consent rights over actions that were not specifically addressed by the protective provisions in the certificate of incorporation. Delaware courts will not infer rights that are not expressly set forth in the certificate of incorporation, and thus “no impairment” clauses cannot be relied upon to provide protection that is not otherwise specifically granted. 

Consider Your Exit When You Enter 

In In re Trados Inc. Shareholder Litigation, 2013 WL 4511262 (Del. Ch. Aug. 16, 2013), the Delaware Court of Chancery noted that a typical investor’s investment timeframe is at odds with a company’s perpetual existence. Accordingly, investors whose investment horizon will require the company to engage in a liquidity event in a finite time period need to consider their exit strategy when they invest. If there is a divergence of interests between the holders of the preferred stock and common stock in a sale because, for example, all of the sale proceeds would go to the preferred stock and none of it would reach the common stock, it will generally be the duty of the board of directors to prefer the interests of the common stockholders to those of the preferred stockholders. In fact, directors could breach their fiduciary duties if they favor the interests of the preferred stockholders under these circumstances. In Trados, the court identified several contractual exit provisions to address the difficult fiduciary duty issues that can arise if such contractual exit rights are not present. These options include contractual drag-along rights requiring other stockholders to sell their shares to a purchaser if a majority of the stockholders approve the sale, put rights allowing the stockholder to put their stock to the company at a predesignated price after a fixed period of time, or a contractual agreement with the company to commence a sales process after a fixed period of time. Each of these options has limitations but, given the difficult fiduciary duty issues in the absence of such rights, consideration should be given at the time of investment to having a contractual exit strategy. 

Make Your Vote Count

In order to maintain control over their investment in the company, preferred stockholders often negotiate for certain special voting rights in exchange for their investment in the company. Any such voting rights must not only be clearly and specifically set forth, but they also must be carefully drafted to ensure that they are consistent with Delaware law and are included in the proper organizational document of the company. 

Set Forth Election and Voting Rights 

The most important voting right of preferred stockholders is often the right to designate a certain number of directors to the company’s board of directors. Under Delaware law, however, unless the certificate of incorporation provides otherwise, the majority of the stockholders of the company are entitled to elect all of the directors of the company. Thus, in order to provide preferred stockholders with the ability to designate a certain number of directors to the company’s board of directors, the election and voting rights of the preferred stockholders must be included in the certificate of incorporation. Election and voting rights of preferred stock that are only set forth in an investor rights agreement or a voting agreement and are not also included in a certificate of incorporation may not be specifically enforceable under Delaware law. 

Vacancies to be Filled in Same Manner as Appointed 

Many companies include a provision in their certificate of incorporation or bylaws that provides that any vacancy in a board seat may be filled by a majority of directors then in office. These provisions typically purport to apply regardless of whether the board seat was elected by a particular class or series of stock. It is not clear, however, that such a provision will work to fill a vacancy in a board seat that was elected by a particular class or series of stock. Section 223(a)(2) of the DGCL provides that, unless otherwise provided in the certificate of incorporation or the bylaws, “[w]henever the holders of any class or classes of stock or series thereof are entitled to elect 1 or more directors by the certificate of incorporation, vacancies and newly created directorships of such class or classes or series may be filled by a majority of the directors elected by such class or classes or series thereof then in office, or by a sole remaining director so elected.” 

The inclusion of the permissive term “may” suggests that the procedure for filling vacancies and newly created directorships is merely permissive and is not exclusive of other mechanisms that may be set forth in the certificate of incorporation or the bylaws. Thus, vacancies in seats elected by the holders of a particular class or series of preferred stock may, unless expressly provided otherwise, be filled by other stockholders. Drafters should be aware of such potential issues and consider providing that any vacancies must be filled in the same manner as the director who was originally appointed to the board of directors and may not be filled in any other manner. 

Eliminate Common Stockholders’ Ability to Vote on Amendments to Preferred Stock Provisions 

Once preferred stock has been issued, regardless of whether it was created by a stockholder-approved amendment to the certificate of incorporation or by the board of directors in a certificate of designation pursuant to blank check authority, the terms of that series of preferred stock can only be altered by amending the certificate of incorporation under Section 242 of the DGCL, which requires the approval of all stockholders entitled to vote generally, including the common stockholders. Drafters of preferred stock provisions, however, can provide in the certificate of incorporation that common stockholders are not entitled to vote on any amendment to the certificate of incorporation that relates solely to the terms of one or more series of preferred stock, if the holder of such affected series is entitled to vote on the amendment. As a result, if the parties want to retain the flexibility to seek to change the terms of preferred stock without having to obtain the consent of the common stockholders, they must include a provision to that effect in the certificate of incorporation. 

Voting Agreements Should Include an Irrevocable Proxy 

In addition to the right to designate certain members of the company’s board of directors, preferred stockholders frequently enter into an agreement with the company and other stockholders to vote their shares for the election of certain designees to the company’s board of directors. Drafters of any such voting agreement should be aware that it may be difficult to enforce such an agreement (other than through costly litigation) if the voting agreement does not include an irrevocable proxy granting the holder of such proxy the power to vote the shares subject to the voting agreement in accordance with the terms of the voting agreement in the event that any party to the voting agreement fails to do so. 

Appraisal Rights for Preferred Stock 

As a general matter, holders of preferred stock have the same appraisal rights under Section 262 of the DGCL as the holders of common stock. Unlike common stock, however, the fair value of the preferred stock in an appraisal proceeding is based solely on the contractual rights granted to the preferred shares being appraised under the certificate of incorporation. As a result, the preferred stockholders are only entitled to rights that are clearly and expressly provided to them in the event of a merger in the certificate of incorporation and are not entitled to additional merger consideration through the appraisal process. 

Whether a preferred stockholder is entitled to a preference over the common stockholders in a sale of the company depends on the terms of the preferred stock. Often the preferred stock has specific provisions governing its rights in a sale of the company. In the absence of such specific provisions, however, preferences to which preferred stock may be entitled in a “liquidation, dissolution or winding up” of the company will not apply to a merger, particularly where the terms of the preferred stock expressly state that a merger will not be deemed to be a liquidation, dissolution, or winding up for purposes of the liquidation provisions of the preferred stock. In the absence of such specification, the preferred stock will be deemed to have no “preference” over the common stock in a sale and instead will be entitled only to pro rata treatment with the common stock. 

In determining the fair value of the preferred stock based on the certificate of incorporation, a Delaware court will not consider speculative or probable contractual features of the preferred stock. For example, in In re Appraisal of Metromedia International Group, Inc., 971 A.2d 893 (Del. Ch. 2009), the Delaware Court of Chancery rejected an argument by preferred stockholders that, in determining the fair value of the company’s preferred stock, the court should consider the preference of the preferred stockholders contained in the certificate of incorporation in connection with a redemption or liquidation because the preferred stockholders argued that it is likely that such an event could occur in the next few years. The court rejected the argument, noting that a redemption or liquidation of the preferred stock was too speculative, and determined that the preferred stockholders were only entitled to receive the amount per share as provided in the certificate of incorporation in the event of a merger. 

On the other hand, the court will consider nonspeculative contractual features of the certificate of incorporation in determining the fair value of the preferred stock. For example, in Shiftan v. Morgan Joseph Holdings, Inc., 57 A.3d 928 (Del. Ch. 2012), in the determining the fair value of the company’s preferred stock, the court took into account the economic reality that the preferred stockholders would have been entitled to mandatory redemption of their shares just six months after the merger. Therefore, even though the redemption had not (and would never) take place due to the merger transaction, the fact that, prior to the merger, the redemption was certain to occur in the near-term (within six months) was relevant to the court’s determination of value of the preferred shares in the merger transaction. 

Conclusion

As demonstrated by the examples set forth above, the precise words that drafters employ clearly matter in determining the special rights, powers, and privileges of preferred stock. Such rights must be set forth clearly in the certificate of incorporation and will not be presumed by a Delaware court if challenged. Accordingly, drafters should be familiar with the DGCL and the relevant case law and take great care to ensure that all of the desired provisions are clearly expressed and defined at the time of the preferred stockholders’ investment in the company.

 

Selling LLC Interests: The Tax Consequences May Not Be What You Expected

Posted on December 17, 2013 by - Uncategorized

For a deal lawyer, few transactions are more commonplace than the sale of LLC interests. Sadly, the tax consequences of even some of the most routine of these sales can be stranger than any reasonable person would expect. This article touches on a few basic tax concepts, but in this area even some of the basics tend to evoke astonishment. The complexity of the tax aspects is no reason to shun LLCs. In situations where the client has a choice, the authors rarely recommend any other form of entity. However, business lawyers who work with these entities should be forewarned that the benefits can come at the price of often bewildering tax rules. 

The oddity of these tax principles becomes especially evident when comparing a simple sale of corporate stock with a sale of LLC units. We do not mean to suggest that the tax consequences of selling corporate stock are simple either. However, the rules on stock sales are generally more familiar to lawyers and, at least in most instances, tend to be more intuitive. 

Note that some LLCs actually are classified as corporations for tax purposes or are disregarded – additional grounds for complexity and confusion. But most LLCs are treated as partnerships for tax purposes and those are the only LLCs we are going to deal with here. 

A Simple Example

In 2010 Eva sells one of her shares of Paradise Inc. to Adam for $1,000. Paradise Inc. is a classic “C” corporation, subject to two levels of tax; it pays tax on its own income, and the shareholders pay additional tax when they receive dividends. Paradise Inc. pays some dividends out of its earnings. Paradise Inc. enjoys vigorous growth in value, and in mid-2012, Adam purchases one more share from Eva, this time paying $10,000. In early 2013, however, perhaps feeling some buyer’s remorse, Adam sells the second share for $10,000, the same amount he had paid for it. Since he sells the share at cost – and we’ll assume he had no transaction expenses – he recognizes no gain or loss. 

Now take the identical facts, except that Paradise is an LLC taxed as a partnership, rather than a corporation. It would be natural – but, as it turns out, quite misguided – to assume that LLCs are something like corporations, so that if Adam sells the second LLC unit for $10,000, he simply breaks even. But that is unlikely to be the case. 

LLC Basis in Constant Flux

One reason the sale of LLC interests is so complicated is that a member’s basis in an LLC interest changes so frequently. The amount that Adam pays for the units is only the starting point, and adjustments have to be taken into account to determine Adam’s basis. To a large extent, the reason the adjustments are needed is that the LLC does not pay tax on its own income. Instead, the members pay tax on the income as the LLC earns it, whether or not they receive distributions from the LLC. To determine which member is taxable on which portion of the income, the tax rules require an allocation of the income among the members. The allocation – which is essentially an accounting entry – increases a member’s basis, but the member generally is taxable on it even if the member receives no distribution. Conversely, when losses are allocated, the member suffers a decrease in basis but may be entitled to deduct a loss. Distributions reduce the members’ basis, offsetting the effect of income allocated. Contributions increase basis. Borrowing by the LLC is also allocated among the members, and each member’s share of that debt increases basis, even if such member has no liability on the debt. Each member receives an annual “Schedule K-1” from the LLC informing the member of these various adjustments. 

To make things simpler, let’s assume that the LLC incurred no debt, suffered no losses, received no capital contributions, and distributed to the members exactly the same amounts as it allocated to them. With these assumptions, Adam’s basis in his LLC interest should be the amount he paid to acquire the interest, just as his basis in the corporate stock was the purchase price. But even with these assumptions, other complications await. 

The “Blended” Tax Basis of LLC Units

Adam has a separate basis in each share of Paradise Inc. When he sells the second block of shares for what he paid, he has no gain or loss; it does not matter what he paid for the first block. Not so with Paradise LLC units. Adam’s basis in the different LLC units is blended or pooled; the division of his LLC interest into separate units has no significance under the tax rules. 

Adam paid a total of $11,000 for his LLC units ($1,000 in 2010 and $10,000 in 2012). His basis in half the LLC interest therefore is only $5,500. When he sells half his LLC interest for $10,000, he recognizes $4,500 of income. This is so regardless of which unit he chooses to sell. 

Thus, Adam has $4,500 more gain on selling the LLC unit than on selling the corporate stock. This is the result despite our assumption that Adam’s basis in both Paradise Inc. stock and Paradise LLC units equaled the purchase price, and even though in both cases the pricing of the transactions was the same. This does not mean LLCs are disadvantageous. If Adam had understood the relevant rules, some tax planning and restructuring might have served him well. For example, redemptions of LLC units can be tax-free in situations where comparable redemptions of corporate shares would be taxable. But Adam must understand the tax rules in order to see what alternatives might work better for him. 

Capital Gain or Ordinary Income Depends on LLC Assets

We turn next to the character of Adam’s gain – is it ordinary income, capital gain, or a mixture? The answer will be important given the current tax rules. For individuals, the maximum tax rate on ordinary income is often nearly 20 percentage points higher than on long-term capital gain. But to determine which rates apply, we need to know the makeup of the LLC’s assets. 

While the sale of LLC interests often results in capital gain, there are very large exceptions. To the extent the gain is attributable to so-called “hot assets” – i.e., inventory items and “unrealized receivables” of the LLC – Adam will recognize ordinary income instead of capital gain. While the first category seems straightforward, the latter category is a technical category that frustrates both tax and non-tax practitioners. In general, “unrealized receivables” refers to items that have not been taxed yet. For example, an account receivable of a medical practice that has not been included in income is an unrealized receivable. The definition, however, also extends to more esoteric concepts such as depreciation recapture. 

It is generally much easier to figure out the character of gain on the sale of corporate stock. There is no need to examine the assets of the corporation because the tax rules don’t “look through” the corporation to its assets. Adam knows whether he has ordinary income or capital gain on selling Paradise Inc. stock without regard to the assets the corporation holds. 

Let’s make another simplifying assumption about Paradise LLC: all its assets are “cold,” and so Adam’s gain on selling his units is entirely capital. 

Adam’s Gain Is Partly Long-Term and Partly Short-Term

Under current law, for the seller to get a favorable tax rate on capital gain, the asset must be held longer than one year. Gain on capital assets held for shorter periods is still considered capital gain, and may sometimes be advantageous, but the advantages do not include any break on the tax rate. Short-term capital gain and ordinary income are taxed at the same rate. 

Adam acquired his first unit in Paradise LLC more than a year before the sale, but he sold the second unit, which was held less than a year. However, just as the division of Adam’s LLC interest into units was ignored in determining the amount of his gain, that division is also ignored in determining his holding period (assuming Paradise LLC is not publicly traded). Under the tax rules, Adam simply sold half his interest in the LLC – from the tax viewpoint the attempt to separate his interest into two units has no effect. Adam’s holding period is divided, but the division ignores the existence of units. It turns out, in our simplified example, that 50 percent of his gain is short-term and 50 percent long-term. 

In comparison, if Adam had recognized any gain on the sale of his second share of Paradise Inc. stock, all the gain would have been short-term. So in that instance the LLC holding period rule would have been more favorable. The rule for splitting the holding period of LLC interests may help or hurt, depending on the situation. The important point is to be aware of the rule and plan accordingly. 

No Automatic Qualification for Most Favorable Rate

If Adam had recognized capital gain on the sale of Paradise Inc. stock, he could have determined his maximum tax rate without inquiring about the assets that the corporation happened to have. He would have qualified for the 20 percent maximum rate on long-term gain, although his short-term gain would have been considered ordinary income taxable at a maximum rate of 39.6 percent. (These rates do not include the 3.8 percent “Medicare” tax that went into effect in 2013, or any state and local taxes.) 

The maximum long-term capital gain rate on the sale of LLC interests by individuals is generally 20 percent, just as it is on corporate stock. However, if the LLC holds depreciable real property, then a 25 percent maximum rate may apply to at least some of the gain. If any of Adam’s long-term capital gain on the sale of his LLC units is attributable to “collectibles” – such as art, antiques, metals, gems, stamps, or coins – held by the LLC, the maximum rate increases to 28 percent. 

Some Issues Between Adam and the Buyer

The buyer of Adam’s LLC unit – call her Lilith – will start with a cost basis of $10,000, equal to the fair market value of the unit she just purchased. This is a reasonable result as far as it goes, but it may obscure the potential problems discussed below. (If Paradise LLC had any debt, Lilith’s basis might start off higher than $10,000, but we have stipulated that the LLC is debt free.) 

For example, suppose that the LLC had earned a significant amount of income shortly before Lilith acquired her unit, and had distributed the proceeds to Adam, Eva, and any other members at the time. Since Lilith did not enjoy any benefit from that income, it would not seem fair to require her to pay tax on it. However, if she is not careful, she may be stuck with part of that tax bill. 

As noted above, the tax rules require the LLC’s income to be allocated to its members. Under one allocation method the income is prorated – smoothed out as if the income had been earned each day of the year. Under that method, Lilith is allocated a portion of the income for the year based on the number of days she has been a member. It is irrelevant whether the income is earned before or after she buys in, or whether she gets the slightest benefit from the income. It is easy to construct examples where the new member bears catastrophic tax liability – perhaps more than her total purchase price – on income that she had no share of. Distortions of this kind do not arise on the sale of classic “C” corporations. Note that under our facts it is the buyer who is harmed by this distortion. In some instances, however, it would be the seller who suffers – for example, if Paradise LLC had incurred a significant loss before the sale, Lilith might be allocated some portion. 

The way to prevent such distortions is to “close the books” as of the date that interests in the LLC change. If the books of Paradise LLC close when Adam sells units to Lilith, then Lilith would not be allocated any of the income arising before the sale. The LLC agreement may leave the choice between proration and closing the books to the buyer and seller, but it need not. It is possible that the LLC agreement will limit or even eliminate one or the other of the two methods. Adam and Lilith need to examine the LLC agreement. 

Closing the books solves one kind of problem, but it fails to resolve another common but perhaps less obvious concern. When Lilith bought her units from Adam, the basis that the LLC had in its assets was likely quite low, much lower than fair market value. The difference between the low basis that the LLC has in its assets and the fair market value basis that Lilith has in her interest in the LLC may cause Lilith to be unfairly taxed. Tax practitioners refer to this as an “inside/outside” basis difference. Lilith has a high basis in her LLC interest (her “outside basis”), but her corresponding share of LLC assets has a low basis (her “inside” basis). For a variety of technical reasons, these types of differences can cause tax inefficiencies. 

Here is an example of the problem.  Suppose that the day after Lilith’s arrival the LLC sells the bulk of its assets for $27,000, and that all $27,000 is gain (i.e., these assets had a zero basis). If Lilith owns one-third of the LLC at the time, she is allocated $9,000 of taxable income. The LLC chooses to distribute $9,000 to Lilith, but – because the LLC has disposed of most of its assets – the value of her LLC declines from $10,000 to $1,000. Lilith plainly has not enjoyed $9,000 of income since acquiring her interest in the LLC. The value of her interest in the LLC did not grow between the time she acquired the interest and the time the LLC sold its assets. In reality, Lilith has simply received back $9,000 of her $10,000 investment. However, the tax rules fail to recognize that reality, and charge her with tax on $9,000 of income, unless the parties take action to alleviate the problem. 

There is a tax election that can resolve this problem. When the election functions as intended, the basis of Lilith’s share of the LLC’s assets is increased and she avoids any consequences of an inside/outside basis difference. Critically, however, the election is made by the LLC, and not by Lilith. Depending on the terms of the LLC agreement, Lilith may or may not be able to require the LLC to have the election in place when needed. The availability of the election is an important consideration for Lilith when she is deciding whether to buy Adam’s units. The units may be less valuable if the election cannot be put in place. 

More Trouble Areas

This article is not intended to provide a definitive survey of tax issues that need to be considered in confecting a sale of an LLC interest. However, in addition to the issues already mentioned, practitioners need to be aware of the following: 

Technical Terminations 

A sale of 50 percent or more of the LLC interests in a 12-month period can cause a “termination” of the LLC for tax purposes, even though the LLCs continuity as a business entity under state law is in no way impaired. While the real world consequences are often not dramatic, for some LLCs (particularly those which own property that qualifies for accelerated depreciation), the results may be significant. 

Deemed Debt Relief 

As noted, one component of a member’s basis in her LLC interest is her “share” of the LLC’s debt. For tax purposes, when a member sells an interest in an LLC, the actual consideration received is artificially adjusted by an amount equal to the change in her share of LLC debt. Depending on the details of the LLC debt and whether she sells all or a portion of her interest in the LLC, these rules can significantly complicate the amount of gain or loss she will have to recognize. 

Differing Types of LLC Interests 

If a member holds different classes of interests in an LLC (e.g., common and preferred units), the sale of one class and not the other can make application of the pooled basis rules even more complicated. In fact even when two LLC units are nominally of the same class, there may be differences between them. Whereas the sale of one of Adam’s two identical LLC units required him to assign half of his total basis to the unit that was sold, the same result does not obtain if the two units have different rights and economics. In that case, it will generally be necessary for Adam to determine the fair market value of both classes. 

Redemptions 

Economically, there is little difference between selling an interest in an LLC and having the LLC redeem such an interest. However, such transactions introduce a number of new issues, particularly if the LLC makes a noncash distribution to effectuate the redemption, which can create unintended consequences. 

Conclusion

Tax issues are messy. No one would hold up the tax consequences of buying and selling stock of corporations as a model of simplicity and clarity. In our experience, however, the tax treatment of stock sales rarely elicits the kind of shock that comparable sales of interests in LLCs – that is, LLCs classified for tax purposes as partnerships – often arouses. Corporations cannot compete with many of the tax advantages that LLCs offer. However, the gap between what most lawyers would expect, and what the tax rules actually require, is larger in the case of LLCs than corporations. While it is never a good idea to rely solely on intuition in anticipating the tax consequences of a transaction, intuition is often especially unreliable when dealing with LLCs.