One of the most basic questions that policyholders consider when assessing insurance policies is “who (or what) is covered?” Some policies, such as commercial general liability policies, answer that question more directly using standard form sections with titles like “Who Is an Insured.” Other liability policies, like those for directors and officers (D&O) liability or errors and omissions (E&O) coverage, may be less straightforward and require a more nuanced analysis of the various policy forms, definitions, and endorsements. In all cases, a good place to start is the policy declarations page, which typically identifies one or more “named insureds.” Those key insureds are the persons or entities who own the policy and whose names appear at the beginning of the policy.
Although the scope and amount of coverage available to entities or individuals varies significantly based on the type of coverage, policy terms, and facts giving rise to a particular claim, attention to the kind of insureds protected under a particular insuring agreement or policy is always critical. One event that could impact—or even eliminate—coverage for insureds is a name change, acquisition, merger, asset sale, or other change in corporate form. This article discusses several common insurability issues related to the corporate form for policyholders to consider when placing or renewing coverage.
Preserving Coverage in Deals
Nuanced analysis of who or what is covered may be academic if a change to corporate form following a deal negates potential coverage under legacy policies altogether. These insurance pitfalls can arise in a variety of ways.
For “claims-made” policies like D&O and E&O policies, an M&A transaction, restructuring, or other change to corporate form may result in a “change in control.” This matters because those policies typically will only cover wrongful acts by insureds that were alleged to occur before the closing date. A change in control sends the policy into “runoff,” which limits coverage to pre-transaction conduct and cuts off going-forward coverage for the company and its directors, officers, or employees.
The runoff terms depend on both the language of the seller’s D&O policy, which may provide for automatic conversion to runoff upon a change in control, and the effective date of the deal. Whether those provisions are triggered—and, if so, when the change in control occurs—can impact coverage for claims for pre-transaction wrongful acts that arise after the triggering event occurs.
To combat the risk of losing future coverage for pre-transaction acts, it is common (and encouraged) for buyers to require targets to obtain “tail” coverage for their policies for pre-transaction liabilities. Tail coverage extends the reporting period for a target’s current policy for a specified period of time. The period of the tail coverage can vary, but three to six years is most common. Tail coverage can protect buyers for claims that may have occurred prior to the consummation of the M&A transaction, and a buyer will want to avoid the risk that a claim is made against the target officers and directors after the acquisition and after expiration of the target’s D&O policy period. It is important to consider that many insurance companies will only provide D&O tail policies to a target company that already had D&O insurance in place before it received an offer to be bought.
Finally, careful attention must also be given to preserving insurance assets as part of any deal. In many deals, a surviving or acquiring entity does not assume all liabilities of the company it is acquiring. Many times, the successful transfer of interests under insurance policies in a particular transaction can turn on applicable state law. Limiting the transfer of liabilities or assets can have potential adverse impacts on the surviving entity’s ability to access historic insurance policies or to trigger coverage for legacy liabilities related to pre-transaction conduct.
Policy Changes May Lead to Unintended Consequences
There is no one-size-fits-all approach to modifying insurance policies to account for changes to corporate form. For example, there may be unintended consequences from identifying named insureds and any associated “dbas” (doing business as) or trade names in the declaration pages of liability policies. Some policyholders have found out the hard way, in litigation, that coverage may be limited depending on the specific wording of named insureds in an insurance policy. See, e.g., Masonic Temple Ass’n of Quincy, Inc. v. Patel, 185 N.E.3d 888 (Mass. 2022); see also Cent. Mut. Ins. Co. v. Davis, 576 F. Supp. 3d 493 (S.D. Tex. 2021) (stating as a matter of first impression that a designation of insured doing business as a named entity may still serve as a limiting phrase if the policy language shows that the parties intended to limit insurance coverage to one specific sole proprietorship).
In Masonic Temple Association of Quincy, Inc., for example, the Massachusetts Supreme Judicial Court held that a company was not covered under a liability policy where the company’s liabilities arose from activities outside the “dba” name identified in the policy’s declarations. The insured hotel business obtained several million dollars in general liability and umbrella coverage. When a dispute arose at a construction project about whether the business had adequate insurance to cover the work, the president of the company reached out to his insurance agent to modify the policies, including by listing the insured with reference to a “dba,” which led to a resumption of the construction project.
Following a fire at the property, an insurer denied coverage on the ground that it insured the hotel business only for operations at the “dba” address listed in the policy. In the coverage litigation that followed, the policyholder argued that the use of a “dba” name did not create a separate legal entity, so all of the company’s activities were covered under the policy, whether they related to the “dba” name or not. But the Massachusetts Supreme Judicial Court disagreed and held that the “ordinary understanding” of the phrase “doing business as” a particular entity meant that the policy only covered liability arising from activities undertaken while doing business as the listed entity. Any other interpretation, the court reasoned, would render the “dba” designation superfluous.
The Masonic Temple decision shows that clarifications to named insured provisions, even if well-intentioned, may have adverse consequences by unintentionally limiting coverage.
Takeaways
Insurance-related considerations for changes to corporate form are not limited to modified declarations pages or tail policies. For example, even in the absence of a change in control, policies may have other requirements related to acquisitions of new subsidiaries or similar operational changes that could jeopardize coverage if violated. Policyholders may have to undergo additional underwriting, or pay additional premiums, to cover the new acquisition. Even where coverage for new subsidiaries is automatic, policies may require notice or acceptance of special terms or exclusions related to the transaction to preserve coverage beyond an initial grace period. Engaging insurance coverage counsel as part of a deal team can help monitor these insurance requirements, ensure continuity of coverage, and avoid any unexpected coverage gaps.
The above concerns require nuanced analysis based on the specific lines of coverage, policy language, and circumstances giving rise to the name change or corporate restructuring. As just one example, the potential adverse impact of modifying named insureds to reflect trade names stands in contrast to insurance requirements in some jurisdictions where state regulators may require proof of name changes in certain policies when filing for a new “dba” or assumed name.
Careful analysis of insurance considerations in conjunction with changes to corporate form is of paramount importance in order to identify and resolve any issues before they cause problems securing coverage months, or even years later, when it may be too late. Retaining insurance coverage counsel early and often in the deal process can help minimize these risks and maximize recovery in the event of a claim.
This article is an introduction to the following article,[1] which was written by this author and published in the October 2023 issue of the Penn State Law Review’s online companion, the Penn Statim:
The Summary of New Developments article is based on the recent update of the New Developments section of chapter 1 of this author’s six-volume book, Mergers, Acquisitions and Tender Offers, which is published by the Practising Law Institute and updated twice a year. This New Developments section is divided into the following principal sections:
Section I, Recent Data: Macro View of the Recent Economic and Financial Impact of M&A, Sections 1:7.5 through 1:7.10;
Section II, Recent Data: Structural Issues in Recent M&A Deals, Sections 1:7.11 through 1:7.19;
Section III, Recent Data: Takeover Defenses, Tender Offers, and Related Issues, Sections 1:7.20 through 1:7.31;
Section IV, Recent Data: Cross Border M&A, Sections 1:7.32 through 1:7.36; and
Section V, Recent Data: Other M&A Issues, Section 1:7.37 through 1:7.43.
It must be emphasized that this Summary of New Developments focuses principally on the recent economic and financial aspects of M&A, and not on substantive legal developments. Those developments are addressed in the relevant chapters of the book, which has twenty-eight chapters. All mentions of specific chapters in the following text refer to Mergers, Acquisitions and Tender Offers.
The following sections of this article briefly discuss some of the highlights addressed in the five major sections of the Summary of New Developments. The emphasis here is on “some,” as there are many important concepts not discussed in this document.
Part I, Macro View of the Recent Economic and Financial Impact of M&A (Sections 1:7.5 through 1:7.10 of the Article)
The Rollercoaster Ride in Recent M&A. From 2013 through 2020, U.S. M&A activity was fairly level in both dollar value and number of deals. However, there was a “rollercoaster ride” from 2020 to 2022, with a significant increase in both deal volume and number of deals from 2020 to 2021, followed by a significant decrease in both of these measures from 2021 to 2022. Worldwide M&A activity generally followed this same pattern.
The fall in U.S. M&A activity from 2021 to 2022 was largely attributable to rising interest rates, which were engineered by the Federal Reserve Board in its fight against inflation.
M&A and GDP. M&A deal volume tends to move in lockstep with the growth or decline in aggregate Gross Domestic Product (GDP).[2] If GDP falls, which happens in a recession such as the recent one attributable to COVID-19, then M&A deal volume tends to fall.
M&A activity is also generally correlated with increases and decreases in the stock market. As inflation increases, interest rates will generally increase, and stock prices will generally fall. In addition, the S&P 500 (a broad measure of the value of stock) and total M&A transaction value generally move in lockstep, with both moving up or down together. However, during the COVID-19 years from 2019 to 2020, the stock market went up rather dramatically, while M&A volume dropped significantly, as did gross domestic product (GDP). This is an indication that the stock market is forward looking, whereas the growth in GDP from year to year is a function of the then-current economic performance.
Also, generally, when domestic M&A activity is robust, foreign M&A activity also tends to be robust, and when domestic activity declines, as was the case in 2022, foreign activity tends also to decline. This may mean that M&A activity, whether domestic or foreign, is driven by the same factors.
Cash or Stock? Most M&A transactions are all-cash deals, and this has remained true in recent years. As discussed in chapter 9, all-cash deals are virtually always taxable to the Target’s shareholders. On the other hand, if the consideration is all stock of the Acquirer, the transaction is generally tax free to the Target’s shareholders. In most years, in approximately 15% of all deals, stock of the Acquirer is the sole consideration.
Top Target Industries. For 2022, the top target industry in terms of both number of deals and dollar value of deals was “Technology Services.”
Domestic vs. Foreign Deals. Although in many years the value of U.S. deals exceeds the value of foreign deals, in all but one year since 2013 (2015), the number of foreign deals exceeded, by a wide margin, the number of U.S. deals. This indicates that the average value of foreign deals is substantially less than the average value of U.S. deals.
Overall Assessment of M&A in 2022. This brings us to the following overall assessment of M&A in 2022 by the Wachtell Lipton law firm, one of the most active law firms specializing in M&A:
The year 2022 was a tale of two halves for M&A. The beginning of the year was active, as robust deal-making carried over from the record-breaking levels of 2021 . . . . [However,] M&A activity slowed considerably after the first half of 2022, [as a result of] [1] a substantial dislocation in financing markets, [2] an increasingly volatile stock market, [3] declining share prices, [4] concerns over inflation, [5] rapidly increasing interest rates, [6] war in Europe, [7] supply chain disruption, and [8] the possibility of a global recession[.][3]
The article points out that “[n]otwithstanding lower overall activity, a number of megadeals were signed in 2022.”[4]
Part II, Structural Issues in Recent M&A Deals (Sections 1:7.11 through 1:7.19 of the Article)
Relative Numbers and Values of Public and Private Deals. While the number of public acquisitions and mergers is significantly less than the number of such private deals, the aggregate deal value of public deals is significantly more than the aggregated deal value of private deals. For example, for 2022, there were 216 acquisitions of publicly held U.S. Targets for a total of $653 billion, while, on the other hand, in the same year, there were 10,900 acquisitions of privately held domestic Targets for a total consideration of $252 billion.[5]
Thus, while the business press is full of articles discussing deals in which a publicly held Target is acquired, the number of these deals is nowhere near the number of non-public deals. However, the average value of these public deals generally exceeds by a wide margin the average value of private deals.
The EBITDA Valuation Metric. As discussed in chapter 11, which deals with valuation, a common deal metric is the comparison of (1) the Target’s earnings before interest, taxes, depreciation, and amortization (EBITDA) with (2) the Target’s total invested capital (TIC) or enterprise value (EV). Both TIC and EV mean the fair market value of the firm’s total debt (net of cash held) and equity. In addressing the EV/EBITDA ratio of the market generally as of the beginning of 2023, the Litera 2023 M&A Report explains:
Perhaps the biggest finding in this report is around EV/EBITDA valuations, which appear to be coming down at long last. Since 2016, the median M&A multiple has hovered around 10x, briefly wading into 11x territory in the buying frenzy of late 2021. For the first time in six years, however, the median EV/EBITDA multiple fell below 10x in Q3 2022, and the fourth quarter is following the same trajectory.[6]
In virtually all cases, the M&A multiple will be higher than the S&P 500 multiple because Acquirers have to pay a price that is higher than the going market price in order to get a sufficient number of a Target’s shareholders to accept the transaction.
Impact of Rising Interest Rates and PE Deals. It can be expected that as interest rates rise, thereby increasing the cost of financing acquisitions, the price Acquirers will be willing to pay for Targets will fall. Also, the increased interest rates in 2022 and 2023 have led some Private Equity (PE) deals (see chapter 14) to be done on an all-equity basis.
The Level of PE Activity. As an illustration of the significance of PE in M&A deals, it has been reported that over the years the following PE firms have completed the indicated number of deals: (1) Shore Capital Partners—586; (2) The Carlyle Group—485; and (3) KKR—438.[7]
Overpayments by Acquirers. In public deals, there is a tendency for the Acquirer to overpay. Investors’ concern about overpayment is illustrated in the 2020 acquisition of Slack by Salesforce. In that transaction, one source reported that the shares of Salesforce fell from around $264 before the deal became known to $220.78 at the end of the day the transaction was announced. The loss was 16.5% of the pre-announcement value, representing a $18.7 billion loss in value, which apparently was more than the amount paid for Slack.[8]
Part III, Takeover Defenses, Tender Offers, and Related Issues (Sections 1:7.20 through 1:7.31 of the Article)
The Pill. As discussed more fully in chapter 5, the most potent defensive tactic against a hostile takeover attempt is the Shareholder Rights Plan (i.e., Poison Pill), and although there had been a decrease in the number of companies with pills from 2006, there appears to have been a slight uptick in the number since COVID. However, a pill can be adopted in a “moment” after a Target’s board receives “notice” of an unwelcome offer.
The potential ineffectiveness of a pill in preventing a hostile takeover is illustrated in the 2022 acquisition by Elon Musk of Twitter. For example, an article in the New York Times on April 15, 2022, discussing the adoption of Twitter’s pill was entitled “Twitter Counters a Musk Takeover with a Time-Tested Barrier.”[9] Twitter’s “Time-Tested Barrier” was effective for exactly ten days, because, as a result of shareholder complaints and threats of suit, Twitter’s board entered into a merger agreement with Musk on April 25, 2022.[10]
This is an illustration that in Delaware, where Twitter is incorporated, a Target cannot use a pill to “Just Say No.” On the other hand, it may be possible for a Target incorporated in certain other states, such as Pennsylvania, to use a pill to “Just Say No.”
There is often a lot of interest in hostile tender offers. These are transactions in which a hostile Acquirer makes an unwanted bid directly to the shareholders of the Target. Tender offers can also be non-hostile as a first step in effectuating a two-step merger. As indicated in chapter 4, in many cases a consensual tender offer followed by merger can be effectuated much more quickly than a one-step merger.
Notwithstanding the large interest in hostile tender offers, they are rare. For example, in 2018 and 2019, there were only three; in 2020, there were six; in 2021, there was one; and in 2022, there were four. The treat of a hostile tender offer can cause a Target’s management to pay closer attention to their jobs; however, with the pill and the threat of a pill, potential hostile Acquirers are significantly deterred.
Deal Protection Devices; Direct and Reverse Termination Fees. A significant amount of time and effort goes into the planning and negotiating of a consensual deal, and an Acquirer will naturally be concerned that it will spend a lot of time and effort in securing a deal and then seeing the deal snatched by a higher bidder. One way of reducing the risk of loss is for the Acquirer to negotiate for a termination fee to be paid by the Target if the Target accepts a higher bid from a third party. As demonstrated in chapter 5, there can be a breach of the fiduciary duties of the Target’s directors if the termination fee is so high that potential topping bidders would be deterred from putting in a higher bid.
In addressing this issue in 2022, the average termination fee when measured against (1) the Target’s Total Invested Capital (i.e., equity and debt) was 4.1%, and (2) deal size was 3.3%.[11] As discussed in chapter 5, absent unusual circumstance, a court is likely to find a termination fee at these levels acceptable.
While termination fees are generally present in negotiated acquisitions of a public Target, they are rare in acquisitions of closely held Targets.
A termination fee paid by the Target to the Acquirer is commonly referred to as a Direct Termination Fee. A termination fee running from the Acquirer to the Target if the Acquirer walks away from the transaction is referred to as a Reverse Termination Fee, and as discussed in chapter 5, as a general matter, they do not present the same fiduciary duty issues as a Direct Termination Fee. Consequently, generally there is no limit on the size of a Reverse Termination Fee. In many transactions, such as in the Twitter deal, the Direct and Reverse Termination Fees are the same size.
In most public deals and in virtually all private deals, there will be a “No Shop” provision, which will, after the signing of the deal, prevent the Target’s board from actively seeking a higher deal. As indicated in chapter 5, while these provisions are generally acceptable in Delaware, they generally cannot be used by a Target’s board to “Just Say No” if it is approached by a potential higher bidder.
In some deals, the Target’s board may be given a “Go Shop,” which will for a specific period of time after the signing of the deal permit the Target’s board to seek an alternative buyer. As a general matter, the Termination Fee the Target will have to pay if it goes with a topping bidder that arises in the Go Shop period will be less than the Termination Fee that will have to be paid if the topping bidder shows up after the Go Shop period.
Banks and Bankruptcies. Virtually every business executive and business lawyer is aware of the bankruptcies of several banks that occurred in 2023. As addressed more fully in chapters 16 and 17, as a result of the Federal Reserve Board’s tight monetary policy (i.e., higher interest rates) for fighting inflation, there were the following three major bank bankruptcies during calendar year 2023 as of June 15, 2023:
Signature Bank;
Silicon Valley Bank; and
First Republic Bank of San Francisco.
In each of the above three transactions the banks were taken over by a profitable bank holding company. As of November 9, 2023, there were also bankruptcies by the following two banks: Citizens Bank, Sac City, Iowa and Heartland Tri-State Bank, Elkhart, Kansas.[12]
As discussed more fully in chapter 16, which deals with bankruptcy generally, and chapter 17, which deals with bank acquisitions, as a general matter, the cause of these bankruptcies was higher interest rates engineered by the Fed in its fight against inflation. Rather than borrowing low and lending high, these banks got caught into the trap of having to borrow high and lend low.
Most Active Investment Banks and Law Firms. As indicated from the following Figure 1-30 in the Summary of New Developments article, many of the usual investment banking firm and law firm “suspects” were the most active in M&A for 2022:
Figure 1-30
Top 10 M&A Investment Banking Firms and Law Firms Ranked by U.S. Deal Volume 2022
Investment Banking Firms (a)
Law Firm (b)
1
Goldman Sachs & Co. LLC
Simpson Thacher & Bartlett LLP
2
JPMorgan Chase & Co.
Sullivan & Cromwell LLP
3
Morgan Stanley
Skadden, Arps, Slate, Meagher & Flom LLP
4
Bank of America Securities Inc.
Latham & Watkins LLP
5
Citigroup Inc.
Wachtell, Lipton, Rosen & Katz
6
Barclays Bank Plc
Kirkland & Ellis LLP
7
Credit Suisse
Weil, Gotshal & Manges LLP
8
Evercore, Inc.
Gibson, Dunn & Crutcher LLP
9
Wells Fargo & Co.
Debevoise & Plimpton LLP
10
Allen & Co., Inc
Cravath, Swaine & Moore LLP
Sources: (a) 2022 Mergerstat Financial Advisor Rank by Total Value, 2023 FactSet Review at 74. (b) 2022 Mergerstat Legal Advisor Ranking by Total Value, 2023 FactSet Review at 75.
Proxy Contests. As discussed more fully in chapters 5 and 8, a proxy contest can involve, inter alia, (1) an attempt by an insurgent individual or group to gain control of the board of a publicly held company, and (2) an attempt by a potential Acquirer to replace the board of a publicly held Target company with the purpose of facilitating the acquisition of the Target by the Acquirer. Proxy contests may also involve the efforts of an activist shareholder, such as Carl Icahn, to use such a technique to gain control of the board for the purpose of changing the Target corporation’s business policies. Activist proxy contests are generally addressed in the next section.
The number of these contests ranged from 102[13] in 2018 to 85 in 2022, with the number going straight down yearly from 2018 to 2022. The reasons for this drop are not clear to this author; however, it can be expected that the SEC’s new “Universal Proxy” rules, which were adopted in 2021, could have had a depressing impact on the number of proxy contests.
Activist Shareholders. As discussed in chapter 28, activist shareholders are involved in many proxy contests. However, the activist does not prevail often; for example, in 2022 the Activist prevailed in eight of the 85 contests. As indicated next, an activist may employ a short selling strategy.
Short Selling and the Attack on Ichan Enterprises. Although short selling strategies are not included in the Summary of New Developments, there could be a heightened interest in short selling strategies as a result of the short selling attack on Icahn Enterprises, controlled by Carl Ichan, arguably one of the “Kings of Short Sellers.”
A traditional short selling investment strategy could include the following steps taken by the Short Seller:
The Short Seller borrows stock of the Short Selling Target;
The Short Seller then sells the borrowed stock on the open market at the going price, say $20 per share;
The Short Seller then talks down the price of the stock through publicly distributed analyses that show that the stock of the Short Selling Target is over-priced; and
After the expected fall in the price of the stock of the Short Selling Target, say to $12 per share, the Short Seller purchases the stock at $12 per share and uses that stock to close out the original borrowed stock position, which was $20 per share.
When the dust settles, the Short Seller has a profit of $8 per share before expenses.
Thus, rather than following the usual investing strategy of buying low and then selling high, the short seller sells high and then buys low, with that stock used to close out the high price position that was financed with debt.
As discussed in chapter 28, Icahn Enterprises, L.P., a publicly held firm controlled by Carl Icahn, came under a short selling attack in 2023 by a short selling firm, Hindenberg Research. As a result of that attack, there was a significant drop in the trading price of Ichan Enterprises, leading one source to title its report on the situation as “Icahn Got Icahn’ed.”
As a result of this situation, it can be expected that there will be a heightened interest in short-selling strategies.
Part IV, Cross Border M&A (Sections 1:7.32 through 1:7.36 of the Article)
In General. Chapters 19 through 22 address various aspects of inbound (i.e., acquisitions by a Foreign Acquirer of a US. Target) and outbound (i.e., acquisitions of by a U.S. Acquirer of a Foreign Target) cross border M&A. This section provides a high-level review of some of the financial and economic considerations of this activity.
Wachtell Lipton publishes an annual Cross-Border M&A Guide,[14] and the 2023 Guide, which was issued in early 2023 covering principally 2022 activity, provides the following overview of cross border M&A activity during 2022:
[Cross Border M&A Generally:] Cross-border merger and acquisition (“M&A”) transactions are a significant part of the global M&A landscape, representing approximately a third of all deal activity annually in recent years.
[The “Reversion to the Mean”:] After a record-shattering year for M&A in 2021, the year 2022 represented a reversion to the mean in terms of M&A volume, reflecting the impact of [1] Russia’s invasion of Ukraine, [2] interest rate spikes, [3] challenging debt markets, [4] ongoing supply chain disruption, and [5] the Covid-19 pandemic.
Worldwide M&A volume decreased to $3.6 trillion in 2022, compared to an average of $4.3 trillion annually over the prior ten years (in 2022 dollars). Cross-border deal volume in 2022 was $1.1 trillion, equivalent to 32% of global M&A volume and consistent with the average proportion (35%) over the prior decade.
[Inbound Transactions:] Acquisitions of U.S. companies by non-U.S. acquirors constituted $217 billion in transaction volume and represented 19% of 2022 cross-border M&A volume.[15]
It is interesting to note that, as would be expected, the bulk of M&A activity takes place in North America and Europe.
The Impact of the Exchange Rate. The foreign exchange rate can have a significant impact on inbound acquisitions and outbound acquisitions. For example, if the dollar becomes weaker (that is, it takes less of a foreign currency to purchase a dollar) when measured against the currencies of the major trading partners of the United States, then (1) it will be cheaper for potential Acquirers located in such countries to buy U.S. Targets, and (2) at the same time, it will become more expensive for potential U.S. Acquirers to buy Targets located in such countries. The reverse is true if the dollar becomes stronger (that is, it takes more of a foreign currency to purchase a dollar).
The UNCTAD World Investment Report. This Report, which was not available at the time of the writing of the Summary of New Developments, gives the following high-level overview regarding the level of M&A in 2022:
The multitude of crises and challenges on the global stage – the war in Ukraine, high food and energy prices, risks of recession and debt pressures in many countries – negatively affected . . . cross-border mergers and acquisitions (M&As), [which] were especially shaken by stiffer financing conditions, rising interest rates and uncertainty in financial markets.[16]
It can be expected that the war between Israel and Hamas, which began in October 2023 (and is still raging as this article is being written in early November 2023) will have a depressing impact on cross border M&A involving a company located in, or doing significant business in, the Middle East.
Another section of the UNCTAD Report provides the following observations on the M&A component of Foreign Direct Investment (FDI), which is investment by a company located in one country, such as the U.S., into another country, such as France:
In 2022, FDI flows to developed countries as a group fell by 37 per cent, largely in Europe and North America. In the other developed countries, they rose . . . In the United States, flows declined by 26 per cent to $285 billion, mainly due to the halving of cross-border M&As, which generally account for a large share of inflows. Among the 10 largest [M&A transactions], only one occurred in the United States. The decrease in M&As had a direct impact on the equity component of FDI, which fell by 35 per cent. . . . [I]n Canada [FDI] decreased by 20 per cent to $53 billion, as cross-border M&A sales fell by 37 per cent.
While cross-border M&As declined to $11 billion, announced greenfield [new investment] projects rose 28 per cent, to $25 billion.[17]
U.S. Acquirers of Foreign Targets, and Foreign Acquirers of U.S Targets. From 2018 to 2023, the number of Foreign Targets of U.S. Acquirers in outbound acquisitions exceeded the number of U.S. Targets of Foreign Acquirers in inbound acquisitions. Thus, over this period there were, and generally there are, more U.S. Acquirers of Foreign Targets than Foreign Acquirers of U.S. Targets. However, the number of inbound and outbound acquisitions for each of those years were not dramatically different. For example, in 2022, there were (1) 2,519 acquisitions by U.S. Acquirers of Foreign Targets and (2) 1,842 acquisitions by Foreign Acquirers of U.S. Targets.[18]
In elaborating on one aspect of inbound activity, a 2021 article entitled American Companies You Didn’t Know Were Owned By Chinese Investors contains, inter alia, discussions of the following U.S. companies that have significant Chinese shareholders: (1) AMC; (2) Shanghai Automotive Industry Corp (SAIC), which has a partnership with GM; (3) Spotify; (4) Hilton; and (5) GE’s appliance division.[19]
CFIUS-Type Restrictions. As a result of the growth in cross border acquisitions and ownership, many countries have adopted investment restrictions for investments by foreign persons similar to the Committee on Foreign Investment in the United States (CFIUS) law in the United States, which is discussed in chapter 19. On this development, the UNCTAD World Investment Report 2023 says:
[T]he trend observed in recent years towards introducing or tightening national security regulations that affect FDI in strategic industries continued and expanded. The approach to FDI screening varies significantly from country to country, resulting in a patchwork of different regimes. Together, countries with FDI screening regimes accounted for 71 per cent of global FDI flows and 68 per cent of FDI stock in 2022, compared with 66 and 70 per cent, respectively, in 2021. Furthermore, the number of merger and acquisition (M&A) deals valued at more than $50 million withdrawn by the parties for regulatory or political concerns in 2022 increased by a third, and their value increased by 69 per cent.[20]
These foreign CFIUS-type restrictions are discussed in chapter 20, which deals with outbound acquisitions.
Part V, Other M&A Issues (Sections 1:7.37 through 1:7.43 of the Article)
Recent Developments with Special Purpose Acquisition Companies (SPACs). SPACs, which are addressed generally in chapter 6, are companies organized through a blank check initial public offering (IPO). In these transactions, at the time of the IPO, the issuing company has no business other than the plan to use the funds raised in the IPO to acquire an operating company. When a SPAC completes an acquisition, the transaction is sometimes referred to as a de-SPAC. Obviously, SPAC transactions are heavily regulated by the SEC.
As indicated in the Summary of New Developments article, the number of SPACs between 2018 and 2022 has been on a “roller coaster” ride with (1) 2018 and 2019 having 29 SPACs each; (2) 2020 jumping to 98; (3) 2021 more than doubling at 210; and (4) 2027 more than halving to 127. Also, through August 2023, there were just 22, an 80% decline. [21]
Introduction to Blockchain and Cryptocurrency M&A. Although this topic is introduced in the Summary of New Developments, this author has limited expertise in this area. However, it appears that the SEC disclosures by Coinbase, which was the first major crypto company to go public in an initial public offering, can provide helpful information on this topic. For example, Coinbase’s April 1, 2021, IPO prospectus provides the following background information on Bitcoin, the largest cryptocurrency:
Bitcoin sparked a revolution by proving the ability to create digital scarcity: a unique and finite digital asset whose ownership could be proven with certainty. This innovation laid the foundation for an open financial system. Today, all forms of value – from those natively created online such as in-game digital goods to traditional securities like equities and bonds – can be represented digitally, as crypto assets. Like the bits of data that power the internet, these crypto assets can be dynamically transmitted, stored, and programmed to serve the needs of an increasingly digital and globally interconnected economy.
Today, we enable customers around the world to store their savings in a wide range of crypto assets, including Bitcoin and USD Coin, and to instantly transfer value globally with the tap of a finger on a smartphone.[22]
Coinbase’s more recent SEC filings may be helpful in understanding this topic as well.
For an excellent review of many of the legal issues impacting cryptocurrencies in the context of M&A, see the following article: Blockchain M&A: The Next Link in the Chain.[23] Among other things this article addresses the following issues:
U.S. Federal Securities Laws Considerations. [See chapter 6]
Commodities Regulation Considerations.
Federal and State Money Transmission Considerations.
U.S. Anti-Money Laundering Considerations.
Sanctions Considerations.
1940 Act Considerations.
IP Rights Considerations.
Privacy and Cybersecurity Considerations.
CFIUS Considerations [See chapter 19]
Tax Considerations [See chapter 9]
The Impact of Environmental, Social, and Governance (ESG) on M&A. Two lawyers from Wachtell Lipton paint the following picture of the potential impact of ESG on M&A in 2022:
In the past year, ESG has played an increasingly prominent role in activist campaigns, most dramatically exemplified by Engine No. 1’s success in electing three directors to Exxon Mobil’s board, as well as by the development of the two-front activist “pincer” attack in which an ESG activist attack is followed by an attack from an activist focusing on financial returns. Activists have also leveraged ESG to further their M&A theses: Third Point called for the breakup of Royal Dutch Shell, Elliott called for the separation of SSE’s renewables business and Bluebell called on Glencore to divest its coal business.
ESG’s influence is also increasingly evident in the context of M&A negotiations and larger deal considerations. As one example, it has become ever more critical for acquirors to comprehensively diligence the ESG profile of potential Targets—a result of the SEC’s increased focus on the adequacy of ESG disclosures and the growing legal, financial and reputational costs of ESG underperformance.[24]
This topic is discussed from a due diligence perspective in chapter 3.
The Impact of ChatGPT and Other Artificial Intelligence (AI) Firms on M&A. Business activity with AI is fast moving as indicated by the announcement in January 2023 by Microsoft of the expansion of its partnership with OpenAI, a leader in the AI business. A Microsoft press release[25] on the transaction explained:
Today, we [Microsoft] are announcing the third phase of our long-term partnership with OpenAI through a multiyear, multibillion dollar investment to accelerate AI breakthroughs to ensure these benefits are broadly shared with the world.
This agreement follows our previous investments in 2019 and 2021. It extends our ongoing collaboration across AI supercomputing and research and enables each of us to independently commercialize the resulting advanced AI technologies.
Supercomputing at scale – Microsoft will increase our investments in the development and deployment of specialized supercomputing systems to accelerate OpenAI’s groundbreaking independent AI research. We will also continue to build out Azure’s leading AI infrastructure to help customers build and deploy their AI applications on a global scale.
New AI-powered experiences – Microsoft will deploy OpenAI’s models across our consumer and enterprise products and introduce new categories of digital experiences built on OpenAI’s technology . . . .
Exclusive cloud provider – As OpenAI’s exclusive cloud provider, Azure [a computer system] will power all OpenAI workloads across research, products and API services.[26]
Obviously, this is a very complex topic, and the discussion here and in the Summary of New Developments is designed only to alert the reader to some of the issues related to AI.
Preliminary Report on M&A Activity in 2023. This section of the Summary of New Developments article discusses some of the M&A developments occurring in 2023 that are not discussed in the preceding sections. The developments discussed here generally occurred after the submission of the New Developments sections to PLI at the end of June 2023 and before September 30, 2023, several days before the publication of the Summary of New Developments on the Penn Statim.
This section of the article shows that both worldwide “Value” and “Number of Deals” were down dramatically through August 2023. With respect to the dollar size of deals, through August 2023, there were twenty-nine deals with an acquisition price of $5 billion or more, whereas in the same period during 2023 there were forty-nine deals of that size.[27]
I thank my following Penn State Law Research Assistants for comments on this article: Akshaya Senthil Kumar, an LLM student, and William Schroeder, a third-year student. ↑
GDP is the dollar value of aggregate purchases of new products and services by (1) consumers, (2) firms, (3) federal, state, and local governments, and (4) foreign persons (netted against foreign purchases by U.S. persons). ↑
Igor Kirman, Victor Goldfeld, Elina Tetelbaum, Wachtell Lipton Rosen & Katz, Takeover Law and Practice: Current Developments, Harv. L. Sch. F. Corp. Governance (May 3, 2023), https://perma.cc/95JP-2CD3. ↑
FactSet Mergerstat, 2023 FactSet Review, at 25 (Table 1-3, Composition of Aggregate Net Merger and Acquisition Announcements, with respect to Number of Deals) and at 31 (Table 1-5, Composition of Net Merger and Acquisition Announcements, 2018-2022, with respect to Value of Deals) (May 2023). ↑
Litera Corp., 2023 M&A Report: Return to Normal: Resilience and Resetting 12 (Dec. 1, 2022), https://perma.cc/QS5E-BVKA. ↑
Since 1992, shortly after the breakup of the Soviet Union, the Commercial Law Development Program of the U.S. Department of Commerce (CLDP) has aided post-conflict and developing countries through commercial law reform. These reforms are critical in establishing legislative, regulatory, and judicial environments conducive to international trade and investment, and in creating a level playing field for U.S. firms seeking to conduct business abroad.
CLDP works closely with the U.S. Department of State and engages in capacity-building technical assistance legal training programs with more than seventy foreign governments. These programs draw upon highly experienced regulators, judges, policymakers, business leaders, and attorneys from both public and private sectors to deliver results that make meaningful and lasting changes to legal and business environments in the host countries (seethe CLDP’s website). By providing technical legal assistance to countries seeking to understand and embrace international best practices in the development and implementation of commercial law, CLDP contributes to the global building and strengthening of the rule of law.
Expertise involved
CLDP attorneys and experts advise on commercial law topics, including energy transition, ethics and anti-corruption, information and communications technology, infrastructure (public private partnerships and project finance), intellectual property, private sector development, arbitration, procurement, bankruptcy, investment, and trade.
What does CLDP do and where?
CLDP operates worldwide and offers volunteer opportunities for legal experts to contribute to efforts that advance the rule of law through commercial legal reform. Current programming is conducted in the following regions of the world:
Europe and Eurasia;
Latin American and the Caribbean;
the Middle East and North Africa;
South Asia;
Southeast Asia and the Pacific; and
sub-Saharan Africa.
There are also global initiatives that target the development of commercial law frameworks; regulations and policies in energy sectors; women-owned and small business access to government contracts; digital connectivity; and international commercial arbitration.
Sample projects
A sample of regional projects illustrates the breadth of subject matter involved. For example:
To assist the transition of countries to stable, market-based economies that are integrated with the world’s economies, CLDP works with countries to align their rules and processes with international best practices [Eastern Europe, Southeastern Europe, the Southern Caucasus, and Central Asia].
CLDP works with government procurement agencies to improve transparency and effectiveness of systems and procedures, and it also supports better insolvency practices [Latin America and the Caribbean].
In the Middle East and North Africa, CLDP connects U.S. experts with country counterparts to assist and train on a range of commercial and legal issues, including insolvency in commercial arbitration.
Relying upon private sector lawyers, businesspersons, and professionals along with governmental officials, CLDP programming in South Asia includes trade and investment assistance, intellectual property protection, technology transfer and innovation, competition and consumer protection, company and franchise law reforms, energy and mining extractive concerns, information and communication technology, transportation and infrastructure, eCommerce and cyber law, banking and financing, insolvency and bankruptcy, ADR, and women’s economic empowerment.
CLDP also works with Southeast Asian and Pacific Island countries to develop transparent legal and procedural frameworks to oversee complex infrastructure projects to attract high-quality investors and developers [Thailand, Cambodia, Burma, Myanmar, Malaysia, Timor-Leste, Indonesia, Philippines, Vietnam, and the Pacific Islands].
In sub-Saharan Africa, CLDP seeks to reform and strengthen intellectual property legislation, administration, and enforcement on a country basis [Ghana, Nigeria, Liberia, Mali, South Africa, and Kenya]; and on a regional basis with the Economic Community of West African States (ECOWAS), Southern Africa Development Community (SADC), and East African Community (EAC).
On a global-initiative level, CLDP helps countries on the verge of becoming major oil and gas producers establish the capacity to manage resource revenues, maximizing value and transparency.
These projects rely on many pro bono lawyers and experts to help build and implement commercial law frameworks incorporating best practices of contracting, accounting, and taxation to attract foreign investment.
Role of volunteers (pro bono) and their expertise
CLDP operates only when invited by the host government, and first seeks to identify and assess problematic points in a host country’s commercial law framework. CLDP attorneys, who have experience employing a variety of development approaches, assess whether improvements needed in a host country commercial law framework are substantive or procedural, human or institutional. If expertise is needed from the private sector, pro bono volunteers conduct capacity-building training or legislative and regulatory reviews. The CLDP lawyer handling the project works to identify volunteers with the appropriate expertise from various channels, including federal and state judicial organizations and bar associations. The rich range of expertise found in the ABA Business Law Section would greatly enhance pro bono lawyer contributions to CLDP’s work and strengthen the global rule of law.
Procedure for your involvement
As a channel for announcements of CLDP opportunities, the Business Law Section (BLS) Rule of Law Committee will receive periodic notices of CLDP project opportunities and then liaise with BLS committees with the relevant expertise. The type of legal expertise is specified in the CLDP announcement, and CLDP will invite volunteers whose expertise matches CLDP’s project requirements and who are interested in participating for a video interview with CLDP project coordinators. Under this new cooperative program with the BLS, volunteer lawyers—if selected after the interview—may be offered the opportunity to provide in-person or remote technical legal assistance, including, inter alia:
seminar-type presentations for foreign officials;
simulation-styled training for the development of negotiation skills of foreign officials;
desktop or in-person review of draft laws and regulations to ensure they are compatible with international best practices;
revision of national investment laws ensuring they are conducive for foreign investors; or
service as arbitrators or judges for international moot court competitions.
While some CLDP projects are being conducted on a remote basis, many programs now involve volunteers conducting training programs in foreign countries and engaging in person-to-person interactions with foreign government officials, diplomats, and lawyers. In such cases, the volunteer’s pro bono contribution is time and expertise; CLDP will pay for the international travel costs.
Whether an issuer qualifies as a foreign private issuer, or FPI, will determine the filing regime it must follow with the Securities and Exchange Commission (SEC) and the applicable corporate governance requirements. The SEC and the exchanges in the United States give considerable deference to home-country requirements for an FPI and impose few additional requirements. An issuer’s FPI status is determined as of a date within thirty days before the initial filing of the registration statement with the SEC. Thereafter, FPI status is tested annually at the end of the second quarter of the issuer’s financial year.
Definition
A foreign private issuer is an entity (other than a government) incorporated or organized under the laws of a jurisdiction outside of the United States, unless the following two conditions apply:
more than 50% of its outstanding voting securities are directly or indirectly owned of record by U.S. residents, and
any of the following applies:
the majority of its executive officers are U.S. citizens or residents,
the majority of its directors are U.S. citizens or residents,
more than 50% of its assets are located in the United States, or
its business is administered principally in the United States.
A company incorporated under the laws of a non-U.S. jurisdiction will be treated as a U.S. issuer if more than 50% of its voting securities are held directly or indirectly by U.S. residents and it has any one of the enumerated U.S. contacts.
FPIs are allowed a number of benefits that are not available to U.S. issuers.
Determining FPI Status
Securities ownership. An issuer must look through record ownership of brokers, dealers, banks, and nominees holding securities for the accounts of their customers in the United States and in the issuer’s home country (and, in the case of an issuer with a public trading market, the country of its primary trading market if not the United States or its home country). Where an issuer cannot determine the ultimate residency of the owner of shares held by a nominee (either because the nominee will not provide the information or it imposes an unreasonable charge for the information), the issuer is entitled to presume that the residency of the nominee’s customers is the same as the nominee’s principal place of business. The issuer must also consider any beneficial ownership reports and any other information available. If an issuer has actual knowledge about the residency of its shareholders, it must consider that information in making the determination.
Non-voting securities are not included in the calculation.
If an issuer has more than one class of voting securities with different voting rights, the issuer can choose between two options: (1) calculating the percentage of voting power held by U.S. citizens or residents or (2) calculating the percentage of the number of securities. However, once the issuer chooses a method, it must apply that method consistently.
Residency and citizenship of officers and directors. The tests for officers and directors are separate, as are the tests for U.S. residency or U.S. citizenship. Dual citizens with U.S. citizenship are counted as U.S. citizens for these tests. Members of senior management with significant management responsibility or policy-making functions must be included as executive officers. Executive officers of subsidiaries must be treated as executive officers of the issuer if they perform policy-making functions for the issuer. A person with permanent resident status in the United States (sometimes known as a “green card” holder) must be counted as a U.S. resident. For other individuals who live in the United States but are not green card holders, the issuer must establish criteria to determine residency and apply the criteria consistently. Factors could include tax residency, nationality, mailing address, physical presence, or immigration status.
Location of assets. In determining the location of the issuer’s assets, an analysis of the balance sheet is required. Consideration should be given to the accounting treatment of the issuer’s assets in either a geographic segment footnote or other disclosures in the financial statements. However, additional analysis is required of the various categories of assets on the balance sheet. There may be considerable judgment in determining the location of assets. The issuer should adopt a documented methodology for making the determination and apply it consistently. In addition, the issuer’s auditors should review the methodology.
Location of administration. An issuer’s business is administered from the location where operational and policy decisions are made. In making the determination, the number of days the CEO spends at the issuer’s non-U.S. offices, the location of meetings of the board of directors and meetings of shareholders, and the location where each principal business function is administered should be considered.
Read More
This article is based on a CLE program titled “Disappearing Deference to Home Country Law for Foreign Private Issuers” that took place during the ABA Business Law Section’s 2023 Hybrid Spring Meeting. To learn more about this topic, view a recording of the program, free for members.
Raising rates is a standard business practice, often indicative of increased value and expertise. However, managing a client relationship in a way that makes a rate increase not only acceptable but also welcome is a nuanced skill. It’s rooted in consistent value delivery and open communication. In this article, we’ll delve into the strategies and best practices that can make this delicate transition smoother for both lawyers and their clients.
Setting the Foundation: Building a Strong Client Relationship
Deliver Extraordinary Service from Day One
The foundation of any successful client relationship is exceptional service. From your first interaction, strive to exceed expectations in terms of legal expertise, responsiveness, and outcomes. This sets the stage for any future discussions about rate adjustments.
Regularly Communicate Value
Your monthly invoice is more than just a bill; it’s an opportunity to communicate value. Use it to summarize the work that you’ve done, the time that you’ve saved the client, and the positive outcomes that you’ve achieved. This keeps the client aware of the value that you provide.
Build a Personal Relationship
A strong client relationship goes beyond professional interactions. Take the time to understand not just your client’s business but also their personal challenges and goals. This deeper connection fosters loyalty and can make conversations about rate increases more comfortable.
Be Transparent
Transparency is crucial in any client relationship. Keep your clients informed about any changes in their cases, matters, or billing. Even when there’s no significant update, a quick check-in can go a long way toward showing that you’re actively thinking about their needs.
Offer Value-Added Services
In today’s competitive landscape, going beyond billable legal work is essential. Consider offering value-added services such as educational webinars, professional introductions, newsletters, or even 24/7 availability for emergencies. These services not only enhance your value proposition but also provide tangible justifications for a rate increase.
Solicit and Act on Feedback
Feedback is invaluable for continuous improvement. Regularly solicit it through check-in meetings and anonymous surveys. More importantly, act on this feedback to refine your services, thereby enhancing your value proposition.
The Mechanics of Raising Your Rates
Assess the Value Delivered to the Client
Before initiating a rate increase, take stock of the additional value that you’ve been providing. This could be enhanced legal expertise in a specialized area, faster response times due to additional staff, or investments in technology that lead to more efficient and faster service.
Be Mindful of Timing
The timing of your rate increase can significantly impact its reception. Ideal times include after a successful case resolution, during a scheduled client review where you can demonstrate added value, or when introducing new services or technologies. The end or beginning of a fiscal year also offers a natural transition point.
Craft a Value-Backed Pitch
Your pitch should be a compelling narrative that centers around the value you bring to the table. It should review the value that you’ve consistently delivered, justify the rate increase by explaining new value-added services or expertise, and discuss how these enhancements will benefit the client. Write down your pitch and practice it to ensure clarity and confidence.
Choose the Right Communication Channel
The avenue you choose for this delicate conversation should facilitate a two-way dialogue. Options include an in-person meeting, a videoconference, or a formal letter or email followed by a meeting.
Conduct the Meeting
The discussion should be structured yet open. Execute the meeting with poise and professionalism. Listen actively, and be prepared to address any questions or concerns that your clients may have.
Follow Up
After the meeting, send a summary email or letter outlining what was discussed and agreed upon. Implement the new rates and added services as discussed and continue to monitor and communicate the value being provided.
Conclusion
In our many years of experience working with attorneys on business development and client relations, the prevalent concern around raising rates has been the fear of losing clients. However, it’s worth noting that we’ve only seen a client sever ties for this reason once. This underscores that with the right approach, most clients understand and accept the necessity of rate adjustments. A rate increase, when presented as a reflection of enhanced value, can actually strengthen your client relationships. The key is to focus on what’s in it for the client. By following these best practices, you’re not just asking for more—you’re offering more. Good luck!
The European Union (EU) Foreign Subsidies Regulation (FSR) has now entered into full effect. On October 12, 2023, its last element—the obligation to notify the European Commission (EC) of certain M&A transactions and public procurement procedures—became applicable. Companies must now adopt internal implementation measures to comply with all the obligations imposed by the FSR. This article will briefly outline the main aspects of the FSR and demonstrate why FSR issues may be important even for US companies.
A. Background
Investments in the EU by companies receiving subsidies from non-EU countries (including the US) have increased rapidly in recent years. This has raised concerns that fair competition in the EU market could be distorted, as subsidies granted from EU member states are subject to the EU’s strict rules on state aid. Adopted at the end of 2022, the FSR is intended to tackle this issue, with the goal of creating a level playing field in the EU for EU and non-EU companies alike.
The FSR empowers the EC to impose remedies on companies that receive subsidies from non-EU countries (such as reducing market presence or repaying the subsidies). The EC may even prohibit contemplated M&A transactions or require a completed transaction to be reversed. Fines for noncompliance can be imposed of up to 10% of aggregate worldwide turnover and periodic penalty payments. To avoid this, companies must make sure they are prepared, as the EC intends to enforce the FSR rigorously.
B. Three main tools
Under the FSR, the EC has three tools for assessing the legality of foreign subsidies:
First, the “M&A tool,” which enables the EC to review certain mergers and acquisitions of control. It creates an obligation to notify the EC of any M&A transactions that exceed two thresholds and a standstill obligation. Companies must notify financial contributions from non-EU countries when:
at least one merging company, the target, or the joint venture is established in the EU and generates aggregate turnover of at least EUR 500 million in the EU, and
taken together, all companies involved have received more than EUR 50 million in financial contributions from non-EU countries in the three preceding years.
Notifiable M&A transactions must not be implemented before their clearance by the EC. This has a direct impact on deal timelines (“standstill obligation”).
Second, the “public procurement instrument,” which expands the notification obligation to include procurement procedures. The EC is to be notified of financial contributions from non-EU countries when:
the estimated total value of the awarded public procurement agreement is at least EUR 250 million, and
the bidder has received at least EUR 4 million in financial contributions from non-EU countries in the three preceding years.
And third, a general instrument for market investigation, the “ex officio review tool.” Regardless of the above-mentioned formal notification obligations, the EC will also be able to investigate ex officio any potentially distorting foreign subsidies. A wide margin of discretion enables the EC to initiate such ex officio investigations with almost no restrictions. However, it is not yet clear to what extent the EC will actually make use of this tool.
C. Financial contributions and foreign subsidies
Notification requirements are tied to “financial contributions” granted (directly or indirectly) by non-EU countries. The term refers to more than just “foreign subsidies” and is defined very broadly.
A “financial contribution” can include but is not limited to:
transferring funds or liabilities (such as capital injections, grants, loans, loan guarantees, fiscal incentives, setting off operating losses, compensation for financial burdens imposed by public authorities, debt forgiveness, debt to equity swaps, or rescheduling),
the foregoing of revenue that is otherwise due (such as tax exemptions, or granting special or exclusive rights without adequate remuneration), or
providing goods or services or purchasing goods or services where a foreign subsidy necessitates finding a foreign financial contribution with:
a benefit for a company engaging in an economic activity in the internal market, and
a limitation of the benefit, in law or in fact, to one or more companies or industries.
Once notified, the EC will assess whether the foreign financial contribution constitutes a foreign subsidy and evaluate whether it has any distorting effect on the EU market. Finally, the EC may carry out a balancing act, taking into account all positive and negative effects of the foreign subsidy. The actual test criteria to be applied remain unclear and will only be further clarified by the EC in the coming years. The EC is expected to choose an approach inspired by well-established principles and jurisprudence regarding EU state aid law.
D. What do companies need in order to be prepared?
Because the FSR creates new notification requirements, companies are facing additional administrative burdens to ensure M&A compliance and be M&A-ready (i.e., collecting the necessary data and preparing a compliance system). The FSR will impact deal timelines and transaction security by creating one more regulatory filing that will have to be considered in addition to merger control and foreign direct investment filings.
The FSR also provides companies with new options to use the FSR itself against competitors. Companies can complain to the EC, which can result in an ex officio investigation. For example, such informal complaints over distortive subsidies from Qatar and the United Arab Emirates were raised by EU soccer clubs and associations earlier this year. So far, the EC has reacted with restraint.
E. Outlook
Because of the FSR’s wide scope, implementing the duties resulting from the FSR is a topic that also matters to US companies. Just to mention one example: according to the parties, the merger between the two US fashion companies Tapestry and Capri is subject to the FSR M&A notification obligation. Capri has a well-established business in Europe (brands such as Michael Kors, Jimmy Choo, or Versace). Hence, according to the EC Implementing Regulation it is deemed to be “established in the EU.” Therefore, the transaction is covered by the FSR regardless of the fact that Tapestry and Capri are both US—and not EU—companies.
Although concrete effects of the FSR may not have been strongly felt so far, this may change soon. According to the EC’s department for competition and its Director-General Olivier Guersent, the new EU reviewing power and the EC’s FSR activities will be “ramped up” over the next few months.
Specifically, FSR investigations may be initiated in the wind power industry in the near future. The EC recently encouraged the industry to submit information on potential unfair practices distorting competition in the wind power market. In its European Wind Power Action Plan of October 24, 2023, the EC explicitly announced that it intends to make use of the tools provided to it by the FSR. Another sector that could attract the EC’s interest is the electric vehicle industry: President of the European Commission Ursula von der Leyen announced in her State of the Union speech on September 12, 2023, the launch of anti-subsidy investigations into electric vehicles from China. FSR investigations could follow, although this is uncertain.
However, the situation remains very dynamic. So far, seventeen M&A deals have been pre-notified to the EC in order to discuss and determine jointly whether they will be covered by the FSR. More FSR (pre-)notifications to the EC will certainly follow soon. The EC can also be expected to extend its ex officio FSR activities sooner or later—in general and in regard to other specific sectors.
Knowledge is power, they say. In the context of a Delaware limited liability company (“LLC”), knowledge about the company’s finances, governance, operations, and affairs is found in the company’s books and records. But like any power, the power of a Delaware LLC’s members and managers to obtain information and knowledge about their LLC can be abused. A disgruntled, difficult, or disruptive member or manager can use their information rights as a cudgel against the LLC and its management, harassing them with burdensome or redundant requests for information and records for no legitimate reason.
But a member’s or manager’s right to LLC information is not absolute. The Delaware Limited Liability Act (the “Act”) establishes limits on why and how a member or manager can request and obtain LLC documents and information. However, those limits may not prevent bad actors’ abuse of those rights. Fortunately, the Act allows an LLC to further tailor and restrict members’ and managers’ information rights in its limited liability company agreement. Given the disruption, burdens, costs, and animosity involved in illegitimate or abusive information requests, Delaware LLCs should thoughtfully consider the information rights provisions they include in their organizing documents.
Information Rights under the Delaware LLC Act
As set forth in Section 18-305 of the Act, members and managers can make a reasonable, written demand for information from the LLC if the stated purpose of the request is “reasonably related to” either the member’s interest as a member of the LLC or the position of manager and the requested information is “necessary and essential to achieving that purpose.” This information includes:
True and full information regarding the status of the LLC’s business and financial condition.
A copy of the LLC’s federal, state, and local income tax returns for each year (promptly after becoming available).
A current list of each member and manager’s name and last known business, residence, or mailing address.
A copy of any written LLC agreement and certificate of formation, and all amendments and executed copies of any powers of attorney pursuant thereto.
True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each member and which each member has agreed to contribute in the future, and the date on which each became a member.
Other information regarding the affairs of the LLC as is just and reasonable.
While an LLC must provide company documents and information so long as the request is “necessary and essential” for a proper purpose relating to the requestor’s role as a member or manager, Delaware courts have held that an LLC is under no obligation to create documents, explanations, summaries, or commentary. In evaluating whether a member or manager has a proper purpose, Delaware courts have held that when a manager makes an information request, they have made out a prima facie case for access given their role in managing the operations of an LLC. However, that presumptive manager access to information may nevertheless be denied if the LLC can demonstrate that the manager has made such request for an improper purpose.
Seemingly, the Act’s requirements of a proper purpose and limitation of requests to only “necessary and essential” documents would be sufficient to prevent the abuse of information rights. But that is not necessarily the case. A member or manager determined to cause havoc through abusive requests still has plenty of leeway to do so under the Act, including dragging the LLC through costly litigation about the legitimacy or scope of their demand if the LLC refuses to produce the requested information. LLCs can and should establish more robust protections against using information rights as a weapon.
Further Narrowing Information Rights in a Limited Liability Company Agreement
Like many other rights and obligations in the Act, the provisions in Section 18-305 regarding access to LLC information are default rules. That is, they apply in the absence of any corresponding provisions in the limited liability company agreement or the absence of any limited liability company agreement at all. As explained in that section, “The rights of a member or manager to obtain or examine information as provided in this section may be expanded or restricted in an original limited liability company agreement or in any subsequent amendment approved or adopted by all of the members or in compliance with any applicable requirements of the limited liability company agreement.”
To keep information rights from being abused, LLCs should consider drafting or amending their limited liability company agreement to include language providing the following:
Any sensitive information requested, including customer lists, financial records, and other proprietary information, shall remain confidential and not be disclosed to others pursuant to detailed confidentiality and nondisclosure provisions. Section 18-305(c) of the Act permits managers to keep confidential from members information (i) in the nature of trade secrets, (ii) that the manager believes in good faith is not in the best interest of the LLC to disclose, or (iii) that the LLC is required by law or agreement to keep confidential. Nevertheless, including restrictive covenants regarding confidential information in a limited liability company agreement that clearly delineate the scope of and restrictions on such information can reduce disputes over whether information falls under Section 18-305(c).
Information will be shared with members only on a “need-to-know” basis, meaning that only those members who require the information to perform their duties or make informed decisions will have access to it.
Access to detailed financial information—such as tax returns, bank statements, and investor agreements—is restricted to a subset of members, such as managers or designated financial officers.
Information rights may be terminated upon the withdrawal or expulsion of a member from the LLC.
Copyright 2023 Bodman PLC. A version of this piece was previously published as a Bodman Business Client Alert. Bodman has prepared this for informational purposes only. Neither this article nor the information contained in this article is intended to create, and receipt of it does not evidence, an attorney-client relationship. Readers should not act upon this information without seeking professional counsel. Individual circumstances or other factors might affect the applicability of conclusions expressed in this article.
On May 15, 2023, the New York Times reported that “The Greatest Wealth Transfer in History Is Here, with Familiar (Rich) Winners.”[1] This transfer of wealth includes giving to tax-exempt organizations, as highlighted by a recent Forbes article on how the late Subway cofounders gave away billions in order to minimize tax liability for themselves and their foundations.[2] But this unprecedented transfer of wealth occurs at a time when many predict an imminent economic slowdown or worse. The convergence of a massive transfer of wealth and an economic downturn might create a perfect storm, imposing the remedy of centuries-old fraudulent transfer law against charities that receive gifts that are later shown to constitute fraudulent transfers by the donors. The result may be money judgments against the charities.
This article examines what a charity should know about its exposure to liability as the transferee of a donation that turns out to be a fraudulent transfer by the donor. A charity can perform due diligence to manage most kinds of risk resulting from its receipt of a donated asset (e.g., hard-to-manage/risky assets, the risk of inadvertently participating in a tax shelter,[3] etc.), but a charity—even a large charity with sophisticated general counsel—faces a much more difficult challenge in attempting to mitigate the risk potentially posed by fraudulent transfer law. This article will also address how the law surrounding this intersection has evolved and how the courts have approached the issue of charity liability under fraudulent transfer law.
Fraudulent Transfer Law in a Nutshell
The core of the ancient doctrine of fraudulent transfer permits a creditor to set aside a transfer made by its debtor when the debtor intended to “hinder, delay, or defraud” any of its present or future creditors. A fraudulent transfer of this primordial type has come to be referred to as involving “fraud in fact” or “actual fraud.” Fraudulent transfer law also permits a creditor to set aside a transfer made by its debtor when, regardless of the debtor’s intent, the debtor does not receive “reasonably equivalent value” in return and the debtor is in a sufficiently bad financial condition, such as by being insolvent at the time of, or as a result of, the transfer. A fraudulent transfer of this type has come to be referred to as involving “fraud in law” or “constructive fraud.” A gift will almost certainly satisfy the first requirement of constructive fraud because gifts are typically made without the donor receiving, or even expecting to receive, any asset in exchange. Not surprisingly, constructively fraudulent transfers are quite often made by a debtor to the debtor’s friends and family.
Fraudulent transfer law is addressed by state statutes as well as the Bankruptcy Code. The vast majority of states have adopted the Uniform Fraudulent Transfer Act (“UFTA”), promulgated in 1984.[4] The UFTA was amended in 2014, and those amendments included changes in terminology as well as a name change to the Uniform Voidable Transactions Act (“UVTA”).[5]
The terms actual fraud and constructive fraud, although consistent with the UFTA terminology, are misleading because no fraud is required under either theory of recovery. Consequently, under the UVTA, the term fraudulent transfer was replaced with voidable transaction.[6] More than half of the states that have adopted the UFTA have adopted the UVTA amendments to the UFTA. However, because the decisions discussed below involved application of the UFTA and its terminology (as well as the Bankruptcy Code) references will be made to the traditional UFTA terminology.
It is important to understand that both present and future creditors may seek relief under fraudulent transfer law.[7] Additionally, the actual fraud theory requires the plaintiff creditor only to prove that the debtor made the transfer with intent to hinder, delay, or defraud creditors. Because direct evidence of intent is often difficult to obtain, a creditor may rely on circumstantial evidence of intent such that intent may be presumed or inferred (e.g., the “badges of fraud”). A claim under the actual fraud theory does not disappear because the debtor received value in exchange for what the debtor transferred. If the debtor received sufficient value in exchange, it may be that the debtor’s creditor need not seek fraudulent transfer relief against the debtor’s transferee because the creditor can satisfy its claim against the debtor by simply pursuing the debtor. But receipt of value by the debtor from the transferee does not mean that a creditor is prohibited from seeking recovery against the transferee. As the attractiveness of the exchanged asset diminishes, the prospects of an actual fraud claim against the transferee increase.
Merely avoiding a fraudulent transfer is not the only remedy available to creditors. As many courts have noted, rewarding a debtor and transferee with a mere reversal of the transfer simply encourages debtors to transfer “low-hanging fruit” because the worst that can happen is a creditor will reverse the transfer. Instead, a creditor may seek a monetary judgment against the transferee of the transfer. In addition, as discussed later, the creditor might also seek additional relief, such as punitive damages.
Why would someone in financial distress donate to charity? As one court noted, “[p]rominent displays of charity attract public attention generally. They can attract new investor-victims through the general semblance of success and a charity-specific ‘affinity factor.’ And, they put up a broad cover of good will that can mask the perpetrator’s underlying dishonesty.”[8]
Charity Exposure to Fraudulent Transfer Liability
In a common fraudulent transfer scenario involving a donor’s transfer of wealth to a noncharity, a debtor may transfer assets to a friend or a trust created for family members. These individuals might be aware of the debtor’s plan to thwart creditors and can make a well-informed judgment as to whether it is worth participating and assuming the risk of a monetary judgment. The debtor may even conspire with individuals to assure them that if anything goes wrong, the debtor will make the transferee whole. Not surprisingly, courts have awarded compensatory and punitive damages to a creditor who expends resources unwinding transactions, including by imposing liability on transferees and others who assist the transactions. Courts commonly appeal to utilitarian and retributivist principles in fashioning fraudulent transfer relief. This is reflective of a cause of action that has its roots in a penal statute, the ancient Statute of 13 Elizabeth.[9]
Charities, as transferees, may assert various defenses against creditors. In an action under the so-called actual fraud theory, the charity may assert an absolute defense under UFTA section 8(a). Specifically, the charity will escape exposure if it can show that it acted in good faith and gave reasonably equivalent value. If attacked under the so-called constructive fraud theory, the charity can defend itself by showing that it provided reasonably equivalent value, because failure of the transferee to give reasonably equivalent value in return for the asset it received from the debtor is a prerequisite for any constructive fraud claim. The analysis can differ if the debtor is bankrupt because, for example, a good-faith defense would not exist for a charity that is considered to be the debtor’s “initial” transferee but would exist for a charity that is considered to be the debtor’s “subsequent” transferee that provides value and does not know about the voidability of the transfer.[10]
A donor to a charity might intend to thwart creditors, but the charity most likely has no idea of a donor’s circumstances or intent. In contrast to a charity, a friend or family member of the debtor who receives a fraudulent transfer is bound to have information about the debtor and the transfer that will enable the individual to make a decision—and to seek legal advice—about the individual’s fraudulent transfer exposure. Importantly, the remedies for a fraudulent transfer include not only avoidance of the transfer but also a possible money judgment against the transferee. This is more likely to occur where the transferee transfers the transferred asset or dissipates the asset before a creditor can reach it (though the UVTA and UFTA literally give the creditor a free choice between avoidance and a money judgment).
Given the range of remedies and potential impact on charities, it is worth reviewing relevant case law.
Cases Involving Charities as Transferees
Cases about fraudulent donations to charity often feature large gifts made by principals of Ponzi schemes, funds received through auctions and pledges, and situations in which the charity may attempt to escape liability in bankruptcy by claiming that it is a “mere conduit.” Timing may also play an important role. Such fact patterns appear in the following cases.
Scholes v. Lehmann. Perhaps the best-known case involving a charity’s exposure to fraudulent transfer liability is Scholes v. Lehmann.[11] In Scholes, the receiver for corporations owned by a Ponzi scheme principal brought fraudulent transfer actions (under Illinois law) to recover investor funds from the former principal’s spouse, one of the Ponzi scheme investors, and several charities that received funds from the corporations. The charities argued that the donations they received from the principal should not be subject to attack under fraudulent transfer law, which would provide the receiver with money judgments against the charities in the amount of the donations. A money judgment against a charity can be problematic because charities may not hold onto donated funds but instead apply the funds for immediate charitable purposes.[12] At the oral argument on appeal from money judgments rendered against the charities, counsel for the charities argued that if charities are liable for fraudulent donations, charities will have to host “annual ‘fraud balls’ at which they try to raise money to pay judgments in suits brought by persons who claim that some of the money donated to the charity had been obtained from these persons by a fraud or theft by the donor.”[13]
In upholding the district court’s judgment that the charities were liable, Judge Posner gave thought to ways in which charities might limit their exposure. Instead of annual “fraud balls,” charities could screen donors (which he acknowledged “hardly seems feasible”) and hold cash reserves for fraudulent transfer exposure.[14] Judge Posner also considered whether a charity could obtain insurance to cover its fraudulent transfer exposure. Judge Posner found the charities’ arguments “appealing” but commented that charities should seek relief through the legislative process.[15]Scholes highlights the danger a charity faces of being held responsible for paying a creditor for the amount of a donation received.
In re Rothstein Rosenfeldt Adler, P.A. The case In re Rothstein Rosenfeldt Adler, P.A.[16] involved the bankruptcy of a law firm accused of orchestrating a $1.2 billion Ponzi scheme that resulted in a named partner’s fifty-year sentence. The issue arose as to whether the law firm payments to a charity for auction items via a competitive auction, as well as payments pursuant to a pledge, would be recoverable by the bankruptcy. Alternatively, if section 548(c) of the Bankruptcy Code applied, it would permit the charity to retain the funds and enforce its obligation to the extent that it gave value to the debtor and acted in good faith. The court determined that the charity acted in good faith and received value in exchange for auction items[17] as well as pursuant to a preexisting pledge agreement.[18]
In re Engler. The case In re Engler[19] involved a Ponzi scheme that bilked investors out of approximately $170 to $350 million; in the process, the debtors running the Ponzi scheme donated to a church project. The donations were the subject of a recovery action by a Chapter 7 bankruptcy trustee, which ultimately proved unsuccessful for the trustee, the details of which follow.
A group of parishioners of St. John the Evangelist Catholic Church in Naples, Florida, sought to raise money for Food for the Poor, an international faith-based organization. Specifically, Food for the Poor was raising money for its Jamaica Housing Project (“Project”). Some of the church parishioners created the Jamaica Outreach Program (“JOP”), a nonprofit organization, to raise money for the Project, where funds would be used to help build homes for poor Jamaican residents. Because the JOP had not obtained its 501(c)(3) tax-exempt status at the time it began soliciting donations for the Project, the JOP asked the church to receive donations on its behalf, to which the church agreed. Because the church believed it could not set up a separate project account under Diocesan accounting rules, it accepted donations—including funds from the debtors—into its general operating account, which was commingled with church revenue. However, the church did create a subaccount and separately accounted for the donations.
Because the fraudulently transferred funds were separately accounted for and were not for the church’s use, the court held that the church was a “mere conduit” and thus escaped liability for receiving this fraudulent transfer under section 550 of the Bankruptcy Code:
All of the donors, including the Debtors, specifically earmarked their donations for the Project. And that is where the money ultimately went. This is not a case where the Debtors simply donated money to the Church to build a parish center or fund its general operations. The Church’s use of the Debtors’ donation was circumscribed by its legal obligations to the Debtors and the JOP.[20]
Pergament v. Brooklyn Law School. The timing of a fraudulent transfer to a charity may play a role in determining whether the charity can escape liability on the ground that it is a conduit or is entitled to assert a good-faith defense. Such was the case in Pergament v. Brooklyn Law School,[21] in which a debtor was sued for allegedly bilking someone out of millions of dollars. During the course of the litigation, the debtor paid tuition for his children (including to Brooklyn Law School) before ultimately having a judgment entered against him. After the judgment of approximately $11 million was entered against him, he filed bankruptcy. Pergament demonstrates how timing matters. If the tuition payments were refundable, the student for whose benefit the transfers were made—not the school—could be viewed as the initial transferee. But once the tuition payment obligation matured (i.e., after the refund period expired), then, as to the amount considered nonrefundable, the tuition became the school’s (viewed as a creditor), and the school could do whatever it wanted with the funds. At this point, the school would become the “initial transferee” and not a mere conduit.
State Laws That Provide Limited Protection to Charities
Some states have special statutes that provide some protection for charities that receive fraudulently transferred assets. These states include Florida, Georgia, and Minnesota. The key issues with these statutes is to determine whether protection exists based on the type of person making the donation (e.g., individual or business entity), the type of asset donated, the type of charity entitled to protection, the period for which protection may exist, potential caps on annual amounts donated, and the nature of the fraudulent transfer theory being asserted (constructive versus actual) that is required to trigger protection under the statute. The nature of the fraudulent transfer theory is particularly important because if the debtor-donor is running a Ponzi scheme, courts will presume that the debtor’s charitable donations are subject to recovery under the actual fraud theory. Where more than one state’s fraudulent transfer law may apply, complex choice of law issues emerge. While the UVTA amendments provide certainty for a charity performing due diligence on large donations due to an easy-to-apply choice of law pointer, no such provision exists in the UFTA, leading to expensive litigation to determine applicable fraudulent transfer law.[22]
Florida. In Florida, section 726.109 of the Florida UFTA (relating to defenses, liability, and protection of a transferee) provides that a charitable contribution to a “qualified religious or charitable entity or organization” is not a constructive fraud transfer under section 726.105(1)(b) as long as the contribution was received in good faith. This protection does not extend to an actual fraud claim available to all creditors or the type of constructive fraud claim available to present creditors when the debtor is left insolvent after the transfer. Put differently, a contribution to a charity where the donor makes the donation with actual intent to hinder, delay, or defraud, or does not receive reasonably equivalent value in exchange for the contribution and is rendered insolvent, is fair game for certain creditors to pursue a charity as a transferee.
Further, a contribution from a “natural person” is a fraudulent transfer if the transfer was received on, or within two years before, the earlier of the date a cause of action is brought for a fraudulent transfer, the filing of a bankruptcy petition, or commencement of insolvency proceedings under any state or federal law, including an assignment for the benefit of creditors or the appointment of a receiver. The statute goes on to provide that the transfer will not be fraudulent for the natural person if the transfer was made consistent with the person’s practices of making charitable contributions or the transfer was received in good faith and the amount of the contribution did not exceed 15 percent of the person’s gross annual income for the year in which the contribution was made. The charitable contribution protected by the Florida UFTA is one that is defined in Internal Revenue Code (“I.R.C.”) section 170(c), as long as the contribution is a financial instrument as defined in I.R.C. section 731(c)(2)(C) or cash.
The effect of these statutory protections is to protect charities from certain forms of constructive fraud claims, as well as protect charities for receiving relatively small and routine donations made by individuals. This means that donations made by the debtor-donor with actual intent to hinder, delay, or defraud creditors (e.g., donations from Ponzi schemes) are prone to recovery, whereas tithing transfers by individuals are less likely to be recovered.
Georgia. Georgia’s UVTA has a special section dedicated to transfers to charities. Section 18-2-85 provides that a transfer made to a “charitable organization” will be considered voidable only if it is established that (1) a voidable transaction has occurred as described in section 18-2-74 (actual and constructive fraud as to all creditors) or 18-2-75 (constructive fraud as to present creditors), and (2) the charitable organization had actual or constructive knowledge of the voidable nature of the transfer.
Minnesota. Minnesota’s protection for charitable organizations is housed in the definitional section of Minnesota’s UVTA. Here, the term transfer does not include a transfer of a charitable contribution to a “qualified charitable or religious organization or entity,” with some exceptions. If the transfer was made within two years of a claim brought under the Minnesota UVTA, the charitable contribution is considered a voidable transfer.
However, a contribution within two years that was not made with actual intent to hinder, delay, or defraud the debtor-donor’s creditors is not a voidable transfer as long as the amount involved did not exceed 15 percent of the gross annual income of the debtor for the year in which the transfer of the contribution was made, or the contribution exceeded that amount but was consistent with practices of the debtor in making charitable contributions. Investment returns on the amounts contributed are excepted from the term transfer. Only charities described in I.R.C. section 170(c)(1), (2), or (3) may use this protection.
Federal Bankruptcy Law Protection for Charities
Section 548 of the Bankruptcy Code was amended by the Religious Liberty and Charitable Donation Act of 1998 to provide charities with some protection from a fraudulent transfer attack brought in the debtor-donor’s bankruptcy case. Section 548(a)(2) provides that a charitable contribution to a “qualified religious or charitable entity or organization” will not be considered a constructively fraudulent transfer if (i) the amount of the contribution did not exceed 15 percent of the gross annual income of the debtor in the year the contribution was made, or (ii) the contribution exceeded the 15 percent amount but was consistent with the debtor’s practices in making charitable contributions. The protection does not extend to a transfer that is attacked under the actual fraud theory. Furthermore, it has been held that a contribution that exceeds the 15 percent ceiling and is not “consistent with the debtor’s practices in making charitable contributions” is voidable in its entirety, not merely the portion above 15 percent.[23] As Professor Jeffrey Davis noted, even though this protection extends to charities defined in I.R.C. section 170(c)(1) and (2), “it is clear that congress’ motive was to protect tithes received by churches.”[24]
Insurance Coverage for Fraudulent Transfers
In Scholes v. Lehmann, Judge Posner suggested that a charity might obtain insurance coverage to limit its fraudulent transfer exposure. Unfortunately for charities, many policies exclude an insured-transferee’s monetary obligation from the definition of loss. Payment of such amounts has been compared to disgorgement or restitution for which coverage should not exist on public policy grounds. Such transactions are generally viewed as uninsurable either under the definition of loss and/or via endorsement.[25]
It may be that a charity and/or individual directors could seek defense coverage under a directors and officers (“D&O”) policy for engaging in a “wrongful act,” but as to a monetary judgment, a fraud exclusion could apply. Ultimately, the terms of the policy, including governing law, are vital to determining the extent to which coverage exists. Consequently, charities should consult with their insurance adviser regarding the extent of coverage provided (if any) in the event that the charity is sued as the transferee of a donation. A few cases discussed below highlight some of the issues involved in coverage disputes involving fraudulent transfer liability.
Case Law Regarding Fraudulent Transfer Coverage
In Huntington National Bank v. AIG Specialty Insurance Co.,[26] a lender accepted loan payments from a borrower who allegedly ran a Ponzi scheme and later filed for bankruptcy. Some of the loan payments were received by the lender in good faith, but some payments made after a certain date, according to the court, were not received in good faith. Recall that section 548(c) of the Bankruptcy Code provides a good-faith defense. These subsequent payments, if not received in good faith, would be subject to recovery by the bankruptcy trustee. The lender eventually agreed to return $32 million via settlement with the bankruptcy trustee.
One of the key issues in the case was whether the lender was entitled to recover under its insurance policy that covered professional services, which policy had been issued by two different insurers (primary and excess coverages). Coverage potentially existed under the policy because the alleged wrongful acts of the lender arose from the lender’s performance of banking services to the bankrupt borrower. The primary policy covered losses arising from a claim first made against the insured during the policy period and reported to the insurer for any wrongful acts of the insured in rendering or failing to render professional services. A “loss” was defined to include damages, judgments, settlements, and defense costs. Importantly, the definition of loss was modified by an endorsement to exclude “matters that may be deemed uninsurable under the law pursuant to which this policy shall be construed.”[27] The policy also had several potentially applicable exclusions.
Ultimately, the primary insurer concluded that the policy terms precluded coverage. This prompted the lender to sue the insurer, alleging breach of contract and bad-faith denial of coverage. The insurer argued that no “loss” had occurred, and even if a loss had occurred, coverage was precluded by the endorsement. The court considered the governing law, Ohio, in its coverage analysis. The court noted that in other cases a distinction was made between the wrongful “retention” of money, which might be insurable, versus the wrongful “acquisition” of money, which is not. In the case before it, the court focused on whether the lender’s receipt of payments accepted without good faith constituted unlawful taking of money or unlawfulholding of money. The lender argued that the fact that the loan payments by the borrower were found to be fraudulent transfers by the borrower meant only that the money was wrongfully held by the lender. The court held that while the lender had a right to be repaid, it did not have a right to accept payments from the debtor in the absence of good faith and to the detriment of the borrower’s fraud victims. Because acceptance of the funds by the lender was “wrongful,” the receipt of the payments was the wrongful taking of money and was uninsurable.[28]
Huntington National Bank thus illustrates how a court will focus on the type of fraudulent transfer along with the facts and circumstances when evaluating insurance coverage. It also illustrates how courts generally avoid finding coverage for monetary judgments due to public policy against insurability for what the courts might view as disgorgement or restitution.[29] However, each case must be examined on its merits, considering not only the terms of the insurance contract but also governing law, as highlighted in Sycamore Partners Management, P.P. v. Endurane American Insurance Co.[30]
In Sycamore Partners, Delaware law applied to a coverage dispute involving a fraudulent transfer. Notably, in Delaware, losses are uninsurable as against public policy only if the legislature so provides. In that case, investment funds (Sycamore) purchased all of the stock of a target company (Jones Group) in a leveraged buyout where Jones Group was renamed Nine West. Nine West sold various high-performing assets to Sycamore, which then sold those assets for a net profit of $336 million.[31] Nine West ultimately filed for bankruptcy, from which a variety of lawsuits, including a fraudulent transfer action, were brought against Sycamore and its management. Sycamore ultimately settled by paying $120 million to Nine West’s estate in exchange for dismissal of the claims.
Sycamore made a claim against its insurers to recover a portion of the settlement and the expenses it had incurred to defend Nine West’s claim. The insurers denied coverage, prompting Sycamore to sue them for breach of contract. The insurers raised several defenses, including the argument that the settlement was not insurable as a matter of public policy because it constituted disgorgement by Sycamore of ill-gotten gains that Sycamore had procured from the Nine West transactions.
The insurance policy contained a “law most favorable to insurability” clause, which the court viewed as a choice of law clause. Because Sycamore was seeking coverage, the provision allowed Sycamore discretion to choose any reasonable forum that it believed would maximize its chances of defeating the insurability defense. Sycamore chose Delaware law, which the court would utilize unless the insurers could demonstrate clearly that the “law most favorable” provision was unenforceable because of a public policy in a state with an interest materially greater than Delaware’s. Because the insurers could not do that, the court had to decide whether the settlement was insurable under Delaware law. Recall that in Delaware, losses are uninsurable as against public policy only if the legislature so provides. On this point, the court looked to Delaware law: while Delaware has a fraudulent transfer statute, it does not have a statute that renders insuring against disgorgement or restitution contrary to Delaware public policy. While the court ruled in Sycamore’s favor (on Sycamore’s motion for partial summary judgment as it pertained to the insurers’ uninsurability defense based on public policy grounds), the court also noted that it was not suggesting that insurance companies are required to cover restitution or disgorgement. It just so happened that, based on the terms of the particular insurance policy, the insurers were faced with their own contractual limitations that resulted in coverage.
Important Considerations for Charities Receiving Large Gifts
Many issues that are ancillary to transferee liability under fraudulent transfer law can be addressed in advance by a well-drafted gift agreement.[32] However, given its potential exposure to transferee liability, a charity should consider additional steps to minimize its risk when it accepts a donation or donations that bring an increased probability of liability. Given their susceptibility to receiving donations tied to Ponzi schemes, charities should also consider the use of a morals clause to address ancillary issues arising out of particularly egregious donor fact patterns.[33]
Searching public records for pending lawsuits is an easy way to discover whether a donor’s circumstances suggest an unusual likelihood of a fraudulent transfer action. A sound understanding of the nuances of fraudulent transfer law would also be helpful. For example, knowledge of applicable fraudulent transfer law would help to decide the period for which the charity retains funds—and how it retains them—before using them. A charity would benefit if it were able to identify factors that might give rise to its actual or constructive knowledge of the nature of the donation as a fraudulent transfer, which may later affect its entitlement to a defense.
Some protection might already exist in case law that may deter fraudulent transfers to charities in the first place. Many courts have awarded damages (including punitive damages) to creditors in fraudulent transfer cases, thereby providing a potential deterrent effect from those wishing to hinder their creditors. “Without punitive damages, nothing other than costs would deter a debtor from attempting to fraudulently transfer his assets. If he gets caught, so be it: The cost would simply be what was owed in the first place.”[34] In certain circumstances, courts have also been willing to find those who conspire or aid and abet fraudulent transfers to be liable for damages. Some state fraudulent transfer statutes provide a creditor with attorney fees, which may also act as a deterrent to the fraudulent transfer of assets.
A charity that finds itself the target of a recovery action will reach out to legal counsel to review the viability of the claim and potential defenses, and analyze the costs and benefits involved in defending the action. Charities and their executives should consult with their insurance advisers—before litigation is filed or threatened—as to whether coverage for fraudulent transfer–related litigation exists under their policies. That inquiry may involve determining whether certain policies could provide coverage (e.g., errors and omissions (“E&O”) or D&O), whether any difference in coverage exists based on the nature of the fraudulent transfer (e.g., actual versus constructive fraud), and what types of losses are potentially covered. If coverage is not available, charities should consider negotiating with carriers for the coverage sought. If coverage is not available or feasible on the commercial market and a risk-scoring analysis supports pursuing such coverage, a charity should consider the use of alternative risk solutions (e.g., a risk retention group, a captive insurance company,[35] etc.).
In closing, where a charity finds itself exposed for receipt of a fraudulent transfer, the courts have ruled in favor of creditors. These decisions pit the public policy of fraudulent transfer law protecting creditors against the public policy supporting charitable giving. While the decisions might seem harsh to charities, there are general defenses along with limited statutory protections, and charities can—and should—take the steps described above to protect against a court order requiring the return of funds.
SeeLetter from Kevin M. Brown, Acting Comm’r, Internal Revenue Serv., to Charles E. Grassley, U.S. Senator (June 28, 2007) (“In the tax shelter area, abusive programs often require a ‘tax-indifferent party’ to make the scheme work. Some tax-exempt customers continue to allow themselves to be used, often in new ways, as accommodation parties to enable abusive tax shelters.”). ↑
The first uniform act was the Uniform Fraudulent Conveyance Act (“UFCA”), promulgated in 1914. Because the UFCA is in force in only two states, it will not be addressed. ↑
In 2014, the Uniform Law Commission changed the term fraudulent transfer to voidable transaction via amendments to the Uniform Fraudulent Transfer Act (with such act being renamed the “Uniform Voidable Transactions Act”). Notwithstanding the change in terminology, the modern term voidable transaction will be referred to as fraudulent transfer unless context requires otherwise. ↑
Given the modernization of terminology under the UVTA amendments, the term actual fraud should be replaced with primordial rule, and constructive fraud should be replaced with undercompensated transaction. ↑
See generallyDavid J. Slenn, The Fraudulent Transfer of Wealth: Unwound and Explained (Am. Bar Ass’n Publ’g 2022). ↑
In re Petters Co., Inc., 532 B.R. 100, 104–05 (Bankr. D. Minn. 2015). ↑
South Carolina’s fraudulent conveyance statute still calls for a penalty and incarceration. A number of states have a criminal statute that addresses “defrauding creditors,” which may mean secured or unsecured creditors. These range from misdemeanors to felonies, based on certain factors. ↑
See In re JVJ Pharmacy Inc., 630 B.R. 388, 400 (S.D.N.Y. 2021) (explaining the difference between an initial and subsequent transferee):
The difference between the first two categories [initial transferee and entity for whose benefit the transfer was made] and an “immediate or mediate transferee of such initial transferee,” i.e., a subsequent transferee, has legal significance. A subsequent transferee can raise an affirmative defense to liability by demonstrating that it took the transfer “for value . . . in good faith, and without knowledge of the voidability of the transfer avoided.” Id. § 550(b)(1). Meanwhile, the initial transferee or the entity for whose benefit the transfer was made is limited to the defense contained in section 548(c), which is similar to the defense available to a subsequent transferee in section 550(b)(1), but for one important difference. Under section 548(c), an initial transferee or entity for whose benefit the transfer was made may retain the transfer if it took the transfer “for value and in good faith” and “gave value to the debtor in exchange for such transfer or obligation.” Id. § 548(c) (emphasis added). Thus, while a subsequent transferee may invoke a defense to recovery by proving that it took the transfer “for value” from the previous transferor, in addition to acting in good faith and without knowledge of the transfer’s avoidability, the initial transferee or the entity for whose benefit the transfer was made must further show that it “gave value” to the debtor.
See alsoIn re Teleservices Grp., Inc., 444 B.R. 767, 793 (Bankr. W.D. Mich. 2011), objections overruled sub nom. Meoli v. Huntington Nat’l Bank, No. 1:12-CV-1113, 2015 WL 5690953 (W.D. Mich. Sept. 28, 2015), rev’d in part sub nom. Meoli v. Huntington Nat’l Bank, 848 F.3d 716 (6th Cir. 2017). (“Of course, treating Huntington as the initial transferee would have eliminated its eligibility for the Section 550(b)(1) defense and would have brought Section 548(c) into play instead.”). ↑
Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995). ↑
Id. at 760 (“In this case, the charities used donations for “missionary endeavors here and abroad, but included as well are earthquake relief in San Francisco and the construction of a chicken hatchery and a children’s dormitory in Africa.”); see alsoPetters, 532 B.R. at 105 (“By the time they are called to account, charity-recipients have usually expended the donated funds on their mission—many times without capital enhancement from the expenditure.”). ↑
The nature of the conflict pits important public policy that one must be honest to his creditors before anyone else, against public policy supporting charitable organizations. See Petters, 532 B.R. at 105 (“[T]his invocation of fraudulent transfer remedies presents a snarl of conflicting public policy considerations. It is a troubling conundrum for any court that presides over such litigation.”). ↑
In re Rothstein Rosenfeldt Adler, P.A., 483 B.R. 15, 17 (Bankr. S.D. Fla. 2012). ↑
Id. at 21 (“The auction and attendance was an arm’s length transaction and the funds were received by the Foundation from RRA in good faith.”). ↑
Id. (“The pledge agreement entered into by RRA was entered into in good faith by the Foundation, was a customary and routine arm’s length transaction, and was a typical arrangement that the Foundation participated with many other donors. The payments were received in the same manner. These contributions raised RRA’s profile in the community, which provided it with additional intangible value.”). ↑
In re Engler, 497 B.R. 125 (Bankr. M.D. Fla. 2013). ↑
Pergament v. Brooklyn L. Sch., 595 B.R. 6 (E.D.N.Y. 2019). ↑
The differences among potentially applicable fraudulent transfer statutes governing a fraudulent donation might determine a charity’s liability. See In re Palm Beach Fin. Partners, L.P., No. 09-36379-BKC-PGH, 2014 WL 12498025, at *10 (Bankr. S.D. Fla. Dec. 10, 2014). The bankruptcy court, sitting in Florida, applied Florida’s choice of law rules. In doing so, the court applied the Second Restatement’s “significant relationships” test for actions sounding in tort and concluded that Georgia law applied to the trustee’s fraudulent transfer claims. The National Christian Foundation, Inc., as transferee-defendant, argued for application of Minnesota law, which potentially barred the trustee’s claims. Id. at *3 (“Minnesota’s Charitable Contribution Exception applies retroactively. Although Florida and Georgia both passed amendments enacting similar charitable contribution exceptions in 2013, neither Florida’s amendment nor Georgia’s amendment applies retroactively.”). ↑
See In re McGough, 737 F.3d 1268, 1275–76 (10th Cir. 2013) (transferee charity, Word of Life Christian Center, unsuccessfully argued for a return of only the amount that exceeds 15 percent):
Despite the statute’s plain meaning, the Center argues we should nevertheless adopt its interpretation of the statute because to do otherwise would reach an absurd result—it would protect a debtor’s right to donate 15% of his GAI to a charitable organization but allow a trustee to avoid the entire amount of the donations if they are one cent over the 15% threshold. Such a result, according to the Center, would place an undue burden on churches and other charitable organizations which would have to investigate a donor’s financial background in order to use funds within two years of their receipt (the reach-back period). Moreover, according to the Center, to allow a trustee to avoid the entire transfer if it exceeds 15% of GAI would undercut the purposes of RLCDPA—to protect religious and charitable organizations from having to turn over donations they receive from individuals who subsequently file for bankruptcy and to protect the rights of debtors to make religious and charitable donations up to 15% of their GAI.
See generally Kyle D. Black, Looking Past the Labels: How to Determine Whether Disgorgement or Restitution Payments Are Insured, Brief, Summer 2022, at 34, 35 (“Insurers do not want to insure a thief. And courts have generally recognized that using insurance proceeds to restore ill-gotten gains is against public policy. That is why directors and officers (D&O), errors and omissions (E&O), and professional liability policies often exclude ‘fines and penalties’ or other ‘matters which may be deemed uninsurable under applicable law’ from their definition of ‘loss.’” (internal citations omitted)). ↑
Huntington Nat’l Bank v. AIG Specialty Ins. Co., No. 2:20-CV-256, 2022 WL 17741060 (S.D. Ohio Dec. 16, 2022). ↑
The lender filed an appeal to the Sixth Circuit on January 17, 2023. ↑
The insurance company noted such decisions in its response in opposition to the lender’s motion for partial summary judgment. Defendants’ Response in Opposition to the Huntington National Bank’s Motion for Partial Summary Judgment at 12–13, Huntington Nat’l Bank v. AIG Specialty Ins. Co., 2021 WL 6552130 (S.D. Ohio Dec. 17, 2021) (“Chubb Custom Ins. Co., 2011 WL 4543896, at *11; William Beaumont Hosp., 552 F. App’x at 498; see also In re TransTexas Gas Corp., 597 F.3d 298, 309 (5th Cir. 2010) (holding that the insured’s claim for fraudulent transfers was uninsurable under the law); Level 3 Commc ‘ns, Inc. v. Fed. Ins. Co., 272 F.3d 908, 910 (7th Cir. 2001) (‘a “loss” within the meaning of an insurance contract does not include the restoration of an ill-gotten gain’); Millennium Partners, L.P. v. Select Ins. Co., 24 Misc. 3d 212, at *216 (NY Sup. Ct. Mar. 9, 2009), aff’d, appeal dismissed, 68 A.D.3d 420, 889 N.Y.S.2d 575 (2009) (‘disgorgement of “ill-gotten funds is not insurable under the law” because such disgorgement “does not constitute ‘damages’ or a ‘loss’ as those terms are used in insurance policies”’).”) ↑
See generally Reynolds T. Cafferata, Anatomy of a Charitable Gift Agreement—with Useful Drafting Tips, 46 Est. Plan. 19, 2019 WL 4254678 (2019). The agreement may not only include terms of payment and enforcement but also identify the proper parties to the gift agreement to minimize a challenge to the gift by a third party whose consent was required. ↑
For an overview of how such a clause would help, including a sample morals clause, see Adam Scott Goldberg, When Charitable Gift Agreements Go Bad: Why a Morals Clause Should Be Contained in Every Charitable Gift Agreement, Fla. B.J., Dec. 2015, at 48, 50 (“A good agreement includes a process for amendment, an effective date, a reporting and stewardship clause, a governing law clause, and a clause stating the agreement represents the entire agreement between the parties. A very good agreement should also include a morals clause (commonly referred to as a bad boys or misconduct clause). The charity’s failure to place a morals clause in an agreement can lead to bad publicity, awkward situations, and future litigation.”). ↑
Alliant Tax Credit 31, Inc. v. Murphy, 924 F.3d 1134, 1150 (11th Cir. 2019). ↑
For an overview of captive insurance and associated tax and regulatory issues, see The Captive Insurance Deskbook for the Business Lawyer (David J. Slenn ed., Am. Bar Ass’n Publ’g 2018). ↑
So many capable law firms spend countless hours strategizing how to attract more business and cultivate clients. But while most firms recognize that law is a business, they focus mainly on the proficiency of their work product and sometimes fail to appreciate the finer business relationship nuances that help to attract and retain business.
There may have been a day when client relationships were so tight that law firms had a lock on virtually all of a client’s flow and needed to do little to nurture the relationship. To be sure, there are still some high-stakes matters that inevitably are entrusted to only a small cadre of lawyers with proven track records and institutional connections to avoid second-guessing on why someone new was tried out if the result is suboptimal. And perhaps a client’s close personal relationship with a law firm friend or colleague influences some flow.
Otherwise, however, it is relatively open season. Clients use many law firms and are often open to expanding their roster, particularly for specialized or boutique-ish needs. They also tend to select individual lawyers, rather than law firms that then internally designate a partner to head the assignment. And they typically assign work based on practical factors that blend past experiences with the overall relationship dynamic—including steering away from irritants, unpleasant experiences, and noncompetitive fees. More and more, clients are considering diversity factors as well.
Among the most important decisions for an in-house lawyer is which outside counsel to hire and when to change horses. A client’s baseline expectation for all outside counsel is certainly quality work, so if the product falls short, whether due to sloppiness or worse, the relationship is obviously in peril. And, unsurprisingly, the internet and legal marketplace abound with advice about strengthening relationships by understanding the client and its needs, improving communications, and enhancing efficiency.[1]
But what about the smaller things? Does it also matter if a client’s emails or calls are not returned for hours or days? Should the client’s dissatisfaction with a product or service invite argument, rebuke, and a complaint to a more senior in-house representative? Are there typos in the client’s own name in drafts? Has the firm served up an engagement letter loaded with one-sided terms and conflict waivers? Is the bill twice what was expected?
Think of all the other commercial relationships in life where the enterprise offers quality goods, but the shopping experience is exasperating. The more critical the deliverable—whether for household use, for medical diagnosis and treatment, or for a technological innovation—the more a customer will tolerate the dissatisfaction. Conversely, for the mundane items or services that are in abundant supply, the exasperation can quickly alienate the customer.
The legal industry does not operate in a special bubble immune from commercial reality. Law firms should focus beyond their work product on the nuances, hiccups, and irritants that can likely be managed and mitigated but have the potential to snowball if left festering. This article accordingly drills down, based on the author’s decades managing a global in-house litigation and regulatory proceedings group and previous practice as a law firm litigator, on some of these finer points that can make a difference in attracting new business, reinforcing relationships, and avoiding needless disruption:
Embracing the Fundamentals. Fundamentals are the substantive aspects of work product that every law firm should get right and that clients expect, and that may truncate the relationship if a contrary pattern emerges.
Exhibiting Proper Etiquette. While a superstar lawyer hired for a critical assignment may be afforded more latitude, most clients will not tolerate flippancy, abusiveness, and arrogance.
Handling “Difficult” Clients. Client representatives are human, bringing their stress and eccentricities to the relationship.
Soliciting Business. Websites and blast client memos are far less likely to attract business than proper introductions, networking, and successes.
Learning from Failures. Rather than burying a relationship failure by failing to deal with a fracture or blaming the client, what can be done to salvage and repair?
Getting Noticed. Whether new to the legal practice or a veteran, there are ways to make a mark with a potential client.
Embracing the Fundamentals
Law firms universally claim to provide top-notch work product and to represent clients zealously. Some market themselves as smarter or nimbler than the competition. Others point to their deep experience handling certain legal topics. Many have slogans or taglines that purport to capture their special distinction and talents.
Fundamentally, however, while law firms themselves may recognize particularly impressive work product of peers—denoting a “lawyer’s lawyer”—many clients do not have the capacity or sensitivity to scrutinize those avowed credentials on that level. They instead measure success or failure largely by the result. At the same time, they do notice smaller nuances that tend to undermine credibility and that are easily avoided with care and diligence.
Some precepts are so basic that they require little discussion here. Obviously, a law firm should never lie to or mislead a client, eviscerating the entire relationship of trust and possibly implicating ethical issues.[2] Clients also expect and deserve respect and responsiveness, which may come at different levels but must always meet a threshold standard. And law firms should not overstate their expertise, as it is better to candidly pass on an assignment than risk the relationship when they prove to be outmatched.
Other fundamentals, however, impact the quality of work product and avoid the embarrassing hiccups.
Master the Facts and Law. First and foremost, a failure to master the facts and law will invite an awkward client discussion as to how something was missed. Bevies of postmotion submissions addressing matters that should have been detailed in the motion itself beg the question of whether balls were dropped even if the client ultimately prevails. Winning a clawback of discovery materials that never should have been produced is not a “victory” from a client’s perspective. More likely, these lapses will invite a discussion of whether the law firm should bear the cost of the needless sideshows, and raise concerns as to the firm’s quality controls.
Research should be thorough and updated. Factual investigations should leave open no loose ends and include a comprehensive review of documents, emails, and witnesses. In a world of electronic communication, it is no longer feasible or cost-effective for law firms to manually review every email and text, but the process must be robust and avoid surprises. And even then, law firms should never assume or represent that every fact has been definitively pinned down because something is often lurking around the corner.
Don’t Overpromise, Overpredict, or Guess. Clients understand uncertainty and risk, but they want their expectations to be managed realistically. Law firms can get overly enamored with their positions and make bold predictions that prove unsustainable. Even worse, preferring not to seem unprepared, they may shoot from the hip or make an educated guess that proves unfounded.
For better or worse, outcomes tend to be scrutinized with hindsight. If success depends on prevailing on a series of uncertain factors or arguments, they should be spelled out and realistically assessed individually and holistically. If adverse legal authority exists, it should be flagged. And above all, little in the legal world is a sure thing, meaning that even the most optimistic assessments should recognize and factor in potential adverse results. Law firm predictions often influence internal reserves, and overoptimism can translate into awkwardness when the ultimate price tag and reserves deviate.
The same is true with respect to scheduling. An aggressive prediction on when drafts will be ready does not help a client manage the workload. Whatever the prediction, if there are delays, the worst thing is for a law firm to grant itself an unannounced extension rather than engaging with the client and discussing the delay and a more realistic schedule.
Be Precise and Don’t Overrely on Technology. No law firm would knowingly file with the court a brief full of typos, skewed margins, and erroneous citations. Yet, strikingly, drafts go to clients even misspelling their names. Any client will resent being made a proofreader, but the sloppiness also may raise concerns about the substance of the entire work product.
Spell check and auto-citation are simply not replacements for good, old-fashioned proofreading and cite checking. The system may miss misspelled words that, in fact, spell other words. Autocomplete may select the wrong filling. Voice dictation often detects a close but unintended word or phrase. And the advent of artificial intelligence brings its own perils, including citation of fictitious authorities and outright plagiarizing of material that reads well but is entirely inapposite.
Exhibiting Proper Etiquette
If a restaurant keeps a customer waiting despite a reservation, ignores the customer once finally seated, and then responds indignantly to complaints about the slow service and quality of the food, would the customer ever return? So, too, law firms can lose sight of the old adage that “the customer is always right” and common rules of etiquette, damaging the relationship regardless of their substantive work product.
As a threshold matter, clients come in different shapes and sizes, so etiquette must be tailored to each client’s preferences and idiosyncrasies. Some are demanding micromanagers, and others delegate and defer to outside counsel. Some are supersmart, and others slower to grasp analysis. Some are inherently nice, and others always on edge with stress. The same is likely true among the law firm lawyers themselves, but potential business is not on the line when internal irritation occurs.
Despite these tailoring needs, several overarching principles always apply.
Understand the Organization-Versus-Representative Dynamic. The “client” in a corporate setting is typically the organization and not the individual liaison. Yet, the reality is that the day-to-day representative holds the reins and probably will be instrumental in securing additional assignments. Going over that individual’s head to register a complaint or question instructions will inevitably cause friction and should accordingly be done sparingly—and even then with extreme finesse that includes, if possible, the individual’s participation.
While the organization must be respected as the “client,” it acts only through its employees, who should be treated as part of the organization and not the arm’s-length adversary. If “Miranda” warnings must be given to protect the organizational privilege—which should be thoughtfully considered in context and not administered automatically—they can at least be expressed gently without making employee witnesses feel like they are under personal scrutiny and perhaps even need their own counsel.
Exploit Communication. Perhaps most important, communication is the key to sustaining any relationship, yet law firms seem to resort almost exclusively to emails these days for most purposes: to gather information, to provide drafts, and even to report developments. Sometimes, virtual meetings occur using online platforms, particularly in the new era when law firms allow lawyers more freedom to work remotely. But seldom does anyone seem to pick up the phone or arrange in-person meetings.
Whether the loss of physical and voice contact is the result of generational culture shifts or the pandemic, the diminishing occurrence of such contact is profound. Think about how close friendships inevitably erode when sustained only by long-distance, occasional texts. Communicating with a client is not a burden to be satisfied through the expedient of email, but an opportunity to reinforce the relationship and demonstrate proficiency. And when better to call live than to report a positive development?
How often to communicate again depends on the client’s appetite. But communications should be aimed at managing the client’s expectations and avoiding surprises:
Developments should be reported promptly, and if a law firm needs to prepare a lengthy summary that gets reviewed up the chain, at least the headline should be reported immediately, with more to follow.
Saving up several rounds of drafts or briefs to send along as a bundle does not help a client representative, who may prefer to review things piecemeal and stay ahead of the curve rather than receiving an overwhelming tome in bulk.
Fire drills occur but should be flagged for the client immediately rather than by delivering an unexpected draft the night before it is due without warning.
Drafting schedules should be discussed at the outset, in all events avoiding the Friday afternoon unadvertised draft that feels like a weekend homework assignment to a client. Law firms undoubtedly manage projects internally to accommodate levels of review, so why not factor in the client’s required lead time at the start?
Law firm team members typically focus on a handful of matters at any time, although each may include dozens of workstreams. Those lawyers live and breathe the matters and so are intimately familiar with deadlines and scheduled calls. By contrast, in-house lawyers and business personnel may manage many dozens of matters and rely heavily on outside counsel for the granular aspects of each one. As a result, law firm emails months before laying out schedules and calls easily get lost in that overwhelming flow or overtaken by the crisis of the moment. Law firms should accordingly update and remind clients regularly about upcoming events and drafts. Even an email flagging that a call is about to begin with the dial-in number or video platform link can be a huge help to a client who has lost track of time or is absorbed in another situation.
Obviously, cost considerations may factor into the method and frequency of communication, but the client should be asked for any preferences.
If electronic communication is used, law firms should at least avoid needless debates and inordinate length and strings that are too unwieldy to read, much less synthesize. And emails and texts should avoid insensitive language or attempted humor that disrupts too many relationships when emerging in the wrong context. Similarly, if a law firm leaves voicemail in an age where few calls are answered by recipients or bygone assistants, the message should be short and succinct (or if the message is lengthy, leave an executive summary at the start).
Offer Reasonable Fees. Finally, fees should be reasonable, competitive, in proportion to expectations, and billed in accordance with the client’s preferred time schedule. They should be discussed up front and along the way, particularly if they start deviating from budgets or forecasts. While a bill in a “bet-the-company” or large transactional matter may be hard to scrutinize against a benchmark, commodity-type assignments in particular tend to have a standard range that will be the baseline for considering the law firm’s cost reasonableness and effectiveness. The best work and result will not likely invite a return engagement if the fees were disproportionate.
Handling “Difficult” Clients
Curmudgeons seem to be everywhere within the legal industry, and clients are no exception.[3] But it is important to distinguish a client who is ornery or having a bad day from one who is involved and demanding. While law firms may be used to total delegation by some clients, others will choose to participate actively and even debate issues with outside counsel. Although such clients are certainly more challenging, they nonetheless are just doing their jobs and can add value.
The Upside of Active Clients. An active client is arguably a benefit for law firms, not a burden. A client who closely manages a matter and has the intellectual skills to discern quality can be impressed and a source for future business recommendations. Client engagement and buy-in takes more effort but also avoids later misunderstandings about potential outcomes and cost. A client’s delivery may be inartful or miss the point at times, but it is worth the time to get on the same wavelength because clients can offer practical business observations and factual precision that outside counsel might otherwise fail to appreciate.
The Downside of Active Clients. On the other hand, some clients can indeed make the adventure more difficult without adding much value. There are the clients who fail to respond to requests for factual information or comments on drafts, or else provide comments at the last possible moment (which may be off target). There are the windbags who never stop talking and the insecure clients who seek to dominate any meeting or call. Others spin the story, forum shop for the advice they want to hear, and interpose outside counsel amid their internal politics and quest for credit. It is even possible that a client is simply petulant, offensive, or demeaning.
There is little to be gained from pushing back where a client’s behavior falls into one of these benignly unhelpful categories. It is better to maintain poise; express empathy and patience; and, if extreme, discreetly escalate the situation within the client organization. Escalation obviously may end up burning bridges so should be a last recourse.
But whatever the circumstances, there is no place for abusive or offensive conduct, and a law firm owes it to the client organization to flag the issue diplomatically at a higher level if it occurs.[4]
Soliciting Business
Law firm memos to clients on legal developments are certainly appreciated, but do they stand a better chance of landing business than the incessant stream of marketing pitches and spam arriving in personal inboxes every day? And perhaps presenting at symposiums and conferences or displaying flashy websites (featuring those catchy slogans and taglines) might raise a law firm’s profile. But those devices are expedients more to maintain a market presence than to secure specific assignments. Does any client really get sold by a catchphrase like (to pluck a few from the internet) “A Small Firm That Acts Big” or “Committed to Helping Our Clients Succeed,” or even “Lawyers You’ll Swear By. Not At.”?
Sometimes a new client may approach a law firm to take advantage of a specific lawyer’s expertise or reputation. Other times, a client may follow a lawyer who moves to a new firm. But otherwise, securing new relationships depends heavily on a firm’s networking and proper introductions.
Garner Introductions. The best channel for an introduction to a client’s legal function is its business team. The legal function, while typically independent, nonetheless is commercial and should respond favorably to a recommendation that comes from the revenue side of the company. If a law firm has steered business opportunities to the client, business personnel in particular should be open to reciprocating by means of such an introduction.
Alternatively, any relationship with the client’s business or legal personnel is an opportunity for an introduction. Perhaps a law firm lawyer and client businessperson are social acquaintances or their children attend the same school. Or perhaps the law firm represents another client in the same industry who can make the introduction.
Exploit Success. If a foot is already in the door, the best time to seek more assignments is in the wake of a victory or good work. If the success story benefited that client, it should be exploited promptly within the organization. But even if the impressive event was for another client, there is every reason to reach out more broadly to the firm’s existing and prospective client base to report the news and discuss how the firm can similarly help.
Don’t Be Picky. As a corollary, law firms should not be picky when trying to establish or expand a relationship. They may prefer assignments that are lucrative or high-profile, but client inventory is uncontrollable, and every firm needs to start someplace. Quality and efficient work will likely be recognized and rewarded with more.
Prepare Retention Letters Carefully. Finally, law firms that are lucky enough to establish or perpetuate client relationships should think hard before serving up one-sided retention letters that dictate a flurry of terms while essentially waiving all past, present, and future actual or potential conflicts. Bar association rules often require some sort of written engagement confirmation, but the versions that seem to proliferate both burden a client with the need to review the tome and elicit the wrong tone for a relationship that should feel close and trusted.
Learning from Failures
Balls get dropped and things go wrong in any relationship. Too often, a small problem gets magnified due to nondetection, avoidance, or mismanagement. And bigger issues are deemed futile or blamed on the client. How hiccups or worse get identified and dealt with can deeply impact the future client relationship.
Detection. Law firms are no different fundamentally than any other supervisory organization that monitors activity and seeks to detect issues. Individuals have a responsibility to self-report when something goes wrong, and more senior lawyers should be on the lookout for problems. Indeed, clients, particularly regulated ones, use surveillance tools as part of their compliance regime, begging the question of whether law firms should do the same to identify circumstances or language that deviates from the norm. If law firms are practiced at spotting problematic client communications, they should be able to apply the same skills to their own.
Obviously, if a client reaches out to complain about something, there is reason for concern even if the complaint is deemed misplaced. Red flags may signify client strain or discontent. Certainly, if business levels drop, that is an occasion to figure out why and explore how to repair the relationships. If lawyers internally refer to a client disparagingly, they are probably not treating the client with respect. And if a relationship lawyer is in regular touch with the client, even just to check in, the substance or tone may suggest that something is amiss.
Engagement and Repair. Even before determining what happened, engagement with the client is critical. The client is not only a source of information but the ultimate arbiter on whether the issue has been adequately addressed. The client should know that someone cares, will investigate, and will report back. By contrast, an ignored client will be left to stew and fester.
Central to dealing with any mishap is a heartfelt apology. If there are corrective measures to be taken, they should be discussed with the client to secure buy-in. Perhaps more frequent communication is needed, or better scheduling efforts. And perhaps the law firm’s fees should be reduced. In an extreme instance, staffing might be adjusted. Finally, whatever the issue, a solution should be considered more broadly to obviate similar problems with other clients.
Getting Noticed
Lots of lawyers are hardworking and smart, so standing out takes something special. Sometimes, getting noticed (whether within the law firm or beyond) is a matter of luck—getting assigned to the right client and matter at the right time. But whether junior or senior, lawyers do have significant control over their fate.
Track Record. Establishing a track record and subject matter expertise is key to attracting career attention. A dramatic success in a high-profile matter will result in instant fame. Otherwise, it takes sustained effort, but virtually anyone can become proficient in a legal area by working on a number of matters, continuously following developments, networking at relevant bar or industry conferences, and publishing insightful pieces. As reputations expand, word gets around, and clients follow.
Observers. You never know who is watching your performance beyond your own client. It may be a codefendant’s client. It may be a lawyer from another firm. It may even be a judge or regulator. The point is that lawyers should always do their best not only to serve their current client, but also because there is a larger audience that may notice. There have been plenty of occasions when this author noticed an adept lawyer representing another party and made it a point to hire that lawyer in the future.
Special Qualities. Above all, lawyers stand out when they exhibit special qualities. They may have a passion to win, fortitude and conviction, eloquence in delivery and advocacy, a flair for written work, a mastery of facts, a recognition of nuances others don’t pick up, a high degree of preparation and organization, and/or precision. This list is not exhaustive, and not every lawyer possesses every quality, but having some of them may help a lawyer rise above the crowd, particularly if a self-critical analysis identifies strengths and weaknesses so that the former can be exploited and the latter minimized. And, needless to say, it helps to be likable and have decent social skills.
Exploiting Opportunity and Taking Chances. Sometimes a lawyer is not looking for a change, but a unique opportunity arises. Perhaps the firm needs more resources in an area outside a lawyer’s comfort zone, representing an opportunity to expand horizons. Clients may need interim help, and there is no better way to get close to a client and learn its business than through a secondment. Pursuing something new and different does not sidetrack the career path; to the contrary, it demonstrates adaptability and utility.
Commerciality and Practicality. The old saying goes “millions for defense, not one cent for tribute.” The problem is that clients pay the bills. Law firms need to think commercially and practically to serve a client’s best interests by balancing results and cost. A quick and practical solution that obviates an expensive and lengthy slog may truncate an otherwise lucrative assignment but will likely earn the eternal gratitude of a client—and repeat business.
Conclusion
Law schools teach concepts and theory to get students intellectually ready to practice law, and law firms focus on producing outstanding legal work product to serve clients and gain reputational glory. These facets are the core of legal practice—but when viewed as a business, the legal profession could afford to pay more attention to the smaller nuances that matter in any commercial relationship.
* * * *
The author wishes to express his gratitude to James Beha, Jonathan Clarke, and Carrie Cohen for sharing their insights on this topic.
For a discussion of the evolution of the in-house counsel role and its relationship to outside counsel, see Eli Wald, Getting In and Out of the House: The Worlds of In-House Counsel, Big Law, and the Emerging Career Trajectories of In-House Lawyers, 88 Fordham L. Rev. 5 (2020). ↑
Interestingly, ethical rules typically proscribe only lies that are “material.” See Leonard M. Niehoff, How Not to Lie: A Don’t-Do-It-Yourself Guide for Litigators, 49 A.B.A. Litig. J. (Summer 2023). There is no room in a client relationship for lying, whether material or not. ↑
Mark Edward Hermann, The Curmudgeon’s Guide to Practicing Law (2d ed. 2020). ↑
For a discussion concerning clients to avoid altogether and setting ground rules with particularly insistent clients, see Lynda C. Shely, Armchair Quarterbacks, 50 A.B.A. Litig. J. (Fall 2023) at 23. ↑
When the New Jersey Revised Uniform Limited Liability Company Act (“NJ-RULLCA” or the “Act”)[1] was adopted on March 18, 2012, it included provisions allowing a New Jersey (“NJ”) corporation to convert to a NJ limited liability company (“LLC”), and vice versa. However, the legislation did not include amendments to the New Jersey Business Corporation Act (“NJBCA”)[2] authorizing such conversions. As a result, the provisions of NJ-RULLCA addressing a NJ corporation’s conversion to a NJ LLC, and vice versa, were dormant for over a decade.
On May 8, 2023, Governor Phil Murphy signed into law Senate Bill 142 (P.L. 2023, Chapter 38), which amended and supplemented the NJBCA to allow a NJ corporation to convert to a NJ LLC, and vice versa. As of the effective date of the law, November 4, 2023 (180 days after enactment), a NJ corporation may finally convert to a NJ LLC (or a foreign LLC), and vice versa. Further, a NJ corporation may redomesticate to another state, and vice versa.
The types of conversions and domestications involving corporations and LLCs in New Jersey may be summarized by the following table:
From
To
1. NJ corporation
a. NJ LLC
b. Foreign LLC
c. Foreign corporation
2. NJ LLC
a. NJ corporation
b. Foreign corporation
c. Foreign LLC
3. Foreign corporation
a. NJ LLC
b. NJ corporation
c. Foreign LLC
4. Foreign LLC
a. NJ LLC
b. NJ corporation
c. Foreign corporation
1. Conversion of NJ Corporation
a. Conversion of NJ Corporation to NJ LLC
NJ-RULLCA provides that a NJ entity[3] (other than a foreign LLC) may convert to a NJ LLC, and a NJ LLC may convert to any other form of entity (other than a foreign LLC).[4] Focusing on corporations, NJ-RULLCA provides that a NJ corporation may convert to a NJ LLC if:
the governing statute of the corporation authorizes conversion;[5]
the conversion is not prohibited by the law of the jurisdiction of the corporation; and[6]
the corporation complies with its governing statute in effecting the conversion.[7]i.
i. Directors’ and Shareholders’ Approval
As a result of the amendments to the NJBCA, the foregoing requisites are satisfied, and a NJ corporation may now convert to a NJ LLC.[8] To convert:
The corporation’s board of directors must adopt a resolution approving a plan of conversion, which plan must state that the corporation will be converting to a NJ LLC and direct that the plan be submitted to a vote at a meeting of the shareholders.[9]
All shareholders, whether or not they are entitled to vote, must be given written notice of the shareholders meeting, with such notice being given not less than twenty nor more than sixty days prior to the meeting.[10]
All shareholders, whether or not they are entitled to vote, must approve the plan of conversion.[11] To repeat, even shareholders holding non-voting shares of stock must vote in favor of the plan of conversion.[12]
The amendments to the NJBCA also provide that the plan of conversion must be approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.[13] This is curious language because the LLC is formed upon conversion and, therefore, is not yet in existence in New Jersey and may not have an operating agreement until conversion. How would the LLC approve the conversion? Nonetheless, because the shareholders of the NJ corporation will likely be the members of the LLC and will want to know the terms of the operating agreement prior to the conversion, this hurdle may be satisfied by the members executing the operating agreement immediately prior to the conversion.
ii. Plan of Conversion
The amendments to the NJBCA do not specify what information should be included in a plan of conversion.[14] By contrast, NJ-RULLCA provides that the plan of conversion must include the following information:
form of the entity after conversion (i.e., a NJ LLC);[18]
the terms and conditions of conversion, including the manner and basis for converting interests of the converting entity (e.g., shares of stock of a NJ corporation) into any combination of cash, interests in the converted entity (e.g., membership interests in a NJ LLC), and other consideration.[19] (For example, the plan may state that a shareholder with 25 of 100 issued and outstanding shares of the NJ corporation will receive a 25 percent membership interest in the LLC.); and
the organizational documents of the converted entity that are, or are proposed to be, in writing (e.g., the certificate of formation and the operating agreement of a NJ LLC).[20]
Therefore, when converting from a NJ corporation to a NJ LLC, the foregoing items must be included in the plan of conversion.
iii. Certificate of Conversion
Once the board of directors and the shareholders approve the plan of conversion, the NJ corporation would file a certificate of conversion with the New Jersey Division of Revenue and Enterprise Services (“NJDORES”).[21] The certificate of conversion must include the following information:
If the corporation wants to change its name, the proposed new name of the LLC.[23] (If the corporate name includes “Inc.,” “Corp.,” etc., it must be changed to “LLC,” “L.L.C.,” etc.; therefore, the proposed new name of the LLC would be included in the certificate.)
The future date or time when the conversion will be effective, if not effective upon filing, which future date cannot be more than ninety days after filing.[24]
A statement that that the plan of conversion was adopted by the board of directors and the shareholders as required by N.J.S.A. 14A:11A-2(3).[25]
NJ-RULLCA does not address the contents of articles of conversion for an entity, such as a NJ corporation, converting to a NJ LLC. It simply requires that the certificate of formation include additional information relating to the conversion.[26]
iv. Certificate of Formation
A NJ corporation converting to a NJ LLC must file a certificate of formation with the NJDORES.[27] In addition to the information required by N.J.S.A. 42:2C-18(b) (which is the name, the registered agent, and the registered office of the NJ LLC), the certificate of formation must include the following information (when a corporation is converting to a NJ LLC):
a statement that the NJ LLC has been converted from a corporation;[28]
the form of the converting entity (e.g., a NJ corporation);[30]
the jurisdiction of the converting entity (e.g., New Jersey); and[31]
a statement that the conversion was approved in a manner that complied with the converting entity’s governing statute (e.g., the NJBCA).[32]
b. Conversion of NJ Corporation to Foreign LLC
A NJ corporation may convert to a foreign LLC.[33]
i. Approval by Directors and Shareholders
See previous discussion at Section 1(a)(i).
ii. Plan of Conversion
See discussion at Section 1(a)(ii). (With any conversion from a NJ entity to a foreign entity, the statute of the foreign entity must be reviewed for any requirements that must be stated in the plan of conversion and the certificate of conversion.)
iii. Certificate of Conversion
Once the directors and shareholders approve the plan of conversion, the NJ corporation would file a certificate of conversion with the NJDORES, which must include the following information:
The name of the corporation, and, if the name has been changed, the name under which it was originally incorporated.[34]
The date of filing of its original certificate of incorporation.[35]
The jurisdiction where the conversion will occur.[37]
A statement that the conversion was approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.[38] (As noted, the LLC is formed upon conversion and, therefore, is not yet in existence and may not have an operating agreement at that time. Nonetheless, the statement will be included in the certificate of conversion since the conversion would need to be approved in accordance with applicable law and, if in existence, the operating agreement.)
The future date or time when the conversion will be effective, if not effective upon filing, which cannot be more than ninety days after filing.[39]
If, after conversion, the foreign LLC will be conducting business in New Jersey, a statement that “it shall comply with the provisions of this act [i.e., the NJBCA] with respect to foreign entities, . . .”[40]
A statement that the foreign LLC may be served with process in New Jersey in any proceeding to enforce any obligation of the converting NJ corporation.[41]
The foreign LLC’s irrevocable appointment of the NJDORES as its agent to accept service of process in any proceeding to enforce any obligation of the converting corporation.[42]
The address of the foreign LLC—within or outside New Jersey—where the NJDORES will mail process of service to the foreign LLC.[43]
c. Conversion / Domestication of NJ Corporation to Foreign Corporation
A NJ corporation may convert to a foreign corporation.[44] This type of conversion is commonly known in NJ as a domestication, although such a term is not used in the amendments to the NJBCA.[45]
i. Approval by Directors and Shareholders
See previous discussion at Section 1(a)(i).
ii. Plan of Conversion
See discussion at Section 1(a)(ii).
iii. Certificate of Conversion
See discussion at Section 1(b)(iii).
d. Effect of Conversion / Domestication of NJ Corporation
The conversion (or domestication) of a NJ corporation to (a) a NJ LLC, (b) a foreign LLC, (c) a foreign corporation, or (d) another form of NJ or foreign entity does not affect any of the NJ corporation’s obligations or liabilities, or the personal liability of any person, incurred prior to the conversion.[46] Upon conversion, the new NJ LLC (or foreign LLC, foreign corporation, or other form of NJ or foreign entity) is, for all purposes, deemed to be the same entity as the NJ corporation.[47]
The amendments to the NJBCA provide that, upon conversion (using a conversion from a NJ corporation to an LLC for this discussion):
all of the corporation’s rights, privileges and powers belong to the LLC;
all of the corporation’s real, personal, and mixed property belong to the LLC and, with respect to real property, it will not revert or be in any way impaired as a result of the conversion;
all debts owed to the corporation will be owed to the LLC;
all rights of creditors and all liens on any property of the corporation are preserved unimpaired, meaning that the LLC’s property is subject to any liens filed against the corporation’s property;[48]
all of the corporation’s debts, liabilities and duties belong to the LLC and may be enforced against the LLC as if it incurred or contracted them; and
all of the foregoing items are not deemed transferred from the corporation to the LLC.[49]
NJ-RULLCA likewise provides:
all of the corporation’s property remains vested in the NJ LLC;[50]
all of the corporation’s debts, obligations and other liabilities continue as the debt, obligations and liabilities of the NJ LLC;[51]
any action or proceeding by or against the corporation is continued as if the conversion had not occurred (in other words, the action or proceeding of or against the corporation continues as the action or proceeding of or against the NJ LLC); [52]
all of the rights, privileges, immunities, powers, and purposes of the NJ corporation remain vested in the NJ LLC, except as prohibited by law (other than NJ-RULLCA);[53] and
upon conversion, the terms and conditions of the plan of conversion take effect, except as otherwise provided in the plan of conversion.[54]
The conversion is not deemed a dissolution (unless otherwise agreed in the plan), and the NJ corporation is not required to wind up its business, pay its liabilities, and distribute its assets.[55] The NJ corporation continues in the form of the NJ LLC (or foreign LLC, foreign corporation, or other form of NJ or foreign entity).[56]
For a conversion of a NJ corporation to a foreign LLC, corporation, or other form of entity, the conversion is not deemed to affect the choice of law applicable to the NJ corporation with respect to matters arising prior to conversion.[57]
2. Conversion of NJ LLC
a. Conversion of NJ LLC to NJ Corporation
As a result of the amendments to the NJBCA, a NJ LLC may now convert to a NJ corporation.[58]
i. Approval by Members
To convert, the NJ LLC must approve a plan of conversion and a certificate of incorporation, which must be approved in accordance with the LLC’s operating agreement and applicable law, as appropriate (which for a NJ LLC means NJ-RULLCA).[59]
NJ-RULLCA provides that all members of a NJ LLC converting to a NJ corporation (or any other form of entity) must consent to the plan of conversion,[60] unless the operating agreement authorizes conversion with the consent of less than all members.[61] Even in a manager-managed LLC (as opposed to a member-managed LLC), the members (not the managers) approve the plan of conversion, unless the operating agreement provides otherwise.[62]
ii. Plan of Conversion
NJ-RULLCA provides that the plan of conversion must include the:
form of the entity after conversion (i.e., a NJ corporation);[66]
terms and conditions of conversion, including the manner and basis for converting interests of the converting entity (e.g., membership interests of the NJ LLC) into any combination of cash, interests in the converted entity (e.g., shares of stock of a NJ corporation), and other consideration;[67] and
organizational documents of the converted entity that are, or are proposed to be, in writing (e.g., the certificate of incorporation, the bylaws and the organizational resolutions appointing directors and officers, and, if applicable, the shareholders agreement).[68]
iii. Certificate / Articles of Conversion
Once the members approve the plan of conversion and the certificate of incorporation, the NJ LLC would file articles/certificate of conversion and a certificate of incorporation with the NJDORES.[69] The articles/certificate of conversion must be signed by an authorized person.[70]
NJ-RULLCA provides that the articles of conversion must include the following information:
a statement that the NJ LLC has been converted to a corporation;[71]
the form of entity and such other information as may be required by the NJDORES to correctly identify the company and the jurisdiction of its governing statute;[73]
the date the conversion is effective under the governing statute of the converted entity;[74]
a statement that the conversion was approved as required by NJ-RULLCA;[75] and
a statement that the conversion was approved as required by the governing statute of the converted entity (e.g., the NJBCA).[76]
By comparison, the amendments to the NJBCA provide that the certificate of conversion must include the following information:
the jurisdiction where the LLC was formed, and, if it has changed, the jurisdiction immediately prior to the conversion to a NJ corporation;[78]
the name of the LLC prior to filing the certificate of conversion;[79]
the name of the NJ corporation as set forth in the certificate of incorporation to be filed with the certificate of conversion;[80]
the future date or time when the conversion will be effective, if not effective upon filing, which future date cannot be more than ninety days after filing;[81] and
a statement that the plan of conversion was approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.[82] (Although the entire statement would be included in the certificate, if there is no operating agreement, then for a NJ LLC the plan of conversion would be in accordance with NJ-RULLCA, which serves as the LLC’s default operating agreement).
Although there is no indication in either the NJ-RULLCA or the NJBCA of how to reconcile the requirements of each statute, a NJ LLC converting to a NJ corporation would likely file one certificate / one set of articles of conversion combining all information required in N.J.S.A. 14A:11A-1(5) and N.J.S.A. 42:2C-80(a)(1) to comply with each statute. In fact, the NJDORES has published two forms of certificate of conversion—one form (CD100) to be used when the resulting entity will be a NJ entity and the other (CD101) when the resulting entity will be a foreign entity. The forms are intended to be used in all types of entity conversions. The NJDORES has done an admirable job of distilling the statutory requirements in NJ-RULLCA and the NJBCA into one-page certificates. The forms are available on the NJDORES website.[83]
iv. Certificate of Incorporation
A NJ LLC converting to a NJ corporation must file a certificate of incorporation with the NJDORES, which must be signed in accordance with the NJBCA.[84] This provision states that a document may be signed by the chairman, president, or vice president of the corporation;[85] however, the corporation would not have any directors until the certificate of incorporation is filed and would not have any officers until the organizational meeting of the directors is held. Therefore, the certification of incorporation will likely be signed by an incorporator.[86]
b. Conversion of NJ LLC to Foreign Corporation
A NJ LLC may convert to a foreign corporation.[87]
i. Approval by Members
See previous discussion at Section 2(a)(i).
ii. Plan of Conversion
See discussion at Section 2(a)(ii).
iii. Articles of Conversion
A NJ LLC converting to a foreign corporation would file articles of conversion under NJ-RULLCA. Because the conversion is to a foreign corporation, it would not need to comply with the requirements under the amendments to the NJBCA. See previous discussion at Section 2(a)(iii) on the contents of the articles of conversion under NJ-RULLCA.
Further, if a NJ LLC converts to a foreign corporation, and the foreign corporation will not be authorized to transact business in New Jersey, the articles of conversion must also include the street and mailing addresses of an office which the NJDORES may use for the purposes of N.J.S.A. 42:2C-81(c), which purposes are discussed in the next two sentences.[88] By doing so, the foreign corporation consents to the jurisdiction of the courts in New Jersey to enforce any debt, obligation, or other liability for which the NJ LLC is liable if the NJ LLC was subject to suit on such debt, obligation, or other liability prior to the conversion.[89] The foreign corporation also appoints the NJDORES as its agent for service of process of any suit relating to such debt, obligation, or other liability.[90]
c. Domestication of NJ LLC to Foreign LLC
A NJ LLC may become a foreign LLC by domestication if:
the foreign LLC’s governing statute authorizes domestication;[91]
domestication is not prohibited by the law governing the foreign LLC;[92] and
the NJ LLC complies with the foreign LLC’s statute in effecting the domestication.[93]
i. Member Approval
All members must consent to the plan of domestication,[94] unless the operating agreement authorizes conversion with the consent of less than all members.[95] Even in a manager-managed LLC (as opposed to a member-managed LLC), the members (not the managers) approve the plan of domestication, unless the operating agreement provides otherwise.[96]
ii. Plan of Domestication
The plan of domestication must include the:
name of the NJ LLC before domestication and other such information the NJDORES requires to correctly identify the LLC (e.g., the business identification number);[97]
jurisdiction of the foreign LLC after domestication;[99]
terms and conditions of the domestication;[100] and
organizational documents of the foreign LLC (e.g., the certificate of formation and the operating agreement or an amendment to the existing operating agreement).[101]
iii. Articles of Domestication
After the plan of domestication has been approved, the NJ LLC would file articles of domestication with the NJDORES, which articles must include:
a statement that the NJ LLC has domesticated to a foreign LLC;[102]
the name of the NJ LLC and any other information required by the NJDORES to identify the NJ LLC (e.g., its business identification number);[103]
the name of the foreign LLC after domestication;[104]
the jurisdiction of the foreign LLC after domestication;[105]
the date the domestication is effective under the foreign LLC’s governing statute;[106] and
a statement that the domestication was approved as required by NJ-RULLCA.[107]
If a NJ LLC converts to a foreign LLC, and the foreign LLC will not be authorized to transact business in New Jersey, the articles of domestication also must include the street and mailing addresses of an office which the NJDORES may use for the purposes of N.J.S.A. 42:2C-85(b), which purposes are discussed in the next two sentences.[108] By doing so, the foreign LLC consents to the jurisdiction of the courts in New Jersey to enforce any debt, obligation, or other liability for which the NJ LLC is liable if the NJ LLC was subject to suit on such debt, obligation, or other liability prior to the domestication.[109] The foreign LLC must also appoint the NJDORES as its agent for service of process of any suit relating to such debt, obligation, or other liability.[110]
iv. Statement of Surrender
When a NJ LLC domesticates to a foreign LLC, the NJ LLC must file a statement with the NJDORES surrendering its certificate of formation. The statement must include:
the name of the NJ LLC and any other information required by the NJDORES to identify the NJ LLC (e.g., its business identification number);[111]
a statement that the certificate of formation is being surrendered in connection with the domestication of the NJ LLC to a foreign jurisdiction;[112]
a statement that the domestication was approved as required by NJ-RULLCA;[113] and
d. Effect of Conversion / Domestication of a NJ LLC
Upon conversion, the NJ LLC will be a NJ corporation governed by the NJBCA.[115] The NJ corporation will be deemed to have been commenced on the date that the LLC was first formed.[116] For example, if a NJ LLC was formed on March 19, 2013, and converted to a NJ corporation on November 5, 2023, the NJ corporation will be deemed to have been in existence since March 19, 2013.
The conversion of a NJ LLC to a NJ or foreign entity does not affect any of the NJ LLC’s obligations or liabilities, or the personal liability of any person, incurred prior to the conversion.[117] Upon conversion, the corporation is deemed to be the same entity as the LLC, which means:
all of the LLC’s rights, privileges, and powers belong to the corporation;
all of the LLC’s real, personal, and mixed property belong to the corporation and, with respect to real property, it will not revert or be in any way impaired as a result of the conversion;
all debts owed to the LLC will be owed to the corporation;
all rights of creditors and all liens on any property of the LLC are preserved unimpaired, meaning that the corporation’s property is subject to any liens filed against the LLC’s property;[118]
all of the LLC’s debts, liabilities, and duties belong to the corporation and may be enforced against the corporation as if it incurred or contracted them; and
all of the foregoing items are not deemed transferred from the LLC to the corporation.[119]
The effect of a NJ LLC domesticating to a foreign LLC is the same as a NJ LLC converting to a NJ or foreign corporation, discussed previously.[120]
NJ-RULLCA contains comparable provisions on the effect of a NJ LLC converting to a corporation, which were discussed in this article earlier at Section 1(d).
The conversion is not deemed a dissolution, and the LLC is not required to wind up its business, pay its liabilities, and distribute its assets.[121] The LLC continues in the form of a NJ corporation.[122]
3. Conversion of Foreign Corporation to NJ Entity
a. Conversion of Foreign Corporation to NJ LLC
A foreign corporation may convert to a NJ LLC if:
the foreign corporation’s governing statute authorizes conversion;[123]
the conversion is not prohibited by the law of the foreign corporation[124] and
the foreign corporation complied with its governing statute in effectuating the conversion.[125]
i. Approval of Directors and Shareholders
The directors and shareholders of a foreign corporation would approve the conversion to a NJ LLC in accordance with the statutory law governing the foreign corporation.
ii. Plan of Conversion
The plan of conversion is summarized at Section 1(a)(ii).
iii. Certificate of Conversion
The certificate of conversion and the certificate of formation to be filed with the NJDORES are summarized at Sections 1(a)(iii) and (iv).
iv. Effect of Conversion
The effect of the conversion is summarized at Section 1(d) in the NJ-RULLCA discussion.
b. Conversion of Foreign Corporation to NJ Corporation
A foreign corporation may convert (that is, domesticate) to a NJ corporation.[126]
i. Approval of Directors and Shareholders
The directors and shareholders of a foreign corporation would approve the conversion to a NJ corporation in accordance with the statutory law governing the foreign corporation.
ii. Plan of Conversion
The plan of conversion is summarized at Section 2(a)(ii) above in the NJBCA discussion.
iii. Certificate of Conversion
The certificate of conversion is summarized at Section 2(a)(iii) above in the NJBCA discussion.
iv. Effect of Conversion
The effect of the conversion is summarized at Section 2(d) in the NJBCA discussion.
c. Conversion of Foreign Corporation Authorized to Do Business in NJ to a Foreign LLC Authorized to Do Business in NJ
The scenario of a foreign corporation authorized to do business in New Jersey converting to a foreign LLC is not addressed in the amendments to NJBCA. Nor is it addressed in NJ-RULLCA. Nonetheless, the NJDORES would likely require the new foreign LLC to file a new application for authority to do business in NJ.[127] This would be comparable to a foreign LLC authorized to do business in New Jersey converting to a foreign corporation. If the foreign corporation seeks to continue doing business in New Jersey, the amendments to the NJBCA require it to file a new application to do so.[128]
4. Conversion of Foreign LLC to NJ Entity
a. Domestication of Foreign LLC to NJ LLC
A foreign LLC may become a NJ LLC by domestication[129] if:
the foreign LLC’s governing statute authorizes domestication;[130]
domestication is not prohibited by the laws of the jurisdiction of the foreign LLC;[131] and
the foreign LLC complied with its governing statute in effecting the domestication.[132]
i. Approval of Members
The members of a foreign LLC would approve domestication to a NJ LLC in accordance with the statutory law governing the foreign LLC.
ii. Plan of Domestication
The plan of domestication is summarized at Section 2(c)(ii).
iii. Articles of Domestication
The articles of domestication to be filed with the NJDORES are summarized at Section 2(c)(iii). The articles must also include a statement that the domestication was approved as required by the statute governing the foreign LLC.[133]
iv. Effect of Domestication
The effect of a foreign LLC domesticating to a NJ LLC is the same as a foreign corporation converting to a NJ LLC, which is summarized at Section 1(d) in the NJ-RULLCA discussion.[134]
b. Conversion of Foreign LLC into NJ Corporation
A foreign LLC may convert to a NJ corporation.[135]
i. Approval by Members
To convert, the foreign LLC must approve a plan of conversion and a certificate of incorporation, which must be approved in accordance with the foreign LLC’s operating agreement and applicable law, as appropriate.[136]
ii. Plan of Conversion
The plan of conversion should address the terms and conditions of the conversion, including the manner and basis for converting the membership interests of the foreign LLC into cash, property, shares of stock, or other rights or securities of the NJ corporation (or of another NJ entity), or whether they will be cancelled.[137] As noted, in addition to the certificate of incorporation, the plan of conversion should include the proposed bylaws of the NJ corporation and proposed organizational resolutions appointing directors and officers, and, if applicable, the proposed shareholders agreement.
iii. Certificate of Conversion
Once the members of the foreign LLC approve the plan of conversion, it would file a certificate of conversion and a certificate of incorporation with the NJDORES.[138] The certificate of conversion must be signed by an authorized person.[139]
The certificate of conversion must include the following information:
the jurisdiction where the LLC was formed, and, if it has changed, the jurisdiction immediately prior to the conversion to a NJ corporation;[141]
the name of the LLC prior to filing the certificate of conversion;[142]
the name of the NJ corporation as set forth in the certificate of incorporation to be filed with the certificate of conversion;[143]
the future date or time when the conversion will be effective, if not effective upon filing, which future date cannot be more than ninety days after filing;[144]
a statement that the plan of conversion was approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.[145] (Although the entire statement would be included in the certificate, if there is no operating agreement, then for a NJ LLC the plan of conversion would be in accordance with NJ-RULLCA, which serves as the LLC’s default operating agreement).
c. Conversion of Foreign LLC Authorized to Do Business in NJ to a Foreign Corporation Authorized to Do Business in NJ
If a foreign LLC is authorized to do business in New Jersey and converts to a foreign corporation, the foreign corporation must file with NJDORES a new application for authority to do business in New Jersey.[146] The application must include:
the name of the foreign LLC that was authorized to do business in New Jersey;[149]
the ten-digit business identification number of such foreign LLC;[150]
the date of conversion of the foreign LLC to a foreign corporation;[151]
the date the foreign LLC was authorized to do business in New Jersey;[152]
the address of the principal place of business of the foreign corporation (which the law describes as the main office or headquarters office);[153]
the foreign corporation’s registered agent and registered office in New Jersey, and that the registered agent may be served with process against the corporation;[154]
the character of the business to be conducted in New Jersey;[155] and
a statement that the foreign corporation is authorized to conduct business in its state of incorporation.[156]
The application must be accompanied by a certificate of good standing (or comparable equivalent) from the jurisdiction of the foreign corporation, which certificate must be issued after the date of conversion and within thirty days of the filing of the application.[157] Upon filing the application, the NJDORES will issue a new certificate of authority to the new foreign corporation.[158]
5. Tax Considerations
There are several tax considerations when converting a corporation to an LLC, and vice versa. The following discussion is a mere general summary, and any conversion should be done in consultation with a knowledgeable tax accountant or tax attorney because the tax laws are complex and contain many nuances.
An LLC taxed as a partnership (i.e., an LLC with two or more members) or as a disregarded entity (i.e., an LLC with one member) may usually convert to a C corporation on a tax-free basis, assuming compliance with certain requirements in the U.S. Tax Code.[160]
ii. Conversion of Corporation to LLC
Generally, a corporation converting to an LLC taxed as a partnership (i.e., an LLC with two or more members) or to a disregarded entity (i.e., an LLC with one member) is treated as a taxable liquidation of the corporation. This means that the corporation is treated as having sold its assets to its shareholders for fair market value (“FMV”), followed by the shareholders’ contribution of the assets to the LLC.
1. C Corporations
The liquidation of a C corporation can result in double taxation—a tax paid by the C corporation and a tax paid by its shareholders.
A C corporation must recognize gain on the liquidating distribution of assets to its shareholders, which is the difference between the FMV of the assets and their adjusted tax basis.[161]
Each shareholder recognizes gain equal to the difference between the FMV of the assets deemed to have been received by the shareholder on liquidation on a pro rata basis with the other shareholders and the adjusted tax basis of the shareholder’s shares of stock surrendered to the corporation in exchange for the assets. If the shares of stock have been held for more than one year, the shareholder would recognize a long-term capital gain. If not, the shareholder would have a short-term capital gain (which would effectively be treated as ordinary income).
2. S Corporations
The liquidation of an S corporation does not result in double taxation; instead, the S corporation’s gain passes through to the shareholders.
An S corporation must recognize gain on the liquidating distribution of assets to its shareholders, which is the difference between the FMV of the assets and their adjusted tax basis.
However, the S corporation’s gain passes through to the corporation’s shareholders on a pro rata basis and is included on their personal income tax returns. If the assets have been held for more than one year, they would generally recognize a long-term capital gain. If not, they would have a short-term capital gain (which would effectively be treated as ordinary income). However, the gain on certain assets, such as accounts receivable and inventory (as well as depreciation recapture), would be ordinary income regardless of how long they have been held.
Each shareholder would also recognize gain equal to the difference between the FMV of the assets deemed to have been received on liquidation and the adjusted tax basis of their shares of stock surrendered to the corporation in exchange for the assets, with the shareholder’s tax basis adjusted to reflect the gain between the FMV of the assets and their adjusted tax basis. If the shares of stock have been held for more than one year, the shareholder would recognize a long-term capital gain. If not, the shareholder would have a short-term capital gain (which would effectively be treated as ordinary income).
Further, an S corporation may be required to pay corporate income taxes if it has built-in gains (“BIG”) in its assets. The BIG tax applies to a C corporation that made an S corporation election and liquidates within five years of the election. The rule is intended to discourage a C corporation from electing to be taxed as an S corporation immediately prior to a liquidation to avoid double taxation. The BIG tax is imposed at the highest corporate tax rate (currently a federal tax rate of 21 percent, plus any applicable state and local income taxes) and is triggered by the disposition of any asset the C corporation held at the time it elected to be taxed as an S corporation. Therefore, it does not apply to any assets acquired after the S corporation election.
b. Tax Clearance Certificates
If a NJ corporation merges into a foreign corporation or LLC, which foreign entity will be the surviving entity, the NJ corporation is required to obtain a tax clearance certificate to complete the merger (that is, in order for the NJDORES to file the certificate of merger), unless the foreign entity is authorized to transact business in New Jersey (or will become authorized to transact business by simultaneously filing an application to transact business in New Jersey).[162]
There is no legal authority on the issue at this time, but it would be logical that a tax clearance certificate would be required when a NJ corporation is converting to a foreign corporation or LLC when the foreign entity will be the surviving entity. In other words, the NJ corporation would need to obtain a tax clearance certificate to complete the conversion (that is, in order for the NJDORES to file the certificate of conversion), unless the foreign entity is authorized to transact business in New Jersey (or will become authorized to transact business by simultaneously filing an application to transact business in New Jersey).[163]
For many entities, the entity’s retaining its employer identification number (“EIN”) is critical to the continued success of its business because of the historical data associated with the EIN—for example, an entity’s credit history with customers or vendors. If an entity is required to obtain a new EIN upon conversion, it could lose all of its credit history and goodwill with a customer or vendor and would need to start from scratch.
Therefore, an important issue when considering conversion is determining whether a corporation converting to an LLC, or vice versa, can retain its EIN or if it is required to obtain a new EIN. The starting point for this analysis is IRS Publication 1635 (Rev. 2-2014).[165] It states that a new EIN is needed if:
a sole proprietor incorporates, which would be an LLC taxed as a disregarded entity converting to a corporation;
a partnership incorporates, which would be an LLC taxed as a partnership converting to a corporation; or
a corporation becomes a partnership or a sole proprietorship, which would be a corporation converting to an LLC taxed as a partnership or an LLC taxed as a disregarded entity. However, a corporation is not required to obtain a new EIN in connection with a corporate reorganization involving only a change of identity, form, or place of organization.[166]
However, the Treasury regulations have exceptions to these general rules, which can be found in the “check-the-box” regulations. Specifically, Treasury Regulation §301.6109-1(h)(1) provides that any entity that has an EIN will retain that EIN if its federal tax classification changes under Treas. Reg. §301.7701-3.
Another source of authority to support an entity retaining its EIN after a conversion or domestication is the Internal Revenue Manual dated April 14, 2022 (“IRM”). Although it is not legally binding on the IRS, its staff relies on the IRM in handling many procedural issues, including an entity’s retention of its EIN.
As noted, IRS guidance (i.e., Publication 1635) states that a new EIN is required upon conversion, but the IRM provides otherwise. The IRM is not binding on the IRS, so there is some risk in relying on it, but it should be viewed as a calculated risk. The balance of this article’s discussion of the EIN issue should be considered proposed best practices to retain an EIN upon conversion.
i. Corporation Conversion to LLC
If a C corporation converts to an LLC through a state’s conversion statute, the new LLC should be able to retain the corporation’s EIN regardless of whether the LLC will be taxed as a partnership, a C corporation, an S corporation, or a disregarded entity.[167] The new LLC should submit a letter to the IRS requesting to retain the corporation’s EIN and provide proof of the conversion (e.g., a copy of the filed certificate or articles of conversion).[168]
When the corporation files its final corporate tax return (Form 1120) and its first partnership tax return (Form 1065), it should attach a copy of the filed certificate or articles of conversion and an explanation that it has converted from a corporation to an LLC and retained the corporation’s EIN.[169]
ii. LLC Conversion to Corporation
If an LLC converts to a corporation through a state’s conversion statute, the new corporation should be able to retain the LLC’s EIN.[170] The new corporation should submit a letter to the IRS requesting to retain the LLC’s EIN and provide proof of the conversion.
When the partnership files its final partnership tax return (Form 1065) and its first corporate tax return (Form 1120), it should attach a copy of the filed certificate or articles of conversion and an explanation that it has converted from an LLC to a corporation and retained the LLC’s EIN.
6. Conclusion
As a result of the amendments to the NJBCA, NJ corporations may now convert to NJ LLCs, foreign LLCs, and foreign corporations, and vice versa. As noted, there are some procedural questions, but they should be answered when the NJDORES disseminates official forms and guidance on conversions and domestications and the New Jersey Division of Taxation provides guidance on the tax clearance issue. In the meantime, New Jersey has finally taken a small step in modernizing its statutes.[171]
NJ-RULLCA uses the term “organization,” but to be consistent with the new amendments to the NJBCA, this article uses the term “entity.” ↑
N.J.S.A. 42:2C-78(a). The exclusion of foreign LLCs is because a change from a NJ LLC to a foreign LLC, and vice versa, is a domestication under N.J.S.A. 42:2C-82, and not a conversion under N.J.S.A. 42:2C-78. ↑
N.J.S.A. 14A:11A-2(2). The new law also allows a NJ corporation to convert to other forms of entity, such as general partnerships and limited partnerships. N.J.S.A. 14A:11A-2(2) & (1) (definition of “other entity”). However, a corporation will not be able to convert to a NJ general partnership or NJ limited partnership until the New Jersey Uniform Partnership Act, N.J.S.A. 42:1A-1, et seq., and the New Jersey Uniform Limited Partnership Law, N.J.S.A. 42:2A-1, et seq., are amended to authorize such conversions. Such legislation has been pending in the New Jersey Legislature for a decade. The current bills, S134 and A3831, have not yet worked their way through the legislative process. ↑
By comparison, a merger of a NJ corporation into an LLC requires only the affirmative approval of a majority of the votes cast by shareholders holding the shares entitled to vote. N.J.S.A. 14A:10-3(1)(b)(2). For NJ corporations organized prior to January 1, 1969, two-thirds approval is required. Id. Therefore, there may be situations where it will be easier to merge a NJ corporation into an LLC than to convert it to an LLC. Where unanimous approval of all voting and non-voting shareholders is questionable, practitioners may continue to use the alternative of merging a NJ corporation into an LLC. ↑
N.J.S.A. 42:2C-78(b)(3). See also N.J.S.A. 14A:11A-2(9). ↑
N.J.S.A. 42:2C-78(b)(4). A NJ corporation converting to a NJ LLC may decide not to have a written operating agreement and instead rely on the default provisions in NJ-RULLCA. See N.J.S.A. 42:2C-11(2). This would be a poor decision, especially for a NJ LLC that will have two or more members, because the default provisions include surprises for the unwary (e.g., members having equal distribution and voting rights regardless of their capital contributions and ownership percentages). See N.J.S.A. 42:2C-34(a) & -37(b)(2). See also Gianfranco A. Pietrafesa, “An Operating Agreement is Essential under RULLCA,” 210 N.J.L.J. 664 (November 19, 2012). ↑
A NJ corporation seeking to convert or domesticate to a foreign entity will also need to comply with the specific requirements in the statute governing the foreign entity, which requirements are beyond the scope of this article. ↑
N.J.S.A. 14A:11A-2(5)(f). This statement is fine for a foreign corporation, but how and why would a foreign LLC comply with the NJBCA? The term “applicable law of this State” should have been used instead of “this act.” For foreign LLCs, this applicable law would be NJ-RULLCA, and a foreign LLC that intends to transact business in New Jersey must apply to do business in New Jersey. See N.J.S.A. 42:2C-58 (application of authority to do business in NJ). By analogy, see the discussion in this article at Section 4(c) concerning a foreign LLC (which is authorized to do business in New Jersey) converting to a foreign corporation, which would be required to file a new application for authority to do business in New Jersey. ↑
N.J.S.A. 14A:11A-2(2) & (1) (definition of “other entity” includes foreign corporations). ↑
Apparently, the amendments to the NJBCA are based on Delaware law and, therefore, like Delaware law, do not use the term “domestication.” See note 91, infra, for a discussion of nomenclature. ↑
A secured party should file an amendment to a financing statement to reflect the change of name of the debtor and/or the change of its state of organization after a redomestication to another state. ↑
N.J.S.A. 14A:11A-1(2) & (1) (definition of “other entity” includes a NJ LLC); N.J.S.A. 42:2C-78(a). NJ-RULLCA and the amendments to the NJBCA also allow other entities, such as general partnerships and limited partnerships, to convert to a NJ LLC or a NJ corporation, or vice versa. However, as noted in note 8, supra, a NJ general partnership or a NJ limited partnership will not be able to convert to a NJ LLC or a NJ corporation, or vice versa, until the New Jersey Uniform Partnership Act and the New Jersey Uniform Limited Partnership Law are amended to authorize conversions. ↑
N.J.S.A. 42:2C-78(b)(3). See also N.J.S.A. 14A:11A-1(11). Other than stating that a plan of conversion must be approved by the entity being converted (e.g., the NJ LLC), the amendments to the NJBCA do not specify the contents of the plan. See N.J.S.A. 14A:11A-1. ↑
N.J.S.A. 14A:11A-1(10); N.J.S.A. 42:2C-80(a)(1) & 42:2C-20(a)(1). It is unknown why the committee that reviewed, drafted, and advocated for the adoption of NJ-RULLCA did not change the word “articles” to “certificate” to conform to the nomenclature typically used in New Jersey. ↑
N.J.S.A. 42:2C-82(b)(1). Note that some jurisdictions do not use the term “domestication”; instead, they use the term “conversion.” For example, Delaware allows the conversion of a foreign LLC to a DE LLC, and vice versa. DE Title 6, §18-214(a) & §18-216(a). Likewise, it allows the conversion of a foreign corporation to a DE corporation, and vice versa. DE Title 8, §265(a) & §266(a). Therefore, going from a NJ LLC to a DE LLC, or vice versa, would be a “domestication” in NJ and a “conversion” in DE. Notwithstanding the different nomenclature in the statutes, the legal effect is the same. ↑
As noted, a secured party should file an amendment to a financing statement to reflect the change of name of the debtor and/or the change of its state of organization after a redomestication to another state. ↑
See N.J.S.A. 14A:13.6-1 (discussed at Section 4(c) infra). ↑
As noted, the governing statute of a foreign LLC may use a different nomenclature (e.g., Delaware uses the term “conversion” for domestications), but it still authorizes a change of an LLC from one state to another (e.g., a DE LLC to a NJ LLC, or vice versa). ↑
The author would like to thank Gordon F. Moore, Esq. of Archer & Greiner, P.C. for his comments to this Section 5(a) of the article. Any errors are the author’s sole responsibility. ↑
Such requirements are beyond the scope of this article. ↑
This article ignores the possibility of a loss on a conversion. ↑
The author would like to thank Jason Zoranski, Esq. of Archer & Greiner, P.C. for his research on the EIN issue and his comments to this Section 5(c) of the article. Any errors are the author’s sole responsibility. ↑
A conversion of a corporation to an LLC, which elects to be taxed as a C corporation (i.e., an F Reorganization), or a domestication of a corporation from one state to another, could be a corporate reorganization, but the language is not clear. ↑
If the new LLC wants to make a “check-the-box” election to be taxed as a C corporation instead of being taxed under the default classification (e.g., as a partnership for an LLC with two or more members), then it would file Form 8832 (Entity Classification Election) with proof of the conversion. ↑
The conversion of a corporation to an LLC should qualify as an F reorganization pursuant to Internal Revenue Code Section 368(a)(1)(F). Under this alternative, the LLC would file Form 1120 (U.S. Corporation Income Tax Return) for the year of conversion and attach an F reorganization statement pursuant to Treasury Regulation Section 1.368-3 with the tax return. ↑
The author would like to thank Gordon F. Moore, Esq. and Shamila R. Ahmed, Esq., both of Archer & Greiner, P.C., for their comments to this article. Any errors are the author’s sole responsibility. ↑
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