Today, some legal experts argue it’s time for Big Law to get more personal. Rather than prioritizing long work weeks and high salaries, firms need to focus on efficiently and carefully meeting their clients’ needs.
That’s where boutique law firms come in. These firms, typically consisting of fewer than thirty experienced lawyers, offer tailored services and have shorter, more intentional client lists.
In many ways, boutique law firms are disrupting the legal industry and paving the way for future innovations. Let’s dive deeper into their benefits and impact on the industry.
(1) Personalization
Boutique firms have a narrower focus and take on a smaller number of cases. This can allow them to deeply engage with each client and provide more custom attention to their needs.
According to research from Law Firm Marketing Club, 84% of clients expect same-day responses to queries. Another 65% expect to be able to speak to an attorney themselves, and 60% expect to have online chat options with their firm.
The bottom line: regardless of the legal subject matter, clients want to have a personal relationship with a responsive attorney—and boutique law firms have the opportunity to give that to them in a different way.
Bigger firms tend to have bigger deals, and with those come greater responsibility and more administrative staff. This can be a con in some situations, as mid-level or junior associates may take on more of the workload, resulting in less face-to-face time between clients and partners.
As with any small business, boutique firms have the opportunity to communicate more directly with clients. They are not bogged down by administrative demands of larger firms, which can result in quicker response times and more personal conversations.
(2) Expertise and Agility
Boutique law firms offer more dynamic representation for clients by leveraging knowledge and expertise in a particular area of law. When clients hire a smaller firm, they are usually opting for expertise over strength and size—and that can pay off.
Many attorneys choose to work at a boutique firm rather than a large firm because they’re passionate about a particular practice. A close-knit specialty environment allows lawyers to zero in on what they’re best at (and most interested in), resulting in more targeted services.
Boutique firms also tend to be agile and adaptable when responding to both client requests and industry regulations. Their small teams, coupled with their high degree of specialty and personal client attention, allow them to adjust to relevant legal changes and trends quickly.
(3) Operations
Finally, boutique law firms may offer effective, direct representation through streamlined operations that leave more room for client services.
Considering that most small firms boast a flatter organizational structure, there are fewer layers of management, reducing the risk of bureaucracy. At the same time, they benefit from having enough team members to get tasks done with urgency and precision.
This culture doesn’t just benefit the client – it can also have a significant impact on the attorneys’ work-life balance. These attorneys will likely get more hands-on experience and client-facing time, but they also tend to have more manageable caseloads and fewer 10+ hour work days.
Conclusion
As the world has become increasingly focused on personalization and speed, it’s time for the legal field to catch up. Boutique firms can help push the field in that direction.
Deciding between a boutique firm and a larger firm depends heavily on your preferences and case-specific needs. The bottom line is that you have options, and evaluating them is the first step in selecting the right partner.
The Ukraine conflict is the most recent event in a long history of strife between Russia and Ukraine that predates the current invasion by 250 years.[2] In relevant recent events, the Maidan Revolution in November 2013 was marked by mass protest against the Ukrainian government’s decision to cease negotiations with the European Union (E.U.) to enter into an association agreement, which was blamed on Russian influence.[3] After 77 protestors were killed in Kyiv, then-President Viktor Yanukovych was exiled to Russia while the Ukrainian opposition party took control of the government.[4] In March 2014, Russia annexed the Crimea, and in May 2014 pro-Western politician Petro Poroshenko won the Ukrainian presidential election.[5] In April 2019, Volodymyr Zelensky became president, unseating incumbent Poroshenko.[6] On February 21, 2022, Russia recognized two breakaway Ukrainian territories, Donetsk and Luhansk, which Russia had been supporting as independent states, and sent significantly more military support into the territories.[7] On February 24, 2022, Russia invaded Ukraine.[8]
The United States has had economic sanctions in place against Russia since 2014, when it invaded Crimea. However, the reaction to Russia’s wholesale military incursion in 2022 has taken the extent and degree of sanctions to a far higher level, creating the need for U.S. companies to establish much stronger diligence programs and in some cases deal with complex compliance issues.[9] The adoption of varying sanctions by numerous other countries and Russia’s recent moves to impose countersanctions and take steps against companies complying with international sanctions have made operating in the global marketplace a complicated and high-risk proposition.[10] Russian countersanctions have focused on indirect expropriation as leverage to punish or control foreign investment in its borders, using the countersanctions framework to extract assets and value from foreign investors. The current countersanctions regime is being implemented in a manner reminiscent of the Russian government’s long-standing use of bankruptcy and taxation law to punish corporations that fell out of favor or ran into conflict with the government.
Russian Bankruptcy Laws
Russian insolvency matters are governed by Federal Law No. 127-FZ On Insolvency (Bankruptcy) (the “Russian Bankruptcy Law”), which has been amended repeatedly since its introduction on October 26, 2002.[11] In late December 2008, further reforms were enacted, including provisions on bankruptcy administrators, payment priorities, secured creditors’ rights, foreclosure on security during bankruptcies, and settlement of taxes.[12] The impact of the Russian Bankruptcy Law and its subsequent amendments has evolved over time; after a few years, it created concern among businesses operating in Russia that the laws would be politically misused because politicians had too much of a role in the process.[13] The implementation and execution of the Russian Bankruptcy Law by the Russian government has drawn criticism; such criticism and concern has become acute and renewed in light of the Ukraine conflict.
Perhaps the most significant development in Russian insolvency law prior to the enactment in 2002 of the Russian Bankruptcy Law occurred with the 1998 legislation, which replaced the 1992 bankruptcy law. The 1992 law was itself a new legal regime instituted in the wake of the fall of the former Soviet Union.[14]
The 1998 amendments were a keen source of interest for both the media and legal scholars because they were heralded as a fundamental reform of bankruptcy laws that had allowed debtors, prior to the amendments, to run up insurmountable debt, which left very little to distribute to creditors or important constituencies like the Russian government and workers.[15] The prior laws were criticized as being too debtor friendly, allowing weaker companies to continue to finance their struggling operations by not paying creditors.[16] Many Russian economic and insolvency experts argued that the bankruptcy laws facilitated heavy payment defaults that Russian debtors were being allowed to accumulate before they were declared bankrupt.[17] The 1998 amendments’ hallmark, and the topic of much of the discussion, was one of hope for a new economic pragmatism towards bankruptcy law that would help modernize the Russian economy.[18] At the time, a payment default rate in Russia existed that threatened the viability of the economy, and those in support of the reforms felt that the bankruptcy laws were too lenient on defaulting debtors.[19]
In April 2009, further amendments were made that included provisions on vicarious, third-party liability in a bankruptcy; lower voluntary bankruptcy filing thresholds; rules regarding conflicts by business entities; and provisions regarding bankruptcy litigation tools such as avoidance actions used to bring assets back into a bankruptcy estate (preference actions or fraudulent conveyances, for example).[20] On July 30, 2017, significant changes were made to the Russian Bankruptcy Law regarding vicarious liability of controlling persons.[21] These and other successive amendments to the Russian Bankruptcy Law were designed to perfect practical application of its provisions and to prevent perceived abuse by shareholders.[22] Because of the prevalence of personal guarantees in Russia, it is also important to note that in 2015, the Russian insolvency laws introduced a personal bankruptcy act.[23]
Russian “Rule of Law”
Though structural improvements have been progressively better through each amendment of the Russian Bankruptcy Law, there are strong opinions over whether or not the laws matter if such laws are not “honestly enforced.”[24]
Legal scholars, journalists, and courts outside of Russia have been consistent in expressing doubts over the legitimacy of the actions of Russian bankruptcy trustees, also known as bankruptcy administrators. For example, the 1998 bankruptcy law amendments were supposed to create a way for creditors to enforce claims, but they have been criticized as instead being used as a new mechanism for insiders to siphon off funds from minority shareholders and creditors; there have been allegations that the fiscal malfeasance has been facilitated by bribes to judges and bankruptcy trustees.[25]
President Boris Yeltsin’s announcement in late 1999 that he would step down as president at the end of 1999 and designate Vladimir Putin as his successor was a surprise to many.[26] President Yeltsin’s regime was tied closely to the rise of oligarchs who had profited from the large-scale privatization of Soviet Union’s economy.[27] Some hoped that this surprise successor would bring a new direction for economic policy focused on further modernization.[28]
The Demise of Yukos
The fate of the Yukos corporation is cited as the definitive indication of how the Putin regime would handle the economy and was lamented as a failure to address the cronyism of the Yeltsin regime.[29] The chairman/CEO of Yukos at the time, Mikhail Khodorkovsky, was a Russian oligarch who attempted to enter into a merger with a Western oil company. The prospective merger was favorably received by the markets with a $43 billion valuation, though the good news came shortly before Khodorkovsky was arrested by the Russian authorities.[30]
The Russian government did not formally privatize Yukos; instead it used the tax laws to orchestrate a takeover that not only jailed Russian nationals, but also rendered foreign and domestic investment worthless through enforcement of the Russian tax code. In April 2001, the Russian government imposed a total assessment of $3.4 billion in taxes owed and sought court enforcement against Yukos, which resulted in an order freezing company assets and forbidding the company from alienating or encumbering its property.[31] The government then engaged in a series of actions that crippled both the company’s finances and its ability to pay any outstanding taxes.[32] A judge who ruled against the government and tried to lift the freeze order was removed from the case and then fired, while a judge who ruled for the government was promoted.[33] The courts also allowed procedural deadlines to be instituted that did not allow for time or access to review documents or evidence.[34] Yukos’s legal department, in turmoil due to the arrests of Yukos personnel, was given exceptionally short deadlines to respond to the government’s case and no effective opportunity to review the government’s evidence.[35] The government also argued that due to the asset freeze, Yukos could not liquidate any assets to pay the fine.[36]
It soon became evident that the true objective of the government was to render the company insolvent and begin taking its assets; this was not done directly, but instead by proxies. In July 2004 the government announced the sale of a Yukos affiliate, YNG, which owned the majority of the Yukos production operations, by selling off the YNG stock owned by Yukos.[37] The government increased the tax liabilities up to $24 billion, and then the sale only yielded $9.35 billion, despite YNG’s stock being valued at between $15 and $20 billion. A state-owned oil company, Rosneft Oil Company, purchased YNG.[38] Yukos filed for bankruptcy protection in 2006; the courts, Rosneft, and the tax authority rejected its restructuring plan, and it liquidated in 2007, with Rosneft taking most of the assets.[39] Promnefstroy, a former Rosneft subsidiary, was given the rights to Yukos’s Dutch subsidiary Yukos Finance B.V.[40]
In March 2022, Russia’s ruling party, United Russia, announced a draft law that provides for the involuntary bankruptcy sale of assets left behind by departing companies from “unfriendly countries.”[41] The proposed law would have placed entities that were 25% or more owned by foreigners from “unfriendly states” into bankruptcy unless they divested their holdings to a Russian entity.[42] While the Russian government placed this draft legislation and similar, more direct, measures aside at that time, a new “Yukos” strategy has emerged out of the battling sanctions and countersanctions that have been implemented because of the Ukraine conflict, and recent countersanctions have involved seizures of foreign companies, which have been justified by the Kremlin as retaliation for seizure of Russian funds.
Russian Countersanctions, Indirect Expropriation
The Russian government has imposed significant “countersanctions” against “unfriendly countries” and controversial third-party sanctions against companies complying with the Western sanctions regimes against Russia and Belarus. This product of the Ukraine conflict was an anticipated, but no less disruptive, byproduct of the U.S., U.K., and E.U. sanctions regimes. The Russian countersanctions have complicated and stymied global efforts by corporations to comply with all applicable laws in the markets in which they operate and has exacerbated the exodus of companies from Russia. The hallmark of these government efforts by the Kremlin and the Russian legislature is a revitalization of the tactic of expropriation—especially indirect expropriation—which harkens back to familiar tactics utilized by the Soviet Union, but adapted to modern global economic and political norms.
Expropriation
Expropriation, the seizure of property of another country’s nationals by a sovereign, is a recognized right of sovereign states (“States”) under certain conditions. For expropriation to be lawful (i.e., where the State does not incur international liability), the taking must be for a State obligation, cannot discriminate against foreigners, must respect due process, and must entail prompt and adequate compensation.[43] If expropriation is legal, compensation may limited “to the value of the company at the time of dispossession, plus interest to the date of payment.”[44] Unlawful expropriation can allow for further damages, including lost profits.[45]
Direct expropriation is a legal transfer of title or the physical seizure of property that benefits the State—or a State-selected third party—accomplished through formal law, decree, or physical act.[46] Large-scale nationalizations are direct expropriation and are rare.[47] Indirect expropriation is the complete or partial deprivation of a property right without a formal transfer of title or seizure.[48] There are many terms for the variants of indirect expropriation, including de facto, creeping, constructive, disguised, consequential, regulatory, or virtual expropriation.[49] Creeping expropriation is worth further examination. Creeping expropriation “encapsulates the situation whereby a series of acts attributable to the State over a period of time culminate in the expropriatory taking of such property.”[50] The State can utilize regulatory, legislative, and judicial processes to interfere with property rights over time to dilute foreign nationals’ rights without transferring title or taking control of the asset.[51]
Modern expropriations typically result from legislative, executive, and administrative acts, which include new legislation; resolutions; decrees; and revocation, cancellation, or denial of government concessions, permits, licenses, or authorizations that are necessary for the operation of a business.[52] Judicial intervention is more rare.[53] Investors have challenged confiscatory tax policy; the prohibition of distribution of dividends; labor regulations or other interference in staffing and operations; judicial decisions; financial regulations; and licensing regimes as expropriation.[54]
Russian Response to Ukraine Conflict
The Russian commission on legislative activities has drafted proposed legislation nationalizing property of foreign organizations leaving the Russian market. It was first announced that the issue would be reviewed by a government commission in March 2022, but the law has not yet been passed.[55] The proposed law on external administration for the management of a company would apply to companies with (1) over 25% shareholding (directly or indirectly) “connected” to “unfriendly” States (including place of registration and place of primary economic activity); and (2) a book value of over one billion rubles (around USD 12 million as of early April 2022) and/or over 100 employees. If passed, this law could have retroactive effect from February 24, 2022.[56]
The proposed legislation would be direct expropriation that would arguably require compensation under international law. Since the Yukos takeover was so successful and was accomplished without payment from the Russian treasury, legislation has typically been geared towards indirect expropriation, which is harder to prove than a direct expropriation and easier to defend against in later lawsuits over compensation.
In May 2021, Russian Prime Minister Mikhail Mishustin signed a decree accompanied by a list of “unfriendly states” that “have carried out unfriendly actions” against Russia, Russian nationals, or Russian entities, primarily by restricting diplomatic relations with Russia.[57] The original designation only included the U.S. and the Czech Republic and was made in response to separate denunciations by the U.S. and the Czech Republic for interference by Russia within the borders of each respective country.[58] The list has been expanded multiple times, and its original purpose has been expanded by the Russian government as a response to sanctions imposed against Russia for its invasion of Ukraine.[59]
On March 5, 2022, the Russian government approved the most recent list of “unfriendly countries,” which included Albania, Andorra, Australia, Canada, members of the European Union, Iceland, Japan, Liechtenstein, Micronesia, Monaco, Montenegro, New Zealand, North Macedonia, Norway, Singapore, San Marino, South Korea, Switzerland, Taiwan (the Republic of China), Ukraine, the United Kingdom (including Jersey, Anguilla, British Virgin Islands, and Gibraltar), and the United States.[60]
Russia also instituted countersanctions by presidential decree on March 3, 2022, including a ban on trade, financial transactions, and the honoring of any contract with any party that is a foreign national of an “unfriendly country,” which is the legal designation for any country that has joined in the sanctions against Russia.[61] The Russian government also passed a resolution that all transactions and operations between Russian companies and nationals from “unfriendly countries” must be approved by the Government Commission on Monitoring Foreign Investment.[62]
Currency Restrictions
The Russian government has also imposed currency restrictions on Russian banks so that their clients cannot withdraw more than the equivalent of $10,000 in U.S. dollars.[63] Otherwise, currency can only be withdrawn in rubles at a rate set by the central bank.[64] Any money deposited since March 9, 2022 cannot be withdrawn. The Russian central bank originally stated these restrictions would remain in place until at least March 9, 2023.[65] The restrictions were recently extended to September 30, 2023.[66]
Patent Licensing
Foreign nationals from “unfriendly countries” are subject to a compulsory license of their patents for a 0% royalty.[67] Owners of Russian patents will receive no compensation for infringement in Russia for as long as the countries remain on the “unfriendly country” list, which is populated with countries that have imposed sanctions on Russia and Russian nationals for Russia’s invasion of Ukraine, as described above.[68] The same type of legislation was extended to trademark and copyright infringement.[69] Hasbro Inc. subsidiary Entertainment One UK, which owns the animated children’s television character “Peppa Pig,” brought a trademark and copyright infringement claim against a Russian citizen in the Russian Arbitration Court for the Kirov Region in 2021.[70] On March 3, 2022 (after sanctions were imposed), the court overturned an award it had given to Entertainment One UK and held that the Russian citizen could continue to use the trademarks without payment or permission.[71] The court ruled that a plaintiff domiciled in an “unfriendly country” cannot claim IP infringement against Russian defendants.[72]
Energy Sector
The most serious restrictions have been in the energy sector, where the government measures have been directly tied to the status of the foreign national’s country on the “unfriendly country” list. For example, there was a ban in 2022 on foreign investment in the energy sector. The law banned foreign investors from unfriendly territories and states from restructuring or selling their interests in Russian strategic enterprises, banks, energy companies, and mining companies until December 31, 2022.[73] In practice this means the government can control the terms under which an investor can restructure/sell its assets and effectively can appropriate the assets indirectly. This law has been applied several times, where foreign businesses were essentially forced to sell or lose their businesses in Russia. The government is able to set the rates centrally under this decree.[74]
In March 2023, Russian countersanctions were expanded.[75] Businesses from “unfriendly countries” are now required to make a voluntary contribution to the Russian state budget, and failure to pay will subject the business to a government-appointed receiver.[76] Shortly after, in April 2023, President Putin authorized expropriation of foreign-owned assets in response to the seizure of Russian assets.[77] The first victims of these policies were, not surprisingly, in the very lucrative energy sector.
In late April, the Kremlin seized the shares of Finland’s Fortum (FORTUM.HE) and Germany’s Uniper (UN01.DE), which operate energy plants in Russia, and placed the shares in the custody of temporary control of Rosimushchestvo, the federal government property agency.[78] Rosneft seized operations and remains in control of the facilities.[79] The Russian government justified the seizures as direct retaliation for seizures of its assets by unfriendly countries.[80]
Consequences for “Unfriendly Countries”
On October 7, 2022, the Russian government moved forward through presidential decree to disenfranchise the owners of the Sakhalin-1 energy project, including the foreign nationals of several countries that the Russian government has designated as “unfriendly countries.” ExxonMobil, a significant owner, operator, and partner in the project, had had difficulty with the Russian authorities since late summer 2022 and initiated a prerequisite to arbitration by sending a “note of difference” to the Russian government after President Putin issued a decree in August 2022 that blocked a sale of its 30% stake in the Sakhalin-1 project.[81] The sale would have effectuated the exit ExxonMobil announced in February 2022 after the invasion of the Ukraine.[82] While not naming a buyer in its SEC quarterly filing, it was reported that Exxon would be selling its stake to existing partner ONGC Videsh of India, which wanted to increase its existing 20% stake.[83] Significantly, India has not joined in Russian sanctions and increased its purchases of Russian oil by 33 times since the invasion of the Ukraine.[84] In April 2022, ExxonMobil disclosed a $3.4 billion write-down on the Russia exit and signaled a third-quarter $600 million impairment charge for unidentified assets.[85] ExxonMobil had valued its Russia holdings at more than $4 billion.
ExxonMobil has denounced the decrees as an expropriation, stating: “With two decrees, the Russian government has unilaterally terminated our interests in Sakhalin-1, and the project has been transferred to a Russian operator.”[86]
Through the October decree, President Putin seized ExxonMobil shares in the oil production joint venture and transferred them to a government-controlled company it established, managed by Rosneft subsidiary Sakhalinmorneftegaz-shelf. Foreign partners will have one month after the new company is created to ask the Russian government for shares in the new entity pursuant to the decree. In addition to ExxonMobil and ONGC Videsh, a foreign-owned entity affiliated with Japan’s SODECO also holds a stake in the project.[87] The decree gives the Russian government authority to decide whether these foreign owners can retain stakes in the project.[88]
President Putin used a similar strategy in a July 2022 decree to seize full control of Sakhalin-2, another gas and oil project in the Russian Far East, with Shell and Japanese companies Mitsui & Co and Mitsubishi as partners.[89] On July 1, 2022, it was reported that Shell had lost its 27.5% stake in the Sakhalin-2 project after the Russian government transferred the project to a new holding company.[90] Japan’s Mitsui & Co and Mitsubishi agreed to take shares in the new holding company, retaining their minority stakes in Sakhalin-2.[91]
Remedies
Multinational corporations have largely been driven out of Russia and suffered a similar fate as Russian citizens who were targeted by the Russian government in the recent past. The Russian government has used regulatory and tax regimes to soften companies, even jail the management, and then seize the assets through the bankruptcy system. The Ukraine conflict has created a sanctions war between the West and Russia where both sanctions regimes have placed corporations in the precarious position of having to navigate between them and risk penalties from lack of compliance within the borders of each regime by compliance in the other.
Another unwelcome product of the conflict and related sanctions regimes is the adaptation of these same takeover techniques to accelerate the exit of foreign companies from Russia and disguise expropriation by using regulatory and legal justifications to seize foreign company assets within Russia. So what recourse is there for foreign companies who have lost millions in their investment and assets in Russia during the Ukraine conflict?
Lessons from the Yukos Bankruptcy
The litigation that followed the dissolution of Yukos provides a useful history regarding the legal issues, opportunities for recovery, and potential liability for those seeking to exercise their creditor’s rights against the Russian government. The Russian government did not stop with the dissolution of Yukos; it pursued employees and management of Yukos who left for fear of criminal prosecution. Extradition requests and subpoenas for records of third-party corporations were denied because the applicable domestic courts outside of Russia had serious reservations about the Russian judicial process, including the criminal and tax proceedings in Russia.[92] The Russian bankruptcy administrator sold Yukos Finance B.V. in the Netherlands and Yukos CIS in Armenia to Rosneft and Promneftstroy, a former Rosneft subsidiary.[93] In assigning the Dutch assets to a locally controlled Dutch trust, the Dutch court held that it was primarily motivated to put the assets in trust by the lack of integrity in the Russian proceedings, which failed almost every possible standard for a proper adjudication of the issues.[94]
U.S. Courts
Bankruptcy courts in the United States are likely to have limited success in untangling insolvency matters in Russia, especially those that are a result of countersanctions. Chapter 15 was added to the U.S. Bankruptcy Code to facilitate cross-border cooperation between U.S. and foreign courts where assets in multijurisdictional disputes are a common challenge.[95] Typical of many treaties, there is a public policy exception in chapter 15, which allows a U.S. bankruptcy court to refuse to cooperate in a cross-border dispute, if cooperation is “manifestly contrary to the public policy of the United States.”[96] The entirety of the current U.S. sanctions regime is based upon the isolation of Russia from the global financial system, and no U.S. bankruptcy court would likely facilitate any payment that would proceed through Russian financial institutions. Section 1503 also prohibits any action that conflicts with a treaty or “other agreement” with other countries.[97] The U.S. currently is acting in cooperation with its allies and partners to impose both export controls and a wide range of sanctions.[98]
Prior to the 2022 invasion of Ukraine, and outside of the current U.S. and E.U. sanctions, a U.S. bankruptcy court granted recognition of a Russian insolvency proceeding as a foreign main proceeding in the In re Vneshprombank case.[99] The U.S. Bankruptcy Court of the Southern District of New York allowed a Russian trustee to take discovery in order to trace and recover a failed Russian bank’s allegedly stolen funds, which were taken by two New York LLCs and deposited within the U.S.[100] Two prior Chapter 15 cases were less successful: one where the Russian foreign representative dropped the matter,[101] and another where provisional relief was granted but the case was dismissed before recognition.[102]
In 2004, embattled Yukos tried to file a U.S. bankruptcy to stop Russian tax authorities from auctioning off its Siberian oil-pumping subsidiary Yuganskneftegaz to collect on the $27.5 billion back tax bill that had been assessed by the Russian government.[103] The U.S. Bankruptcy Court for the Southern District of Texas initially granted a temporary restraining order and preliminary injunction to stop the sale, holding that the evidence presented “support[ed] a finding that it is substantially likely that the assessments and manner of enforcement regarding Plaintiff’s taxes were not conducted in accordance with Russian law.”[104]
The court later granted a motion to dismiss the case brought by Deutsche Bank AG, rejecting arguments made regarding lack of jurisdiction, forum non conveniens, comity, and the act of state doctrine.[105] The court instead dismissed the case based upon a review of 11 U.S.C § 1112(b), holding that a variety of factors warranted dismissal. It held that it was impractical to expect that the Russian government would cooperate with the case (and the court deemed such cooperation essential to the bankruptcy), that funds that were transferred to the U.S. were done so immediately before filing and to create jurisdiction in the U.S., and there were multiple other forums in which Yukos had filed seeking relief which the court felt were as capable as, if not more capable than, the U.S. Bankruptcy Court in determining matters under foreign law.[106]
Multilateral and Bilateral Forums
The U.S. suspended bilateral engagement with the Russian government on most economic issues in response to Russia’s ongoing violations of Ukraine’s sovereignty and territorial integrity.[107] Russia is a party to 60 bilateral investment treaties,[108] including many with countries that are now listed as “unfriendly” under Russian sanctions law.[109] There have been several arbitral awards against Russia related to the annexation of Crimea in 2014 that have had to be enforced against Russian assets outside of Russia.[110] The various measures taken by the Russian government against “unfriendly countries” are in violation of these bilateral investment treaties (and many multilateral treaties).[111] Investment treaties incorporate the basic principles of legal expropriation, which require the taking to have a public purpose, be nondiscriminatory towards foreign nationals, and be subject to due process. Investment treaties also regularly prohibit restrictions on transfers of funds.[112]
Under the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (“New York Convention”), an award against Russia, which is a party to the treaty, can be enforced in the 169 jurisdictions that are also parties to the treaty.[113] There are over 300 billion USD of Russian assets from Russia’s central bank that have been frozen by the U.S. and its allies,[114] though it will take further authority from Congress to attach the assets that have been seized or frozen.[115]
Russia is also a party to the World Trade Organization (WTO), and its measures against the intellectual property of nationals of “unfriendly countries” also could violate the extensive multilateral protections for intellectual property under that umbrella. However, Article XXI of the General Agreement on Tariffs and Trade (GATT) is a “national security exception,” which allows WTO members to breach their WTO obligations for purposes of national security.[116] Article XXI of the GATT was invoked by Russia in a WTO panel dispute between itself and Ukraine over trade restrictive measures taken by Russia, and the Article XXI claim was upheld by a WTO panel on April 5, 2019.[117]
Domestic courts have been largely unsuccessful in suits against the Russian government for lack of jurisdiction.[118] International tribunals also have limited jurisdictional reach. Although Russia was not a party to or had not ratified certain signed treaties, claims have been brought under European Convention of Human Rights in the Strasbourg, though that court has limited remedies available to it.[119]
Between the bilateral tribunals and the Strasbourg Court, litigants against Russia in the Yukos matter fared better under arbitrators.[120] The Russian Chamber of Commerce’s International Commercial Court awarded $425 million to the Dutch trust pursuant to an arbitration provision in the loan documents based on a loan default to which Roseneft became a successor when it took over Yukos assets.[121]
A Spanish arbitrator, pursuant to a bilateral investment treaty, found that unlike the Strasbourg Court, it did not have to analyze whether or not Russia violated its own laws or international norms; instead it had to determine whether nor not Russia engaged in expropriation and acted inconsistently within the expected and normal exercise of regulatory powers to enforce a tax regime.[122] The arbitrator was particularly critical of both the Russian government and the Strasbourg decision under an expropriation analysis.[123] The panel found that Russia had engaged in expropriation, which required compensation.[124]
Conclusion
The accumulating volume and complexity of U.S. sanctions create serious risks for U.S. businesses with respect to both their own vulnerability to sanctions violations and concerns over retaliation from governments involved in the conflict. Proper redress at a later stage for losses incurred due to direct or indirect expropriation will depend on preservation of evidence and strategic planning in anticipation of which forums will be used to recover value from the consequences of the Ukraine conflict.
The pattern that has emerged from Russian countersanctions of using indirect expropriation though taxation, bankruptcy, intellectual property, currency restrictions, and investment controls should be carefully monitored and examined in formulating a strategic approach to the pursuit of recoveries. Equally important is whether assets seized as part of the Western sanctions regime will actually be available to satisfy the losses of these companies once they have found an appropriate forum willing to take jurisdiction over a commercial dispute stemming from a sanctions-induced loss.
The Russian approach to the Western sanctions regime is a direct extension of its recent history of using taxation and regulatory powers to attack real and perceived enemies within its borders, weakening them and then using the bankruptcy laws to take their assets. The countersanction regime justifies the adaptation of this use of government power against foreign companies, who have invested time, technology, and funds in Russia, by conveniently equating them and aligning them with their home countries, and then completely divesting their assets in the process under the color of law. This tactic, disguised as a legitimate exercise of government power, particularly within its borders, was questioned by some, and was criticized early on. The most recent manifestation of this policy, it appears, has no one fooled.
Rafael X. Zahralddin-Aravena, Partner, Lewis Brisbois Bisgaard & Smith LLP, (“LBBS”), Wilmington, Delaware. Opinions, if any, expressed in this article are his and not the opinion of LBBS. ↑
The most recent amendments instituted a ban against filing bankruptcy against certain classes of debtors to act as a stabilizing feature for the domestic economy during the COVID outbreak. Federal Law No. 98-FZ dated April 1, 2020, “On Amending Certain Legislative Acts of the Russian Federation Regarding Prevention and Liquidation of Emergencies.” Bankruptcy is also governed by the Civil Code of the Russian Federation (the “Russian Civil Code”); the Commercial Procedure Code; and the Law on Enforcement Proceedings. The participation of state authorities in bankruptcy proceedings is also regulated by Resolution No. 257 of the Russian Federation Government dated May 29, 2004, “On Protecting the Interests of the Russian Federation as a Creditor in Bankruptcy Cases and in Bankruptcy Proceedings.” ↑
3 Collier International Business Insolvency Guide P 38.05 (2022). ↑
Sabrina Tavernise, “Using Bankruptcy As a Takeover Tool; Russian Law Puts Healthy Companies at Risk,” New York Times, October 7, 2000, at 1; “Russian Bankruptcy Law Updated,” ABI Journal, September 1999. “Under the Bankruptcy Law, 5,300 bankruptcy cases were filed between March 1, 1998 and December 25, 1998, whereas only 4,200 cases were under the courts’ consideration before March. Furthermore, bankruptcy procedures of the Bankruptcy Law were applied to more than 900 cases opened before March.” ↑
Federal Law of the Russian Federation, No. 6-FZ, “On Insolvency (Bankruptcy),” January 8, 1998. See Sobr. Zakonod., RF, 1998, No. 2, Art. 222. The prior statute was the Law of the Russian Federation “On Insolvency (Bankruptcy) of Enterprises” No. 3929-1, November 19, 1992. See Vedomosti, Verkh, Soveta RF, 1993, No. 1, Art. 6. ↑
See, e.g., Tavernise, at 1; William P. Kratzke, Russia’s Intactable Economic Problems and the Next Steps in Legal Reform: Bankruptcy and the Depoliticization of Business, 21 Nw. J. Int’l L. & Bus. 1, 2 (2000) (“[T]he most important legal reforms for Russia are those that eliminate the reward system that encourages economic activity that can be highly inefficient. These legal reforms are an effective bankruptcy law and the de-politicization of business. The two go hand-in-hand. It is the politicization of business that renders Russia’s bankruptcy laws ineffective by making non-viable business entities appear to be solvent. These two reforms, were they adequately implemented, would eliminate rewards for inefficiency.”). ↑
See, e.g., Kratzke at 30–39; Vassily V. Vitryansky, “Insolvency and Bankruptcy Law Reform in the Russian Federation,” 44 McGill L.J. 409 (August 1999) (Deputy Chairman of the Higher Court of Arbitration of the Russian Federation discussing the necessity for bankruptcy reform and the process of drafting and features of the new insolvency law). ↑
3 Collier International Business Insolvency Guide P 38.05 (2022). ↑
Id. There were also amendments regarding residential property developers and credit institutions (specifically incorporating banks and credit institutions into the Russian Bankruptcy Laws, with certain provisions specific to financial institutions not applicable to other business entities, but a repeal of the prior Federal Law No. 40-FZ on Bankruptcy of Credit Organizations). ↑
Federal Law of the Russian Federation No. 154-FZ, “On the Regulation of the Particulars of Insolvency (Bankruptcy) Within the Territory of the Republic of Crimea and the Federal City of Sevastopol and on the Introduction of Amendments to Certain Legislative Acts of the Russian Federation,” arts. 2–4, 6–14, Ros. Gaz. (July 3, 2015). ↑
Bernard S. Black and Anna S. Tarassova, Institutional Reform in Transition: A Case Study of Russia, 10 S. Ct. Econ. Rev. 211, 253 (“Laws that aren’t honestly enforced are little better, and can sometimes be worse, as those without scruples manipulate the laws for personal gain.”). ↑
Paul B. Stephan, Taxation and Expropriation—The Destruction of the Yukos Oil Empire, 35 Hous. J. Int’l L. 1, 16 (2013) (citing to Allen C. Lynch, Vladimir Putin and Russian Statecraft 58–61 (2011)). ↑
Id. at 2 (citing to various sources which have examined the Yukos saga, the law review literature includes Paul M. Blyschak, Yukos Universal v. Russia: Shell Companies and Treaty Shopping in International Energy Disputes, 10 Rich. J. Global L. & Bus. 179 (2011); Sara C. Carey, What Do the Recent Events Involving Yukos Oil Company Tell Us About Legal Institutions for Transition Economies?, 18 Transnat’l L. 5 (2004); Dmitry Gololobov, The Yukos Tax Case or Ramsay Adventures in Russia, 7 Fla St. U. Bus. Rev. 165 (2008); Dmitry Gololobov, The Yukos Money Laundering Case: A Never-Ending Story, 28 Mich. J. Int’l L. 711 (2007); Matteo M. Winkler, Arbitration Without Privity and Russian Oil: The Yukos Case Before the Houston Court, 27 U. Pa. J. Int’l Econ. L. 115 (2006); Brenden Marino Carbonell, Comment, Cornering the Kremlin: Defending Yukos and TNK-BP from Strategic Expropriation by the Russian State, 12 U. Pa. J. Bus. L. 257 (2009); Peter C. Laidlaw, Comment, Provisional Application of the Energy Charter as Seen in the Yukos Dispute, 52 Santa Clara L. Rev. 655 (2012); Alex M. Niebruegge, Comment, Provisional Application of the Energy Charter Treaty: The Yukos Arbitration and the Future Place of Provisional Application in International Law, 8 Chi. J. Int’l L. 355 (2007)). ↑
See Amoco v. Iran, Award, July 14, 1987, para. 192. (“[A] clear distinction must be made between lawful and unlawful expropriations, since the rules applicable to the compensation to be paid by the expropriating State differ according to the legal characterization of the taking.”). ↑
7 The Chorzów Factory Case (Germany/Poland), September 13, 1928, Series A, No. 17 (substantive issue) at 2. ↑
See Starrett Housing v. Iran, Interlocutory Award No. ITL 32-24-1, December 19, 1983, 4 Iran-United States Claims Tribunal Reports 122, 154 (stating “…it is recognized under international law that measures taken by a State can interfere with property rights to such an extent that these rights are rendered so useless that they must be deemed to have been expropriated, even though the State does not purport to have expropriated them and the legal title to the property formally remains with the original owner.”); The Factory at Chorzów (Claim for Indemnity) (The Merits), Germany v. Poland, Permanent Court of International Justice, Judgment, September 13, 1928, 1928 P.C.I.J. (ser. A) No. 17, at 47; and Norwegian Shipowners’ Claims, Norway v. the United States, Permanent Court of Arbitration, Award, October 13, 1922. ↑
Expropriation UNCTAD Series on Issues in International Investment Agreements II (2012) at 11. ↑
Generation Ukraine v. Ukraine, Award, September 16, 2003, para. 20.22. 6. ↑
Suez et al. v. Argentina, Decision on Liability, July 30, 2010, para. 121. ↑
Expropriation UNCTAD Series on Issues in International Investment Agreements II (2012) at 15. ↑
Id. The Iran-United States Claims Tribunal found expropriation where the Iranian Government appointed temporary managers in the subsidiaries of United States companies and the acts of the government appointees. ↑
“Правкомиссия одобрила проект по национализации имущества ушедших из РФ западных компаний” [“Government commission approved a project to nationalize the property of Western companies that left the Russian Federation”], Russian News Agency TASS, March 9, 2022, https://tass.ru/ekonomika/14012987. ↑
Decree of the President of the Russian Federation dated March 5, 2022, No. 252, “On the application of retaliatory special economic measures in connection with unfriendly actions of certain foreign states and international organizations,” http://actual.pravo.gov.ru/text.html#pnum=0001202205030001. ↑
GOR, Resolution No. 295,431-p of March 6, 2022, “Government approves rules for transactions with foreign companies from unfriendly countries and territories,” March 7, 2022; see also 2022 ITA Unpub LEXIS 343. ↑
Decree of the Government of the Russian Federation dated March 6, 2022, No. 299: “On Amending Paragraph 2 of the Methodology for Determining the Amount of Compensation Paid to the Patentee when Deciding to Use an Invention, Utility Model or Industrial Design without His Consent, and the Procedure for Its Payment,” http://actual.pravo.gov.ru/text.html#pnum=0001202203070005. ↑
On March 30, 2022, Russian Prime Minister Mikhail Mishustin announced and signed a law that made it legal to import grey market goods without proving the legitimacy of the products or obtaining the authorization of the trademark owner (which previously was required). Meeting of the Presidium of the Government Commission to Increase the Sustainability of the Russian Economy under the Sanctions, March 30, 2022, http://government.ru/en/news/44982/. The Russian Ministry of Industry and Trade will be issuing a list of products allowed into Russia, regardless of trademark protections. Id. ↑
See e.g. SwissInfo, “Court rules against Russia over Yukos affair,” August 23, 2007, https://www.swissinfo.ch/eng/court-rules-against-russia-over-yukos-affair/6068860 (noting that the Swiss Federal Court would not allow bank records to be sent to Russia because “Russia’s judicial standards fell short of the international norms needed to comply with the request.”); see also Paul B. Stephan, Taxation and Expropriation—The Destruction of the Yukos Oil Empire, 35 Hous. J. Int’l L. 1, 29–30 (2013) (citing to extradition cases Government of the Russian Federation v. Maruev and Chernysheva, Bow Street Magistrates Court, March 18, 2005; Government of the Russian Federation v. Temerko, Bow Street Magistrates Court, December 23, 2005; Regarding Law on Extraction of Fugitives 95/70, Application No. 2/07, District Court of Nicosia, April 10, 2008; and cases that refused to allow the seizure of corporate records Khodorkovsky v. Office of the Attorney General, Federal Supreme Court, Case 1A29/2007, August 23, 2007; Decision of February 6, 2006, Princely Court of Justice of Principality of Liechtenstein). ↑
Judgment of the District Court of Amsterdam in Case No. 355622/HA ZA 06-3612 of October 31, 2007. On appeal, the Amsterdam Gerechtshof (Court of Appeals) (confirming that Dutch law would not recognize any interest in Yukos Finance that Promneftstroy was granted in the Russian proceeding) and Judgment in Cases No. 200.002.097/01 and 200.002.104/01 of October 19, 2010. ↑
See 11 U.S.C. § 1500, et seq. Enacted in 2005, Chapter 15 governs cross-border bankruptcy and insolvency proceedings and was enacted pursuant to the 1997 UNCITRAL Model Law on Cross-Border Insolvency (“Model Law”) that has been enacted by more than 50 countries. ↑
In re Vneshprombank, Case No. 16-13534 (MG), Bank Foreign Main Proceeding Order, ECF Doc. #24. ↑
In re Vneshprombank, Case No 16-13534 (MKV) (Bankr. S.D.N.Y.). Section 1521(a)(4) allows for discovery by a foreign representative who is recognized by the Court. Section 1521(a)(5) “enables a Foreign Representative to take broad discovery concerning the property and affairs of a [foreign] debtor.” In re Foreign Econ. Indus. Bank Ltd., 607 B.R. 160, 170 (Bankr. S.D.N.Y. 2019) (quoting In re Millennium Glob. Emerging Credit Master Fund Ltd., 471 B.R. 342, 346 (Bankr. S.D.N.Y. 2012)). ↑
In re CJSC Automated Services, Case No. 09-16064 (JMP) (Bankr. S.D.N.Y. Nov. 23, 2009) (recognition granted for claims investigation but foreign representative failed to move forward). ↑
In re Rebgun (Yukos Oil Co.), Case No. 06-10775 (RDD) (Bankr. S.D.N.Y. Feb. 28, 2008) [ECF #145] (Chapter 15 case dismissed after provisional relief was granted but before recognition). ↑
In re Yukos Oil Company, 320 B.R. 130, 136 (Bankr. S.D. Tex. 2004). ↑
United States Department of State, U.S. Relations with Russia, Bilateral Relations Fact Sheet, Bureau of European and Eurasian Affairs, September 3, 2021, https://www.state.gov/u-s-relations-with-russia/. Russia and the United States signed an investment treaty in 1992 that was never enacted. Id. ↑
See, e.g. Agreement Between the Government of the Republic of Singapore and the Government of the Russian Federation on the Promotion and Reciprocal Protection of Investments, September 27, 2010. ↑
Convention on the Recognition and Enforcement of Foreign Arbitral Awards (New York, 1958) Commission On International Trade Law. ↑
Seizures by REPO are authorized under the International Emergency Economic Powers Act (IEEPA). 50 U.S.C. §§1701–1707. However, the IEEPA does not allow the U.S. government to take ownership over the assets as it is not a “vesting” statute, unless the U.S. is “engaged in armed hostilities or has been attacked by a foreign country or foreign nationals,” which is not the current state of the conflict in Ukraine. See 50 U.S.C. §1702(c) (the Patriot Act amended the IEEPA). ↑
General Agreement on Tariffs and Trade, October 30, 1947, 61 Stat. A-11, 55 U.N.T.S. 194 (“GATT 1947”). ↑
Terence P. Stewart and Shahrzad Noorbaloochi, “The WTO Panel Report on Article XXI and its Impact on Section 232 Actions,” Washington International Trade Association, April 11, 2019, https://www.wita.org/atp-research/the-wto-panel-report/. ↑
In re Yukos Oil Co., 321 B. R. 396 (Bankr. S.D. Tex. 2005), and Allen v. Russian Fed’n, 522 F. Supp. 2d 167, 171 (D.C. Cir. 2007). ↑
See Paul B. Stephan, Taxation and Expropriation—The Destruction of the Yukos Oil Empire, 35 Hous. J. Int’l L. 1, 36–45 (2013) (excellent discussion of the various available tribunals and the litigants’ approach in each, with the Strasbourg Court and the arbitration available through bilateral investment treaties being most amenable to hearing cases and finding jurisdiction). ↑
Id. (discussing that the Strasbourg Court held on several points in favor of the Russian taxing authority while arbitration panels disagreed with those decisions). ↑
Yukos Capital S.A.R.L. v. OAO Rosneft, Case No. 200.005.269/01, Decision (April 28, 2009) (Amsterdam Gerechtshof). ↑
Stephan at 41. In summary, “[i]t did not have to determine that Russia violated its own laws, much less any of the specific human rights obligations found in the European Convention. Rather, it had to determine whether Russia’s actions, in their entirety, constituted a compensable expropriation. To do so, it only had to determine that the government’s behavior was inconsistent with ‘routine regulatory powers,’ that is normal tax assessment and enforcement.” See also Quasar de Valores S.I.C.A. v. Russian Fed’n, I.I.C. 557 at P 227 (Arb. Inst. Stockholm Chamber of Commerce 2012). ↑
A new rule (12 CFR Part 1002, the “Rule”) issued in final form by the Consumer Financial Protection Bureau (the “CFPB”) earlier this year, though subject to legal challenges and delay, will impose a host of data collection and reporting obligations on lenders to small businesses. This article provides a high-level overview of key considerations for lenders in light of such enhanced future obligations.
A. Statutory Background:
The Rule, issued on March 30, 2023, implements Section 1071 (“Section 1071”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Section 1071, which amended the Equal Credit Opportunity Act, requires lenders who receive applications for small business loans to obtain, maintain, and periodically report to the CFPB certain information about applicants. Further, Section 1071 contemplates that the CFPB will make public the information it receives.
B. The Rule:
Application: The Rule’s reporting requirements apply to any financial institution with at least one hundred “covered originations” in each of the two previous calendar years. “Financial institution” is defined broadly to cover a range of entities engaging in “any financial activity”— i.e., this definition, and by extension, the Rule, could apply to both “traditional” bank lenders and alternative or direct lenders or private credit funds. Covered originations are certain types of credit extensions to “small businesses” (defined as businesses with gross revenues of no more than $5 million in the fiscal year preceding the time of determination).
Requirements: Lenders must report to the CFPB three types of data in connection with each consumer request (importantly, whether written or oral) for a covered credit transaction, including any refinancing of existing debt:
data generated by lenders (e.g., method of credit application and actions taken regarding such application);
data collected from applicants or third parties (e.g., credit purpose, amount requested, and details about the applicants’ business); and
demographic data collected from applicants, including minority-owned business status and information about principal owners.
Additionally, lenders must maintain certain policies and procedures, including:
Procedures reasonably designed to obtain a response to each request for applicant-provided demographic and other data.
Methods to recognize and address “indicia of potential discouragement”—i.e., practices that might cause applicants to decline to provide requested information. Note the CFPB issued a statement that it will “use its enforcement and supervisory authorities to focus on covered lenders’ compliance with” this requirement.
A “firewall” so that, with certain exceptions, persons making credit and other relevant determinations regarding a covered application by a small business do not have access to sensitive information provided by applicants pursuant to the Rule.
Unintentional errors occurring despite maintenance of appropriate procedures will not result in violations of the Rule. There is a presumption that unintentional errors below a numerical threshold are bona fide in nature. Safe harbors for certain types of inaccuracies in reported data also apply.
C. Compliance Considerations:
Smaller lenders will have more time to prepare for compliance than larger lenders. Compliance requirements will be phased in, starting in October 2024 for lenders with at least 2,500 covered originations in the aggregate for both 2022 and 2023. This timing may be affected by litigation for some lenders as described below.
Among other things, lenders must:
Analyze potentially covered credit transactions to determine whether the Rule applies and, if so, collect and provide accurate required data. In addition to developing effective routines to ensure careful and timely reporting, this process involves accurately identifying relevant data for each covered transaction, such as:
the purpose and type of credit;
the application method for such credit;
the reportable amounts (applied for and approved amounts);
pricing information; and
as applicable, reasons for approval or denial of such credit.
Collect and accurately analyze information about applicants, including by identifying relevant demographic and other characteristics.
Maintain procedures to “identify and respond to indicia of potential discouragement” in the credit and lending process.
Develop practices to ensure proper maintenance of the above-mentioned “firewall.” This would involve accurately identifying which persons are (or are not) involved in determining whether to extend credit to a given applicant.
D. Concluding Observations:
The Bureau’s Rule implementing Section 1071 has been the subject of considerable controversy. The rulemaking followed a lawsuit filed by community groups seeking to compel the Bureau to promulgate the Rule, and the process generated voluminous comments, many critical of the new burdens the Rule will impose on lenders. Currently, litigation is pending in federal district court in Texas in which the American Bankers Association and the Texas Bankers Association contend the Rule must be set aside. On July 31, 2023, the court in that case preliminarily enjoined the Bureau from enforcing the Rule against ABA and TBA members pending a decision in CFPB v. Community Financial Services Association, in which the Supreme Court will review the decision of the Fifth Circuit that the CFPB’s funding structure is unconstitutional. Since then, multiple other trade groups representing community banks, credit unions, and others have intervened in the Texas case and requested that implementation of the Rule be enjoined as to their members as well. The Kentucky Bankers Association has also filed a new separate lawsuit together with a group of Kentucky-based lenders similarly contending the Rule must be set aside.
As a practical matter, however, small business lenders would be wise to ensure they can meet future compliance obligations under the Rule. As sketched above, the Rule imposes substantial new administrative burdens, and compliance could prove costly and challenging, especially for community and local institutions. The Rule also seems likely to present challenges for larger institutions, whose existing frameworks for collecting demographic and other consumer information (for example, as required by federal fair lending laws) may not map easily onto the Rule’s distinct requirements. Notably, the Rule is part of a growing trend towards greater regulatory scrutiny over commercial lending, with a particular emphasis on small business transactions—in recent years, state regulators in jurisdictions such as California, Utah, New York, and Virginia have enacted laws mandating broad disclosures by commercial lenders. Considering the Rule’s broad applicability, the numerous new requirements it imposes, and the Bureau’s stated intention to make the Rule’s provisions concerning “discouragement” an enforcement priority, industry participants that engage in small business lending should work with counsel to prepare for compliance.
Your client has finally decided it’s time to acquire an AI-based product/service for its business use and has asked you to review the AI vendor’s standard legal terms relating to the purchase. Where do you begin? This article will highlight some of the key legal issues to consider when acquiring an AI product/service and provide certain risk mitigation strategies that can be employed through contractual means.
Do Your Due Diligence!
Before doing the deep dive into the black and white contract terms, it’s critical to ask your client about the prospective AI vendor. Due diligence is a must in this volatile market, so hopefully your client has done their homework. There are many factors to consider and questions to ask. Is the AI vendor a mature company or a start-up? Has it been the subject of any publicly available complaints, such as regulatory investigations (Canadian or international privacy regulators, the US Federal Trade Commission) or lawsuits?
You also need to know the intended use case, i.e., (i) the nature of the intended AI application; (ii) the industry it will serve; and (iii) how your client will use AI product/service, as these considerations will impact your legal advice. Is the product/service consumer-focused, or is it a business-to-business application that the client will use internally? Has the AI vendor put in place transparency measures to promote openness and explainability in the operation of its products? Will the AI product/service make or affect decisions impacting individuals that are subject to specific laws? What is the origin of the AI product/service? You should understand the scope of its source data—was it captured “in-house” or scraped from “publicly available” sources? You should also confirm the proposed AI contract framework, as the standard vendor terms may reference a number of hyperlinked, ever-changing documents, including an order form, service agreement, separate Terms of Use / Terms of Service, Privacy Policy, additional Legal Terms—all of which should be reviewed.
Consider Bias.
AI systems are far from perfect, as shown by some spectacular (and very public) examples of racist chatbots, financial programs that routinely deny certain minority groups credit/mortgages based on their ethnicity, discriminatory hiring practices, and generative AI programs that hallucinate fictional legal cases, to name a few.
Canadian acquirors of AI products/services should filter and consider their purchases against the requirements of pending Bill C-27, Canada’s proposed Artificial Intelligence and Data Act (the “AIDA”),[1] whose purpose is to expressly regulate certain types of AI systems and ensure that developers and operators of such systems adopt measures to mitigate various risks of harm and avoid biased output.[2] While AIDA will only apply to AI systems that are “high impact” systems (terms are as yet undefined), prospective acquirors should still ask the “hard questions” around the vendor’s bias mitigation practices. Does the AI vendor have an internal AI ethics review board? What kinds of data sets have been used in training the AI product/service? Has the company established measures to identify, assess, and mitigate risks of harm or biased output that could result from a client’s use of the product/service? What steps has the AI vendor taken to ensure the quality and accuracy of its data, to ensure that it is class-balanced and unbiased? Was the source of the AI vendor’s data sufficiently diverse, or was the AI system narrowly focused on a small sample of data that could lead to unforeseen and harmful consequences? Has the AI vendor explicitly tested for bias and discriminatory outcomes? If so, how? Does the company have a plain language description of the AI system that states how it is intended to be used, the types of content that it will generate, and the recommendations, decisions, or predictions that it will make, as well as the strategies to mitigate against bias?
Use Rights / Intellectual Property Considerations / Licensing Concerns.
You should review the draft AI contract to ensure that your client has the necessary rights to use the AI service/product as contemplated, including its affiliates and customers, as applicable. It’s critical to drill down in the prospective AI contract to determine what the vendor says about (i) the ownership of its own intellectual property (AI models, tools), including any licensed third-party content; and (ii) who owns the content/output generated by the AI product/service, as applicable (i.e., the vendor or the client). Since laws are still evolving in this area, all desired client rights must be expressly defined in the AI contract. Many AI systems are built on data sets that have been scraped from other publicly available third-party content, which opens these vendors up to prospective litigation, so a positive affirmation in the vendor contract regarding ownership is essential. Look for language in the AI vendor’s contract to ensure that all rights that make up the AI system have been listed and protected, and that the AI vendor has the right to license the AI technology for its intended uses (any restrictions should be carefully noted).
Privacy/Cybersecurity Issues.
AI systems are rife with privacy concerns. They are myriad, and include (i) ensuring that vendors have the legal authority to process personal information used by the AI product/service, particularly that of minors, in relation to the data sets used to train, validate, and test generative AI models; (ii) individuals’ interactions with generative AI tools; and (iii) the content generated by generative AI tools. Similarly, the AI system should contain mitigation and monitoring measures to ensure personal information generated by generative AI tools is accurate, complete, up-to-date, and free from discriminatory, unlawful, or otherwise unjustifiable effects. Detailed questions should be asked as to whether the AI vendor has put in place sufficient technical and organizational measures to ensure individuals affected by or interacting with these systems have the ability to access their personal information, rectify inaccurate personal information, erase personal information, and refuse to be subject to solely automated decisions with significant effects.
It is therefore critical to understand what the AI vendor says about its own privacy/cybersecurity practices, and whether it has incorporated “privacy/security by design” principles in the development of its AI systems. While AIDA has not yet passed in Canada, existing Canadian privacy laws still require vendors to limit the collection of personal information to only that which is necessary to fulfill the specified task and to ensure that the AI system is not indiscriminately grabbing content solely for the vendor’s benefit. AI vendors should incorporate adequate, reasonable security safeguards to protect against threats and attacks against stored data that seek to reverse engineer the generative AI model or extract personal information originally processed in the datasets used to train the models. The standard AI contact should include detailed language relating to comprehensive privacy protection and mandatory breach notification. Ideally, the vendor will also state in its contract that it adheres to meaningful cybersecurity standards, such as NIST (National Institute of Standards and Technology), which just published its AI Risk Management Framework in January 2023. These requirements and accountability measures must also flow down the vendor’s entire AI supply chain, especially when AI models are built upon one another.
As a start, you should review the AI vendor’s privacy policy, service terms, and terms of use, and subject to your client’s agreement, follow-up questions may be required. You will need to develop a clear picture as to how the vendor will use your client’s content/personal information throughout the life cycle of the AI agreement (including post-termination), and whether/how such personal information will be aggregated/deidentified before use. You should also review the AI vendor’s data retention policies and whether they are acceptable based on your client’s existing third-party obligations/relevant industry.
It is worth noting that starting September 22, 2023, Québec’s Law 25 will grant individuals new transparency and rectification rights related to the use of automated processes to render decisions about individuals (“Automated Decision-Making Systems”) that use the personal information of such individuals. An individual will have the right to: (i) be informed when an enterprise uses their personal information; (ii) request additional information on how the individual’s personal information was used to render a decision, as well as the reasons and principal factors and parameters that led the Automated Decision-Making System to render such decision; (iii) request to have the personal information used to render the decision be corrected, and (iv) submit observations with respect to a decision to a member of the enterprise to review the decision made by an Automated Decision-Making System.
Lastly, it is important to be aware of any “reverse” privacy/security requirements that the AI vendor may incorporate in its standard agreement that create onerous burdens on clients. These may include obligations for clients to notify the vendor of any vulnerabilities or breaches related to the client’s AI service/product and provide details of the breach, provide legally adequate privacy notices, and obtain necessary consents for the processing of client data by the AI vendor, complete with actual representations from the client that they are processing such data in accordance with applicable law. Some AI vendors even require clients to sign separate Data Processing Addenda. It is important to be aware of these additional vendor data requirements and neutralize any that are unacceptable to your client.
Additional Sources of Liability.
Besides the risks above, additional sources of liability include noncompliance with both AI-specific legislation and regulations (which are not limited to Canada, given pending AI regulations in Europe and the United States), but also existing federal and provincial laws (privacy, consumer protection legislation, consumer disclosure requirements). Old laws still continue to apply to AI vendors, and AI systems that are defectively designed would still be subject to product liability laws.
Representations/Warranties/Disclaimers.
Unfortunately, AI products/services are usually offered by vendors on an “as is, as available” basis, with minimal to no legal representations and warranties. Standard contract terms typically contain disclaimers that limit any damages to direct damages with very low dollar liability. You should therefore seek to include express legal representations/warranties regarding the following: (i) the vendor having all necessary rights, including ownership and licenses to make the AI service/product available to the client and for the client to use the AI product/system as contemplated/described; (ii) non-infringement, including no infringement when used by the client as intended; (iii) vendor’s (and the service’s/product’s) compliance with all applicable laws, including privacy laws and jurisdictions outside of Canada (customize as required); (iv) the AI service/product not containing any viruses, malware, etc. that would otherwise damage the client’s systems; and (v) no pending third-party claims or investigations existing that would impact the vendor’s ability to provide the product/service.
Indemnities.
Similarly, many AI vendors do not provide indemnities in their standard legal agreements but rather include reverse indemnities from the client. For example, clients are asked to indemnify the vendor, its affiliates, and personnel from and against claims, losses, and expenses (including legal fees) arising from or relating to: the client’s use of the AI services/product, client’s content, any products or services that the client develops or offers in connection with the AI services or product, or client’s breach of vendor’s terms or applicable law. You should endeavor to minimize the client’s indemnities and balance the agreement through the addition of such critical vendor indemnities as indemnification for vendor’s failure to comply with applicable laws, fraud, negligence/gross negligence, willful misconduct, intellectual property infringement (especially patent and copyright), breaches of confidentiality/privacy and cybersecurity breaches, customer data loss, and lastly, personal injury/death (depending on the product/service). While I do not recommend trying to seek unlimited indemnities as they are generally no longer considered “market,” I recommend instead seeking “super-caps” (i.e., higher caps) for the most critical of these, such as IP infringement; confidentiality breaches and privacy and cybersecurity breaches; customer data loss; fraud; gross negligence/negligence; and willful misconduct. These super-caps may be based on the greater of a specific dollar value or a multiplier based on contract fees paid or payable, or some other formula. Lastly, the scope of the indemnity should include affiliates, contractors, and third-party representatives of the AI vendor as applicable/appropriate.
Dispute Resolution.
You should review what the standard legal agreement says regarding dispute resolution, as many AI vendors seek to restrict a customer’s rights at law (and equity) to deny their day in court. Instead, vendors will insist on mandatory arbitration, naming a US arbitration regime that will prove expensive for the client should it wish to assert its contractual rights. Some agreements also include compelled informal dispute resolution that results in a hold period (i.e., sixty days) before a client can assert a claim. These restrictions may not be in the best interest of the client and should be removed. It is, therefore, important to look at the governing law/jurisdiction clauses carefully and note any special restrictions/differing rights depending on the client’s jurisdiction.
Termination Considerations.
Lastly, don’t forget to look at the termination provisions, as AI contracts often contain robust termination rights in favor of the vendor—i.e., the vendor can terminate the agreement immediately upon notice to client if the client (allegedly) breaches its confidentiality/security requirements, for “changes in relations with third-party technology providers outside of our control,” or to comply with government requests. Also, the vendor may have broad suspension rights that allows suspending the client’s use of the AI system if client is allegedly not in compliance with the AI product/service terms, the client’s use poses a security risk to the AI vendor or any third party, if fraud is suspected, or if the client’s use subjects the AI vendor to liability. Often these broad rights require additional negotiation and tightening to balance the client’s interests. It is also important for the contract to expressly address, in plain language, what happens following contract termination. For example, must the client immediately stop using the service/product and promptly return or destroy the AI vendor’s confidential information? If so, does this include the client’s outputs? Does the client have ongoing usage rights regarding outputs? Will the AI vendor continue to use any ingested client content or personal information, or will this be erased? If yes, consider the protections/restrictions necessary for your client to comply with applicable privacy laws and any particular industry requirements.
Conclusion.
While AI technology may be new, seeking to create balanced legal agreements that correctly apportion risk and liability is not. Notwithstanding the daunting list of risks associated with the use of AI systems, there are a number of risk mitigation measures that prospective buyers (and their counsel) can deploy to manage these concerns. It is critical to negotiate AI contracts with teeth in order to ensure that clients will feel comfortable acquiring and using these products and services on a going-forward basis.
An Act to enact the Consumer Privacy Protection Act and the Personal Information and Data Protection Tribunal Act and to make consequential and related amendments to other Acts, also known as the Digital Charter Implementation Act, 2022 (First Session, Forty-fourth Parliament, 70-71 Elizabeth II, 2021-2022). Bill 27 is comprised of three parts: Part 1 will enact the Consumer Privacy Protection Act; Part 2 will enact the Personal Information and Data Protection Tribunal Act; and Part 3 will enact the Artificial Intelligence and Data Act. ↑
The AI Act defines “biased output” to mean content that is generated, or a decision, recommendation, or prediction that is made, by an artificial intelligence system and that adversely differentiates, directly or indirectly and without justification, in relation to an individual on one or more of the prohibited grounds of discrimination set out in section 3 of the Canadian Human Rights Act, or on a combination of such prohibited grounds. It does not include content, or a decision, recommendation, or prediction, the purpose and effect of which are to prevent disadvantages that are likely to be suffered by, or to eliminate or reduce disadvantages that are suffered by, any group of individuals when those disadvantages would be based on or related to the prohibited grounds. ↑
This article discusses a Showcase CLE program that took place at the ABA Business Law Section’s Fall Meeting on September 7, 2023. All Showcase CLE programs were recorded live and will be available for on-demand credit, free for Business Law Section members.
Over the last several years, issues and trends relevant to the focus on an in-person versus remote workforce and the fate of workers in complex, multitier supply chains have changed dramatically. This session will provide an overview of recent litigation examining corporate directors’ and officers’ (D&O) duties and an overview of emerging legislation addressing workplace misconduct and human rights abuses in supply chains—and it will include a discussion of risk assessment and allocation in the context of mergers and acquisitions (“M&A”).
On September 7, a panel discussion at the American Bar Association Business Law Section Fall Meeting will consider the dramatic direct and indirect changes in the workforce over the past six years, from #MeToo to the pandemic to the “Great Resignation.” The panelists hope to explain the impact of these evolving dynamics on reactions to workplace misconduct and human rights abuses in a variety of different workplaces. The panelists, offering employment law, corporate governance, M&A, and key in-house perspectives, will explain how both the law and best practices have changed in response, and they will provide insights about what business lawyers should advise their clients to do to keep up with current employee/shareholder/stakeholder expectations, conduct appropriate due diligence in these areas, and adhere to new legal requirements.
In the wake of the #MeToo movement, the so-called “#MeToo Representation and Warranty” proliferated in M&A agreements: by 2021 more than half of deals valued over $25 million included specific language focused on sexual harassment or misconduct. The panelists will explain why, despite good intentions, common iterations of the #MeToo representations fail to adequately address the subtle and complex factors that allowed sexual misconduct to proliferate in silence at the Weinstein Company and many other workplaces for decades. The panelists will also clarify how their understanding of effective #MeToo representations has evolved over the past several years, and they will expound on what attorneys can advise their clients to do to ensure that they are adequately addressing liability risk around workplace misconduct in the context of a corporate transaction. The presentation will expand upon what due diligence best practices and emerging trends look like; how thinking has evolved on these efforts since #MeToo went viral in 2018; and what should be done in preparation before the closing of any transaction, including as part of effective integration and policy alignment.
Turning to national and global workforce investigations and high-profile inquiries into corruption, harassment, modern slavery, and other workplace issues related to human rights abuses, the program will expand upon what corporate leaders need to keep in mind as they assess risks associated with a global workforce, especially in the context of transactions. The discussion will include an explanation of the evolution of soft law, like the United Nations Guiding Principles on Business and Human Rights (“UNGPs”) and the Organisation for Economic Co-operation and Development Guidelines for Multinational Enterprises (as recently amended), to hard law, which ranges from “name and shame” frameworks like the United Kingdom’s Modern Slavery Act to mandatory human rights due diligence obligations under France’s Duty of Vigilance, Germany’s Act on Corporate Due Diligence, and the European Union’s long-awaited but imminent Corporate Sustainability Due Diligence Directive.
The panelists will provide guidance on how companies can create policies—like a global code of conduct or business ethics policy—that resonate across borders and effectively address legal risks in various jurisdictions. They will also discuss new risk considerations for directors and officers in the workforce context coming out of the recent McDonald’s decisions, such as board fiduciary obligations to oversee workplace and workforce protections, and officers’ duties to monitor operations within their company-specific silo and collect data for presentation to the board. The panelists will illuminate why it so important, not just from a legal and policy standpoint, but also from a business perspective, to get this right.
The program will feature perspectives from Margaret Egan, Executive Vice President and General Counsel of Hyatt Hotels and Resorts, and Mara Davis, Associate General Counsel, Compliance & Ethics, at Zoom—two panelists who work in-house at large, multinational corporations that are active in the transactional space and operating across the globe. These experts will explain how they are dealing with the dynamics described above on a daily basis and how their respective companies have been able to maintain a cohesive workplace culture despite a growing global workforce, and in the context of hybrid work environments that make personal connection more challenging. They will provide advice on how to set the tone from the top and create a cohesive understanding of corporate culture, especially as new entities are acquired and company reach expands globally. Specifically, they will share their experiences working to create effective community and mentoring/apprenticeship opportunities in a hybrid environment and explain how these efforts dovetail with efforts to address workplace misconduct, such as adequately training investigators even in the context of remote work. Finally, they will draw upon their diverse in-house initiatives to provide examples of how to combat human trafficking, protect staff and supply chain workers from human rights abuses (including sexual harassment), and conduct due diligence in vendor procurement. They will share unique practical suggestions like implementing physical accommodations such as alarm buttons and creating an effective operational-level grievance mechanism as required by the UNGPs.
Together with Egan and Davis, the other panelists—Ally Coll, the founder and CEO of The Purple Method; Harry Jones, a shareholder at Polsinelli; and Charlotte May, a partner at Covington & Burling LLP—will thread these diverse topics together to address how to build a culture of trust and transparency and encourage employees to speak up about workplace issues, even in a remote or hybrid environment. Attendees will leave with an understanding of recent changes in the law; best practices for risk assessment and allocation in the M&A context; and practical changes in workplace investigations, like the use of e-discovery tools and effective reporting channels to ensure that employees and other workers feel safe and protected from retaliation, regardless of where they physically work.
The program will close with a reminder about the upsides of the growing global and hybrid workforce from a company culture, ethics, and business compliance standpoint. The hope is to leave attendees with practical ideas about how to create safe and empowering workplaces, for their own benefit and in order to advise clients on how to do the same.
The use of financial models and projections in fundraising by pre-revenue companies and those in the early and optimistic stages of their business cycle is almost universal. Often, companies disclose assumptions underlying the models and projections. Many include warnings and disclaimers in fine print further advising readers of the uncertainties behind the business and risk in relying too heavily on the models or projections. In these circumstances, the fundraisers feel secure in the disclosures accompanying the models or projections provided to investors.
But what will those models and projections look like two and three years later if the business hits choppy waters, expected business partners change direction, or regulators become less accommodating? Will investors cry foul and draw the attention of the Securities and Exchange Commission (“SEC”), Department of Justice, or other regulators? Recent actions demonstrate heightened enforcement risk to both issuers and their executives in the use of models and projections in fundraising by early- and middle-business-cycle companies. In this article, we offer suggestions on how to mitigate or reduce the risk.
Recent Actions Highlight Danger in the Use of Projections by Early-Stage Issuers
The explosion of initial public offerings by special purpose acquisition companies (“SPACs”) and their privately held target companies via de-SPAC combinations in 2020 and 2021 led the SEC and certain of its officials to raise concerns about the use of projections in fundraising and business combinations. In March 2022, the SEC published proposed rules intended to enhance investor protections, including additional disclosures accompanying projections shared with potential suitors. While the SEC has yet to adopt the proposed rules, recent enforcement activity reflects heightened staff scrutiny of projections and accompanying disclosures used in fundraising that issuers, their executives, and advisors should consider before sharing projections and related disclosures, whether or not connected to business combinations or de-SPAC IPOs.
A client of the authors’ firm, a former executive of a technology company (“TechCo”) that went public via a business combination and de-SPAC transaction, was recently issued a Wells letter notifying him of the SEC staff’s recommendation that the Commission authorize an enforcement action against him. The staff alleges TechCo, and our client, presented misleading financial projections to investors in connection with the business combination and related private investment in public equity (“PIPE”) offering in presentations and filings with the Commission. Specifically, the staff alleges TechCo presented specific revenue projections for the two ensuing calendar years from a particular service unit of the business. Within five months of the first presentation of the projections, however, the targeted business failed to materialize and was later abandoned. Nonetheless, the staff alleges TechCo continued to include the revenue projections for several more months in filings with the Commission.
Ultimately, the staff alleges the projections shared with investors omitted disclosure of assumptions and facts that, in the staff’s view, call into question the reasonableness of the projections. This may sound like a routine SEC enforcement action based on omissions of material facts. Not so fast. A closer look at disclosures and access provided by TechCo to investors reflects a transparency that would ordinarily seem to ward off allegations of any intent to defraud. For example, TechCo’s disclosures with the projections included:
Warning that the projections were based on TechCo management’s “discussions with such counterparties and the latest available information.”
Explanation that the partnerships underlying the projections depended on negotiations over definitive agreements “which have not been completed as of the date of this presentation.”
Confirming once again that descriptions of the business partnerships behind the projections remained “subject to change.”
Arranging for a due diligence call between investors and the potential partner behind the revenue projections at issue.
These disclosures reflect that, at a minimum, investors were told the projections were based on “potential” partnerships, and not signed agreements and committed sales. Moreover, evidence showed that discussions between TechCo and some potential partners continued contemporaneously with most of the filings that included the projections. Nonetheless, the staff alleges that when the partnership negotiations failed to advance as quickly as hoped or expected, continued reference to the projections in filings with the Commission became unreasonable and fraudulent under the federal securities laws.
We often see similar analysis of financial projections and related disclosures in enforcement actions and shareholder disputes where the business fails to develop as expected or as quickly as believed at the time of the share sales. Investors become disillusioned, and recollections of what was disclosed and understood often sour with the passage of time. The recent uptick in enforcement actions regarding technology and early-stage companies, including those that went public via de-SPAC transactions, suggests the clampdown on the use of projections in these circumstances has arrived.
What can an issuer and its executives do to mitigate these risks? Projections are deeply important to investors, and it is unrealistic to propose that companies stop using them, but several strategies could mitigate risk.
Strategies to Mitigate the Risk in Sharing Projections
These strategies to mitigate risk will not close the door to regulatory scrutiny. They can, however, potentially bolster defenses to accusations of deception or misconduct.
1. Title the relevant analysis a “model” and not a “projection.”
If an economic forecast is used in fundraising, title it as a “model” of the business opportunity and not a “projection” of future revenue and income. A “model” describes an analytical tool. A “projection” connotes a prediction or forecast more typical of public companies. Use the “model” description in all communications as well.
2. Do not date the business years in the model.
Date the business progression in the model as Year 1, Year 2, Year 3, etc. Dating the model with specific years (2024, 2025, etc.) can feed into a later characterization of the model as a prediction and provide target dates that can be used against you.
3. Define and disclose when Year 1 in the model begins.
This is particularly important for pre-revenue and early business cycle companies. Does Year 1 begin with the public launch of a new product, adoption of the product by certain partners, regulatory approval of a new product, or clearance of some other hurdle or obstacle to the launch of the business? Defining the start of Year 1 can help guard against unexpected delays in developing the business.
4. Disclose assumptions behind the model.
Disclosing assumptions built into the model can guard against future efforts to allege management concealed factors that years later may appear unreasonable in light of subsequent micro- or macroeconomic events. This should go beyond disclosure of just the Excel spreadsheet or other raw data behind the model. If possible, define terms and provide narrative explanations of the reasoning and bases behind the model. This can help to guard against claims of confusion about the meaning of the data and calculations in the raw model spreadsheet.
5. Document all meetings and presentations relating to the model.
This seems obvious, but we have seen numerous failures by management to memorialize oral representations to potential investors that accompany the presentation of projections and models. Noting questions raised by potential investors can also aid later efforts to reconstruct what was important to investors at the time. This can take the form of a formal transcript or notes from the meeting or presentation.
6. Consider a risk review before sharing the model with investors.
If resources permit, it may be beneficial to have experienced SEC enforcement counsel review the business model and related financial due diligence before disclosure to investors. In addition to identifying potential areas of weakness or exposure, a review may provide a potential advice-of-counsel defense to the company and executives, so long as all related facts are disclosed to reviewing counsel.
While these strategies seem simple, we continue to see enforcement actions aimed at the use of financial projections where some or none of the above strategies were implemented. The SEC’s announced intent to more closely police the use of projections in fundraising, as well as the aggressive positions taken by the staff in the case of TechCo and our client, counsel for greater caution.
This article is related to a Showcase CLE program that took place at the American Bar Association Business Law Section’s Fall Meeting on September 8, 2023. All Showcase CLE programs were recorded live and will be available for on-demand credit, free for Business Law Section members.
In March 2023 the United States experienced two of the largest bank failures in its history, Silicon Valley Bank (“SVB”) and Signature Bank, with the failure of First Republic Bank following shortly thereafter.[1] This article reviews aspects of these failures (mostly of SVB’s failure)—in particular, the effect of rising interest rates, including on longer-duration securities; some of the precipitating events; and whether the failures provide lessons about the regulatory tools that might have led to a different outcome. This article seeks to expand the dialogue away from a binary debate centered around questions of whether the 2023 turmoil means that policymakers should raise (or not) capital requirements and unwind (or not) tailoring of the prudential framework that was undertaken in 2018–2019—largely in response to Congress passing the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018.[2] In an era when questions about the politicization of the federal banking agencies abound, it is worth asking whether there are some policy approaches that can be pursued that avoid, and indeed are more targeted than, some of the policy questions that have become the center of political debates.[3] If achieving that perhaps aspirational goal is possible, it should allow for durable policy and redound to the benefit of finding the right balance between financial stability and economic growth and innovation.
One way to undertake this exercise is by taking a fresh look at aspects of the Dodd-Frank Act (“DFA”) that were never implemented (particularly, section 166); reviewing what the banking agencies previously said about how to capitalize unrealized losses on investment securities; and examining particular attributes of SVB’s failure. These points then can be considered through the lens of what regulators have said about how to respond to the March 2023 banking sector turmoil. Evaluations of this nature are useful because they can help inform how to design regulatory and policy responses that are targeted to address the particular lessons learned from these events.
Accordingly, this article reviews a series of approaches that could be considered to address the attributes of the March 2023 banking sector turmoil and would be less drastic and disruptive than wholesale changes to the prudential regulatory framework, including the regulatory capital standards that apply to large banking organizations. These approaches are revisiting early remediation requirements; revising how unrealized losses on investment securities are capitalized; and designing new triggers to better prepare for the resolution of large banking organizations and, in turn, to develop a more effective resolution paradigm.
By no means are these approaches intended to be presented as the exclusive or best policy approaches that may be pursued in response to the March 2023 banking sector turmoil. Instead, this article seeks to illustrate two main points: one, it is hard to say that the March 2023 turmoil demonstrates the DFA was structurally flawed, given that the agencies have not implemented key provisions of that law; and, two, it is worth considering whether there are targeted responses that would be able to address the problems that were revealed with relative efficiency.
Looking Back at Proposed, but Unadopted, Regulatory Measures
2010: Dodd-Frank Act
In response to the 2008 financial crisis, Congress passed the Dodd-Frank Act “[t]o promote the financial stability of the United States.”[4] This section discusses two of the DFA’s directives to help frame the remainder of the article: first, a study commissioned to understand the effectiveness of prompt corrective actions (“PCA”); and second, a mandate for regulations providing for the early remediation of large, interconnected financial companies facing financial distress.[5]
The PCA regime was adopted in 1992 and “implement[ed] a statutory requirement that banking regulators take specified ‘prompt corrective action’ when an insured institution’s capital falls to certain levels.”[6] As was evidenced by the crisis in 2008, however, there were fundamental weaknesses in the tools used by regulators to deal promptly with emerging issues at the time.[7] These observed weaknesses prompted a study commissioned under the DFA that, among other findings, “recommend[ed] that the bank regulators consider additional triggers that would require early and forceful regulatory action to address unsafe banking practices as well as the other options identified in the report to improve PCA.”[8] Furthermore, section 166 of the DFA was designed to address these same types of concerns.
In particular, section 166 of the DFA requires that, among other things, the Federal Reserve Board (“FRB”) prescribe regulations establishing standards for the early remediation of large, interconnected bank holding companies under financial distress.[9] In 2012, the FRB proposed a rule to implement this provision. At the time, the FRB said:
The recent financial crisis revealed that the condition of large banking organizations can deteriorate rapidly even during periods when their reported capital ratios are well above minimum requirements. The crisis also revealed fundamental weaknesses in the U.S. regulatory community’s tools to deal promptly with emerging issues. As detailed in the Government Accountability Office’s (GAO) June 2011 study on the effectiveness of the prompt corrective action (PCA) regime, the PCA regime’s triggers, based primarily on regulatory capital ratios, limited its ability to promptly address problems at insured depository intuitions. The study also concluded that the PCA regime failed to prevent widespread losses to the deposit insurance fund, and that while supervisors had the discretion to act more quickly, they did not consistently do so. Section 166 of the Dodd-Frank Act was designed to address these problems by directing the Board to promulgate regulations providing for the early remediation of financial weaknesses at covered companies.[10]
The FRB’s proposal would have required a series of early remediation triggers and requirements cascading in stringency, from level one through level four.[11] Level one, or heightened supervisory review, would have been triggered when a firm first shows signs of financial distress such that the firm is likely to experience further decline.[12] Level two, or initial remediation, would have imposed limits on capital distributions, acquisitions, and asset growth for those banks.[13] Of note, at level two, a firm’s assets would have been limited to growing by no more than 5 percent quarter-over-quarter and year-over-year. Level three, or recovery-level remediation, would have required, among other things, development of a capital restoration plan; broad limits on the ability to conduct business as usual; and, importantly, a written agreement with the FRB prohibiting capital distributions, asset growth, and material acquisitions. Furthermore, for level three, a firm would have been subject to a prohibition on discretionary bonus payments and restrictions on pay increases, and supervisors would have had the ability to remove culpable senior management and limit transactions between affiliates.[14] At level four, the FRB would have considered whether to recommend resolution for the firm.[15]
Although these measures ultimately went unadopted, when the FRB implemented the DFA’s enhanced prudential standards in 2014, the FRB said that early remediation requirements would be adopted at a later date following further study.[16] It is not clear whether such a study occurred and, if so, what it concluded.
2013: Basel III Final Rule
When the federal banking agencies began to implement the Basel III capital standards in 2012, they proposed that all banking organizations be required to include certain aspects of accumulated other comprehensive income (“AOCI”) in regulatory capital.[17] AOCI “generally includes accumulated unrealized gains and losses on certain assets and liabilities that have not been included in net income, yet are included in equity under U.S. generally accepted accounting principles (GAAP) (for example, unrealized gains and losses on securities designated as available-for-sale (AFS)).”[18] AOCI is recorded in the equity section of the balance sheet, and, therefore, unrealized losses recorded in AOCI reduce equity.[19] The agencies believed that this proposed AOCI treatment would result in “a regulatory capital measure that better reflects banking organizations’ actual loss absorption capacity at a specific point in time.”[20] In response to the proposed rule, however, the agencies received comments asserting that the proposed treatment would result in “volatility in regulatory capital” and “significant difficulties in capital planning and asset-liability management.”[21] Ultimately, the final rule allowed certain banks not subject to the Advanced Approaches capital standards (ultimately, SVB was among them) to opt out of having AOCI flow through to regulatory capital.[22]
In making this decision, the agencies noted that
while the agencies believe that the proposed AOCI treatment results in a regulatory capital measure that better reflects banking organizations’ actual loss absorption capacity at a specific point in time, the agencies recognize that for many banking organizations, the volatility in regulatory capital that could result from the proposals could lead to significant difficulties in capital planning and asset liability management. The agencies also recognize that the tools used by larger, more complex banking organizations for managing interest rate risk are not necessarily readily available for all banking organizations.[23]
2022: Financial Stability Oversight Council Annual Report
More recently, the Financial Stability Oversight Council (“FSOC”) highlighted these same risks that the agencies observed in 2013. Specifically, the FSOC cautioned in its 2022 annual report that “[i]nvestment portfolios are at risk as [interest] rates rise, . . . [and] a rapid increase in rates may decrease profitability for banks with larger shares of long duration holdings. . . .”[24]
Two charts in the report, reproduced below, highlight the FSOC’s observations. First, the FSOC illustrated that AOCI at the end of 2021 and into 2022 represented negative 15 percent of equity for large complex bank holding companies, above negative 10 percent of equity for large noncomplex bank holding companies, and less than negative 10 percent of equity for U.S. global systemically important bank holding companies (“U.S. GSIBs”).[25] These levels of negative equity sharply increased from 2020 and early 2021. In addition, the FSOC illustrated, correspondingly, that into 2022, U.S. GSIBs held over 60 percent of investment securities as held-to-maturity (“HTM”), whereas large complex and large noncomplex bank holding companies held less than 30 percent and less than 20 percent, respectively, of investment securities as HTM.[26] This illustration is corresponding because HTM securities do not flow through to AOCI; therefore, as a firm holds more HTM securities in its investment portfolio, the investment portfolio will contribute less volatility to AOCI.
Chart A
This chart shows the extent to which unrealized losses on AFS securities resulted in negative equity balances across the banking industry in 2022. Source: FSOC 2022 Annual Report. See footnote 24.
Chart B
This chart shows the percentage of investment securities classified as AFS and HTM and the stark differences in those classifications as between GSIBs, on the one hand, and large complex and large noncomplex bank holding companies, on the other. Source: FSOC 2022 Annual Report. See footnote 24.
Silicon Valley Bank
As of December 2022, just three months before SVB’s failure, SVB Financial Group (“SVBFG”), SVB’s parent holding company, had total assets of just over $200 billion and had invested nearly half those assets in HTM securities like Treasury bonds.[27] As the FRB raised interest rates, SVBFG experienced a dramatic loss in the value of its investment security portfolio; however, as noted above, under regulatory capital standards in effect at the time, this value leakage did not affect SVBFG’s regulatory capital ratios.[28] Indeed, if unrealized losses on SVBFG’s AFS and HTM portfolios had been subtracted from total balance sheet equity and total regulatory capital for accounting and regulatory capital purposes, SVBFG’s balance sheet equity and total regulatory capital would have reflected approximately negative $2.9 and negative $0.65 billion, respectively, in September 2022.[29] The chart below reflects this point.
Chart C
This chart, created by the author, shows the affect investment security losses would have had on SVBFG’s total regulatory capital and total balance sheet equity. See footnote 29.
Further, as stated in FRB Vice Chair Michael Barr’s report on the supervision and regulation of the bank:
On March 9, SVB lost over $40 billion in deposits, and SVBFG management expected to lose over $100 billion more on March 10. This deposit outflow was remarkable in terms of scale and scope and represented roughly 85 percent of the bank’s deposit base. By comparison, estimates suggest that the failure of Wachovia in 2008 included about $10 billion in outflows over 8 days, while the failure of Washington Mutual in 2008 included $19 billion over 16 days. In response to these actual and expected deposit outflows, SVB failed on March 10, 2023, which in turn led to the later bankruptcy of SVBFG.[30]
The deposit outflow on March 9, however, followed a longer, slower-motion outflow of deposits from SVB. Specifically, as reflected in the chart below, from March 31, 2022, until December 31, 2022, SVB’s average total deposits declined from approximately $191 billion to $175 billion, and SVB’s average noninterest-bearing deposits declined from $125.5 billion to $86.9 billion dollars—representing an approximately $17 billion, or 8 percent, and $38.6 billion, or 30 percent, outflow, respectively.[31] That is, the deposit outflow, particularly with respect to uninsured deposits observed in March 2023, in effect began one year prior. Said differently, it also may be possible to frame what occurred as a deposit outflow of approximately $56 billion and $80 billion dollars, respectively, over an approximately twelve-month period, rather than a $40 billion outflow in a single day.
Chart D
This chart, created by the author, shows the deposit outflows experienced by SVB over the year prior to the bank’s failure. See footnote 31.
According to congressional testimony from Federal Deposit Insurance Corporation (“FDIC”) Chairman Martin J. Gruenberg, the FDIC began developing a resolution strategy on the evening of March 9, 2023—just hours before the bank failed.[32] As has been documented rather extensively heretofore, in resolving SVB, the FDIC ultimately invoked the statutory systemic risk exception (“SRE”), which effectively allowed the FDIC to guarantee repayment of all of SVB’s deposits, whether insured or not.[33] The ability to invoke the SRE requires approval by two-thirds of both the FDIC board and the FRB, approval by the Treasury secretary, and consultation with the president.[34] Having successfully invoked this measure, on March 13, the Monday following SVB’s failure, the FDIC stated that “[d]epositors will have full access to their money beginning this morning [and] all depositors of the institution will be made whole . . . both insured and uninsured. . . .”[35] The FDIC has estimated that SVB’s failure will cost the deposit insurance fund $20 billion but noted that “[t]he exact cost will be determined when the FDIC terminates the receivership.”[36]
Select Commentary
The commentary from regulators in the wake of the March 2023 turmoil has included a diverse collection of thoughts, empirical reporting, and proposed solutions for a path forward. Some, including Barr, have focused on the need for stronger capital requirements, saying, “[B]anks with inadequate levels of capital are vulnerable, and that vulnerability can cause contagion.”[37] Others, like FDIC Director Jonathan McKernan, have focused on the idea that “an effective resolution framework [is part of] our best hope for eventually ending our country’s bailout culture that privatizes gains while socializing losses.”[38] And while the Treasury Department’s Assistant Secretary for Financial Institutions Graham Steele approves of the current focus “on the unrealized losses in banks’ available-for-sale and held-to-maturity securities as important metrics to assess a bank’s solvency,”[39] FRB Governor Michelle Bowman has observed that the recent failures rest squarely on “poor risk management and deficient supervision, not . . . a lack of capital.”[40]
Dan Tarullo, a professor at Harvard Law School and a former FRB governor, framed it this way:
I think the agencies need to be especially careful here not to overreact to the events of this spring. It’s of course critical to address the vulnerabilities that were exposed and, as I said earlier, to make sure banks that are undershooting their profit targets do not take excessive risks. But the agencies need to think through whether some ideas for increased regulation would just exacerbate the competitive problems of these banks while not efficiently containing those vulnerabilities.[41]
In the spirit of Tarullo’s comments, the discussion below reviews potential policy tools that are available to address what the spring 2023 turmoil revealed, apart from the broader and more divisive debate about capital calibration and the appropriateness of tailoring the prudential regulatory framework based on the size of a banking organization.
Policy Considerations
Revising Early Remediation
On consideration is whether the FRB should promptly implement the DFA’s early remediation requirements.
Certainly, it should be possible to look back and evaluate how such requirements could have helped avoid the use of the SRE and the hectic resolution of SVB. For example, what triggers could have required swift action as SVB experienced a slow-motion run on 8 percent and 30 percent of its average total and average noninterest-bearing deposits, respectively? If those triggers had been in place, would the March 9 run have been avoided—or at least been less of a surprise? Could triggers be designed that would have prevented the accumulation of SVBFG’s negative equity balance, described above? Or required prompt action once it had accumulated?
Of course, picking the right triggers and remedial actions is no easy task, and it is also worthwhile to avoid fighting the last battle when designing policy. Moreover, remedial actions should be designed to avoid exacerbating a firm’s deteriorating financial condition. Nevertheless, the problems the FRB described when proposing early remediation rules in 2012 (“that the condition of large banking organizations can deteriorate rapidly even during periods when their reported capital ratios are well above minimum requirements”)[42] appear to still be present and to have been a part of the reason why the SRE needed to be used in resolving SVB. Moreover, it is not clear, for example, that given the problem that section 166 is designed to address, whether higher capital requirements would avoid a similar situation in the future.
Accordingly, DFA section 166 seems like a targeted tool that can be evaluated and used to fill the regulatory gaps that March 2023 revealed. In all events, the fact that designing rules involves complicated policy judgments, such as those described above, does not seem like a reason for the agencies to avoid faithfully implementing the laws on the books.[43]
Capitalizing Unrealized Losses on Investment Securities
As also reviewed above, the agencies previously said that having AOCI flow through to regulatory capital results in a capital measure that better reflects banking organizations’ actual loss absorption capacity at a specific point in time. This prior statement appears, in hindsight, to have been correct and worth revisiting, as the agencies recently have proposed.[44] Indeed, in this regard, the way unrealized losses were treated for SVB appears to show that, at least in this respect, capital did in fact play a role in its failure, given that the negative equity position likely caused depositors to have concern about the bank’s financial condition.
That said, the agencies naturally will have to grapple with the question that they previously noted, in particular, whether “tools used by larger, more complex banking organizations for managing interest rate risk are . . . readily available for all banking organizations” and, if not, the size threshold at which having AOCI flow through to capital is not necessary.[45] Making this judgment should involve considering the size above which resolution of an institution is likely to threaten financial stability. This question, however, should not be viewed in isolation. For example, if clear and strong early remediation requirements are in place, as discussed above, and the way in which the FDIC plans for resolution, as discussed below, is enhanced, then the likelihood that the failure of even a relatively large firm would threaten financial stability should be (perhaps materially) lower.
Preparing for Resolution and Developing an Effective Resolution Framework
Another lesson from SVB’s failure is perhaps one of the more obvious—beginning the process to resolve a $200 billion bank the evening before its failure does not provide sufficient runway to conduct an orderly resolution. Thus, the natural question that follows is this: When should the FDIC begin to actively plan for resolution?
For example, if there had been triggers for the FDIC to begin to prepare—such as SVB’s deposit outflows or the dramatically large unrealized losses on SVBFG’s balance sheet and the effective result that had on equity levels—would the SRE have been needed? If the FDIC had begun to prepare for SVB’s resolution, for example, in September 2022 (when the equity balance was negative ~$2.9 billion (see Chart C)) or after year-end 2022 (with average total and average noninterest-bearing deposits down ~8 percent and ~30 percent, respectively, in twelve months (see Chart D)), would the firm’s failure have been easier to manage? Perhaps the FDIC and other regulators would have been able to use this time to identify impediments to a sale, remedy them, and be ready to sell the firm to one or more buyers over a weekend. In addition, this time could have allowed the FDIC and other regulators to evaluate the type of resolution that was best suited to the circumstances. For example, was a resolution of the bank and bankruptcy of the holding company most appropriate, or would invocation of the DFA’s Title II orderly liquidation authority have been useful?
Further, would SVB’s management and board have been spurred to act more swiftly to address the firm’s deteriorating condition if they were advised by the FDIC that the agency was beginning plans for the resolution and sale of the firm? Experience suggests that hearing that message from the FDIC is sobering for management and a board and stiffens the spine to take difficult, and perhaps previously hard to imagine, actions.
Another adjacent question is whether clear and strong early remediation requirements could have worked in tandem with earlier resolution preparedness. Of course, important questions would need to be considered, such as: What are the appropriate triggers for resolution preparedness? Which agency should be responsible for calling in the FDIC to begin that preparation?
Conclusion
All of the above policy considerations, and the others being considered by policymakers, are complex, and different solutions have associated pros and cons. Financial regulatory policy is sufficiently complex that no one proposal is ever likely to provide a magic bullet. The above, however, shows that the DFA had provisions designed to address situations like the one that transpired earlier in 2023, but those provisions were never implemented. To that end, this article aims to put forward for consideration targeted proposals for using those tools in a way that would address the vulnerabilities revealed in the spring of 2023 and would help forge a more resilient financial system—and, in doing so, hopefully avoid, as Tarullo said, an overreaction that could exacerbate broader structural problems facing the banking sector.
This article represents the views of the author, not those of his firm or any client of the firm. The author gratefully acknowledges the assistance of Jeremy R. Lee, associate at Davis Polk, in the preparation of this article. The author also would like to acknowledge with gratitude the willingness of Alex LePore to take the time to challenge and help refine the author’s policy thoughts, whether we agree or disagree, including those thoughts presented in this article.
The Economic Growth, Regulatory Relief, and Consumer Protection Act, S. 2155, 115th Cong. (2018). ↑
See David Wessel, Talking to Dan Tarullo About Bank Mergers, Stress Tests, and Supervision, Brookings (Aug. 10, 2023) (“That’s changed, as so much in the country has changed. Issues that were formerly a little bit blurred have become increasingly partisan. It’s almost as if, when people from one party have a position, there’s a reflexive instinct on people from the other party to oppose that position.”). ↑
Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010) [hereinafter DFA]. ↑
See Enhanced Prudential Standards and Early Remediation Requirements for Covered Companies, 77 Fed. Reg. 634 (proposed Jan. 5, 2012) (to be codified at 12 C.F.R. pt. 252) (“The crisis also revealed fundamental weaknesses in the U.S. regulatory community’s tools to deal promptly with emerging issues.”) [hereinafter Early Remediation Reqs.]. ↑
Recent Bank Failures and the Federal Regulatory Response: Hearing Before the S. Comm. on Banking, Hous., & Urb. Affs., 118th Cong. 7 (Mar. 28, 2023) (statement of Martin J. Gruenberg, Chairman, Federal Deposit Insurance Corporation). ↑
To this end, another of DFA’s requirements that merits revisiting is the unfulfilled obligation of the federal banking agencies to adopt rules regarding the requirement for a bank holding company or savings and loan holding company to act as a source of financial strength for any subsidiary depository institutions. See 12 U.S.C. § 1831o-1. ↑
Virtual patent marking (“VPM”) is a powerful tool with immense potential to enhance the value of patent portfolios covering products. General counsel and attorneys representing U.S. patent owners and licensees need to understand the compelling value of VPM to maximize economic and enforcement advantages and unlock monetization opportunities.
The U.S. introduced VPM in 2011, when it amended 35 U.S.C. §287. Prior to this change, “traditional marking” required listing every relevant patent on the associated article. The VPM statute enables patent owners to post a single list of numerous patents (“VPM list”) on the Internet, associating the patents with articles sold, offered for sale, or imported into the United States. Marking an Internet web address (“VPM-URL”) on patented articles allows the public to navigate to a VPM page hosting the VPM list. The VPM page gives the public legal “constructive notice” of the patents on the VPM list and easy access to understand which patents are associated with particular articles. Updating the VPM list is straightforward, eliminating numerous changes needed to molds, stamping tools, and product labels required with traditional marking. A VPM program streamlines the marking process while providing a convenient platform for patent information.
VPM programs mitigate the risks associated with false marking claims, when expired patents inadvertently linger on physical products. Revisions in 2011 to 35 U.S.C. §292 remove risk that was formerly associated with inadvertently leaving an expired patent on a product. The statute now requires that the alleged false marking was done with an “intent to deceive the public” and that a plaintiff suffer competitive injury as a result.
The VPM list should not have any barriers to access and should be kept up to date. The VPM-URL must be substantially on all associated products and continuously used to support constructive notice. Despite these requirements, the undeniable value and benefits of VPM programs make the effort worthwhile.
Typically, in a patent infringement case, a U.S. patent owner sends a letter to an accused infringer, providing “actual notice.” The date of sending this letter starts a period during which damages may be assessed after a determination of infringement. The U.S. patent owner is entitled to damages for the period from actual notice until infringement stops. Importantly, however, the period can be as little as a few days or months from the actual notice date.
In sharp contrast, using VPM, damages can be assessed for up to six years starting from the date when the VPM-URL appeared on the article and the patent and associated article first appear on the VPM list: the constructive notice date. With U.S. patent infringement damages awards approaching many tens of millions of dollars or more, the monetary value can be greatly influenced by the longest period established by the earliest constructive notice date.
Beyond U.S. litigation, in the context of business acquisitions or the acquisition of a VPM-listed patent portfolio, VPM can provide leverage for higher valuations based on earlier constructive notice dates. This is because, as discussed above, the date of constructive notice holds substantial weight in assessing the enforcement value of a U.S. patent. Thus, incorporating robust and auditable VPM programs into patent strategies presents a wide avenue to amplify value, expand monetization opportunities, and fortify IP assets.
Establishing a VPM program may seem daunting initially, but the benefits it offers through an early constructive notice date are vital to maximizing patent value. VPM management software platforms can be helpful in streamlining this process. General counsel and attorneys must grasp the multitude of benefits VPM offers and encourage adopting VPM as an integral part of ongoing patent strategies. By embracing VPM, U.S. patent owners can elevate the strength and value of their portfolios, safeguard their rights, and provide the maximum options to help navigate the complexities of the intellectual property landscape with confidence.
This article should not be construed as legal advice or legal opinion on any specific facts or circumstances. This article reflects only the personal views of the authors and not the views of the authors’ firms. Consult your patent professional regarding your specific questions.
Private equity funds (“PE funds”) have increasingly embraced carve-out transactions as a strategic maneuver to unleash untapped value within their portfolio companies and generate returns for shareholders. These transactions involve divesting non-core business units from larger enterprises, allowing PE funds to reshape and revitalize their portfolio companies with an eye towards a more profitable exit in the future. In today’s challenging economic climate, PE funds are compelled to evaluate their investments and focus on enhancing the fundamental operations of their portfolio companies.
This article explores the key features of carve-out transactions, highlights the challenges that selling PE funds must anticipate and navigate, and provides insights for improvement and accuracy.
Structuring
Structuring a carve-out transaction is complex, as it entails separating and disposing of a business integrated within the seller’s operations. Selling PE funds must carefully consider the impact of the sale on the retained business enterprise and plan accordingly. Carve-outs can involve the disposal of subsidiaries, business divisions, or specific assets of the portfolio company. In the public market, carve-outs can take the form of a spin-off transaction accomplished through a statutory plan of arrangement.
In addition to tax considerations, PE funds must analyze the operational complexities associated with disentangling shared business functions such as IT systems, supply chains, and human resources. Developing a comprehensive plan to address these challenges is crucial.
Separation of the Target Business
Carve-outs typically require corporate reorganization to separate the target business before completing the transaction. The selling PE fund collaborates with the buyer to identify which assets, liabilities, and contracts are part of the deal and which ones will remain with the retained business. This task becomes particularly complex when the divested business is intertwined with the operations of the corporate parent. PE funds must gain a thorough understanding of shared services, historical cost allocations, and the costs involved in replacing these services going forward. Despite the challenges posed by negotiating terms while the management team is in sell-side mode, effective coordination between the buyer and the management team during the due diligence process is vital. The purchase agreement should include a “sufficiency of assets” representation to ensure the buyer has recourse if they discover that they did not acquire all the necessary assets for the business. While transitional services agreements can temporarily bridge post-closing gaps, pre-closing preparations may be required to ensure that the divested business is ready to operate independently.
A common approach involves spinning off assets, liabilities, and contracts into a newly formed subsidiary, whose shares are subsequently sold to the buyer. Carve-out buyers often seek a thorough understanding of the separation process, contemplating whether the target business will operate as a standalone entity or integrate into the buyer’s group post-closing. The separation process presents structural complexities, including shared key assets or contracts that require transfer, assignment, replacement, or partial termination prior to or in connection with closing. Some contracts and certain types of assets may necessitate third-party consent for transfer or assignment, which can be time-consuming or result in stranded assets if consent is unattainable.
To ensure an orderly and efficient separation, the parties usually incorporate a reorganization step plan into the definitive transaction documentation, aligning all stakeholders on the process. Effective implementation of the reorganization plan is often a condition precedent to closing the carve-out transaction. The definitive agreement may also include “wrong pocket” provisions to ensure assets inadvertently transferred from either the target or retained business are returned to the appropriate entity after closing.
Financial Statements
Availability of financial statements for the target business is critical in pricing a carve-out transaction, just as in any M&A deal. Carve-out financial statements serve as a key aspect of due diligence for the buyer and are essential for the buyer’s capital-raising efforts. However, in some cases, there may be no financial reporting at the target business level, or the consolidated financial information provided by the seller may lack sufficient clarity, particularly where standalone audited or unaudited financial statements are required to secure debt financing. Consequently, preparing suitable financial statements for the target business becomes a significant undertaking for selling PE funds in any carve-out transaction.
Carve-out accounting—as well as determining assets, liabilities, revenues, costs, and expenses attributable to the target business—can be a complicated and time-consuming process, often impacting the transaction timeline.
Pricing the Target Business
Pricing the target in the carve-out transaction requires careful consideration to avoid potential “leakage” due to a number of factors, such as intercompany transfers. Various valuation methods such as discounted cash flow analysis, comparable company analysis, and precedent transactions analysis can be utilized. These methods help establish a fair and reasonable purchase price based on the financial performance, growth prospects, and market dynamics of the target business.
Buyers will look to conduct extensive due diligence to evaluate the financial information provided by the seller, understand intercompany arrangements, and assess the impact on the value of the target business. Negotiations revolve around leakages and potential adjustments to ensure a fair and equitable transaction. Sellers should be prepared for post-closing inquiries to verify compliance with the agreed-upon terms and conditions.
Addressing Employment Matters
Addressing which employees should be transferred to the target in carve-outs can be complex, especially when employees are entangled within the seller’s other business units. Determining which employees will transfer with the divested business, the process of transferring employees, and the treatment of compensation and benefits all require careful planning and analysis. Human resources matters become simpler when the divested business is already operating as a standalone entity with its own employees and subsidiary.
IP and IT Considerations
Carve-outs involving intellectual property (“IP”) assets present challenges in allocating and sharing those assets. Specificity in identifying IP assets and establishing favorable transition services and licensing arrangements can supplement the default allocation standard. Shared IP assets need to be addressed in deal documents, considering the need for one-way licenses or cross-licenses to ensure freedom to operate for both parties. Commercial arrangements for shared IP rights may also be necessary for ongoing dealings between the seller and the divested business.
Data transfer and protection are critical in carve-outs, with careful consideration given to the transfer and sharing of data post-closing. A significant portion of the value of the target business may be tied to data; therefore, the buyer will need to understand what data it requires and how it can ensure it will receive the data. This may include pricing information or customer records, which could include personal information. Compliance with data protection laws, contractual obligations, and cybersecurity concerns should be addressed. Thoroughly reviewing obligations regarding data confidentiality and restrictions on transferring or sharing data is vital. The transaction documents, particularly the transitional services agreement, should establish clear responsibilities for data compliance, remediation of breaches, and liability allocation.
Tax
Tax considerations play a significant role in multi-jurisdictional carve-outs, requiring close collaboration with tax advisors to ensure compliance with local tax obligations. Transfer taxes, value-added taxes, and indirect capital gains taxes should be assessed and addressed in the acquisition agreement, as liability for these taxes can vary.
Transitional Services
Upon completing a carve-out transaction, the unwinding of internal services such as legal, accounting, procurement, licensing, and human resources from the retained business requires careful planning and execution. The parties often negotiate a post-closing transition phase to facilitate this process. Offering transitional services from the outset can expand the pool of potential buyers and maximize the exit value for selling PE funds. However, providing transitional services may burden the management team of the retained business and require their careful attention.
Finding the right balance between providing transitional services and ensuring operational efficiency in the retained business is crucial. Clear delineation of responsibilities, establishing timelines, and effective communication between the parties are essential for a smooth transition and minimizing disruptions.
Conclusion
At a strategic level, PE funds often turn to carve-out transactions in an effort to focus on the portfolio company’s core assets, boost its value proposition for a subsequent exit, improve operational agility, or to simply raise cash in order to shore up the balance sheet. Historically, we have seen carve-out transactions account for a significant percentage of overall deal activity, and this trend is expected to continue in the face of recent supply chain disruptions and difficult economic conditions. While carve-outs often require careful due diligence, strategic planning, and effective execution, they present PE funds with a viable avenue for growth, value creation, and liquidity.
A much-publicized 2003 KPMG survey concluded that nearly 70 percent of mergers and acquisitions (“M&A”) (in various verticals) did not achieve the acquiring companies’ management goals.[1] The key to success in this regard is due diligence. Appropriately conducted due diligence serves a variety of functions, including (1) identifying issues that may reduce the price of the target company;[2] (2) identifying the value and sustainability of product technologies, their threats, and improvement opportunities;[3] (3) identifying possible opportunities for investment;[4] (4) validating existing contracts, approvals, registrations, etc.;[5] (5) identifying the appropriate warranties and indemnities,[6] and (6) assisting in developing the sale and purchase agreement.[7]
While due diligence can serve a variety of goals, the process will often need to be customized for the type of organization being acquired. Specifically, we will focus on the regulatory and compliance due diligence process in the context of companies regulated by the Food and Drug Administration (“FDA”).
Noncompliance Issues and Due Diligence
An acquiring company is expected by the Criminal Division of the Department of Justice (“DOJ”) to perform appropriate due diligence to uncover compliance issues prior to merging with or acquiring a target. A company’s failure to comply with requirements can result in financial penalties, legal actions, damaged reputation, and loss of profit—and it could even extend to criminal charges in severe cases.
If a transaction continues when noncompliance is discovered, the acquirer should consider appropriate self-disclosure to the DOJ and, if appropriate, other agencies such as the Office of Inspector General (“OIG”), Federal Trade Commission (“FTC”), Office for Civil Rights (“OCR”), and FDA in order to minimize or avoid civil and criminal liability, as well as address the complexity and potential financial/criminal fallout.
DOJ Guidance
The DOJ’s updated guidance from March 2023, Evaluation of Corporate Compliance Programs, clarifies its expectations involving “pre-M&A due diligence.” The DOJ believes that “[t]he extent to which a company subjects its acquisition targets to appropriate scrutiny is indicative of whether its corporate compliance program is . . . able to effectively enforce its internal controls and remediate misconduct at all levels of the organization.”[8] To that end, the DOJ expects the following:
An acquirer must complete pre-acquisition due diligence and look to identify misconduct or the risk of misconduct. The due diligence should be conducted by appropriately qualified, appropriately empowered individuals with experience working with FDA-regulated companies.
The compliance function is an integral part of the M&A process.
The target company is evaluated for misconduct and its policies and procedures scrutinized to avoid and address compliance issues.
Noncompliant Companies and Individuals
Noncompliance with Department of Health and Human Services (“HHS”), FDA, and/or other agency expectations may result in a variety of punitive measures, including fines, exclusion from federal health-care programs, and even criminal prosecution. Companies may be a party to various agreements with the government that require a demonstration of ongoing compliance.
Failure to comply with FDA requirements can result in warning letters, product seizures, injunctions, and civil or criminal penalties. For more severe or persistent violations, the FDA may also withdraw product approvals, effectively barring a product from the market. This can lead to substantial financial loss and damage to the company’s reputation.
Both individuals and companies may be temporarily or permanently excluded from participation in federal health-care programs, which can be the death knell for a business or a career killer for an individual.[9] Additionally, the FDA can sue the responsible corporate official for a first-time misdemeanor (and possible subsequent felony) under the Federal Food, Drug, and Cosmetic Act[10] without proof that the corporate official acted with intent or even negligence—and even if such corporate official did not have any actual knowledge of, or participation in, the specific offense.[11]
Reasons Due Diligence May Be Limited
Due diligence is a crucial step in informed decision-making; however, there may be various factors that limit the comprehensiveness of a due diligence review. This endangers the chances of successful outcomes in any business transaction or strategic decision.
Time Restrictions: Due diligence is a comprehensive but time-consuming process. However, business deals and strategic decisions often operate within strict time frames, and this pressure to meet deadlines can restrict the depth and breadth of the due diligence process. Rushed due diligence may result in overlooked details, incomplete analysis, and uninformed decision-making.
Cost Restrictions: Due diligence can also be a costly process that requires the use of external experts or consultants in areas like law, finance, environment, technology, and more. An investor with a limited budget can limit the investigation, causing corners to be cut. This can result in a failure to identify risks or opportunities.
Client Instructions: An attorney conducting due diligence can potentially be limited by the client’s specific instructions. The client may only want certain areas to be investigated or may not wish to dive too deeply into certain aspects of the organization for a variety of reasons, including already available information, perceived insignificance of certain aspects, or the desire to maintain good relations during a merger or acquisition process. Such instructions can limit the comprehensiveness of the due diligence process.
Specifics of the Operation in Question: The nature and specifics of the operation or deal in question can also limit due diligence. For instance, in some cases, the information might be highly sensitive or classified, making it difficult to access. In other cases, the operation might be in a niche or highly specialized field, where expertise is limited or the benchmarks for evaluation are not well-defined. In such cases, despite best efforts, the due diligence process may be inherently limited.
Phase I: Initial Investigation
During the initial request for documents, it is important to set the stage and develop an initial scope of review. In the context of life sciences due diligence scope development, you must consider outlining the metes and bounds of the scope. Working with an experienced FDA regulatory and/or compliance attorney can help you make sure that your scope is all-encompassing and that you have evaluated all possible areas of compliance.
A possible scope for a due diligence audit for a drug company (“Company”) being purchased by a private equity firm, particularly focusing on FDA and HHS compliance issues, may read as follows:
This due diligence process will provide an assessment snapshot of the potential regulatory risks, liabilities, and compliance gaps for the Company. This due diligence will
confirm the validity of the Company’s product approvals;
obtain and review the listing of the Company’s ongoing clinical trials;
briefly review the safety (including adverse event reports) and efficacy data of the Company’s products in question;
briefly review the Company’s quality-control processes, including in the context of its manufacturing practices, labeling, advertising practices, and health-care fraud and abuse issues; and
briefly evaluate the company’s adherence to the Health Insurance Portability and Accountability Act (“HIPAA”) and other HHS regulations related to patient privacy and data security.
Regulatory Strategy
Once a scope of review has been established, consider beginning by looking at the core regulatory strategy for the target company’s products. Review company registrations at both the federal level (including facility, product, and clinical trial registrations) and the state level. At the state level, make sure to examine manufacturer/distributor licenses, sales representative licenses, and more.
Internal Investigation
During your internal investigation, make sure to review the company’s organization chart along with names, titles, and job descriptions of individuals to gain a clear understanding of the company’s internal structure, its decision-making process, and the responsibilities of key personnel.
After this initial phase, request and review standard operating procedures (“SOPs”), work instructions, and records of training on procedures to gain critical insight into the company’s day-to-day operations, processes, and quality-control measures.
Audits and Inspections
Acquirers may find it useful to review the target’s internal and external audit/inspection records for the past two to five years. Records may include quality-control records and details on how adverse events are handled. External inspections, on the other hand, often involve FDA audits, which assess the operation’s adherence to regulatory standards. By reviewing these inspection records, you can identify potential areas of focus for further inquiry.
As requested by the DOJ, utilize an experienced professional to review the existing corporate compliance program,[12] and consider reviewing voluntary disclosures made by the company.[13] Particularly noteworthy is the review of employment agreements, which should ideally include clawback provisions in line with the March 2023 DOJ Criminal Division recommendations.[14]
Moreover, depending on the organization and the acquirer’s desire for audits, the review may extend to matters related to the Foreign Corrupt Practices Act (“FCPA”). This involves identifying areas of potential interest or concern, considering the company’s interactions with foreign officials, and assessing the risk of bribery or corruption.
Phase II: Response Evaluation
After gathering an initial list of inspection and audit findings related to regulation by entities such as the FDA, DOJ, and OCR, as well as state and local law authorities, the next step is to assess the actions taken by the company to address the adequacy of these findings. This involves reviewing trainings, SOP changes, remediation plans, enacted corrective actions, and other steps that the company has taken in response to quality inspections and/or regulatory findings. Look for evidence that the company made swift, substantive, permanent changes that address not only the immediate issue but also future issues in similar situations. This is an area in which it can be especially helpful for an FDA regulatory and compliance attorney to benchmark the target company’s remediation processes and procedures against others in the industry.
As an investor, the goal is to demonstrate that there is an effective quality and compliance program in place—and that the quality and compliance program can catch errors and fix them. Past performance in this regard can not only result in a more valuable company but also be indicative of a future ability to navigate compliance challenges.
Final Report
Upon completion of the due diligence review, just as with most other due diligence reviews, it is ideal to prepare a comprehensive summary of findings. This summary will detail the research conducted, the findings obtained, the limitations encountered during the review process, and any recommendations for improving the operation. The aim of this summary is not just to present a snapshot of the current state of affairs but also, importantly, to provide actionable insights that can help mitigate risks and enhance overall operational efficiency. Ideally, you should also list the scope of the audit and limitations thereof.
Conclusion
Conducting a meticulous regulatory and compliance due diligence review process is integral to understanding the compliance landscape of a company. This review process encompasses a wide range of steps, including understanding the regulatory strategy; inspecting internal and external audits; evaluating privacy issues, corporate compliance, and state and local registrations; and evaluating the steps taken to remedy any findings by entities such as the FDA, DOJ, and OIG, as well as assessing any outstanding issues that remain. An individual well versed in FDA-, DOJ-, and OIG-related due diligence can be an indispensable tool in this assessment.
