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.

1. 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. ↑

2. 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.

1. Press Release, Fed. Deposit Ins. Corp., FDIC Creates a Deposit Insurance National Bank of Santa Clara to Protect Insured Depositors of Silicon Valley Bank, Santa Clara, California (Mar. 10, 2023); Press Release, Fed. Deposit Ins. Corp., FDIC Establishes Signature Bridge Bank, N.A., as Successor to Signature Bank, New York, NY (Mar. 12, 2023); Press Release, Fed. Deposit Ins. Corp., JPMorgan Chase Bank, National Association, Columbus, Ohio Assumes All the Deposits of First Republic Bank, San Francisco, California (May 1, 2023). ↑

2. The Economic Growth, Regulatory Relief, and Consumer Protection Act, S. 2155, 115th Cong. (2018). ↑

3. 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.”). ↑

4. Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010) [hereinafter DFA]. ↑

5. See id. §§ 202(g), 166. ↑

6. Press Release, Fed. Deposit Ins. Corp., FDIC Adopts Final “Prompt Corrective Action” Rule (Sept. 15, 1992). ↑

7. 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.]. ↑

8. U.S. Government Accountability Off., GAO-11-612, Bank Regulation: Modified Prompt Corrective Action Framework Would Improve Effectiveness (2011). ↑

9. DFA § 166. ↑

10. Early Remediation Reqs., 77 Fed. Reg. at 634. ↑

11. Id. ↑

12. Id. at 637. ↑

13. Id. ↑

14. Id. at 638. ↑

15. Id. ↑

16. Press Release, Fed. Rsrv., Federal Reserve Board Approves Final Rule Strengthening Supervision and Regulation of Large U.S. Bank Holding Companies and Foreign Banking Organizations (Feb. 18, 2014). ↑

17. Regulatory Capital Rules, 78 Fed. Reg. 62,020, 62,022 (Oct. 11, 2013). ↑

18. Id. at 62,024. ↑

19. Id. ↑

20. Id. at 62,060. ↑

21. Id. ↑

22. Id. ↑

23. Id. at 62,027. ↑

24. Fin. Stability Oversight Council, Annual Report 36–39 (2022). ↑

25. Id. ↑

26. Id. ↑

27. See Michael S. Barr, Bd. of Governors of the Fed. Rsrv. Sys., Review of the Federal Reserve’s Supervision and Regulation of Silicon Valley Bank 22–23 (2023). ↑

28. Id. at 87. ↑

29. SVB Fin. Grp., Quarterly Report (Form 10-Q) (May 6, 2022); SVB Fin. Grp., Quarterly Report (Form 10-Q) (Aug. 8, 2022); SVB Fin. Grp., Quarterly Report (Form 10-Q) (Nov. 7, 2022); SVB Fin. Grp., Annual Report (Form 10-K) (Feb. 2, 2023). ↑

30. Barr, supra note 29, at 4. ↑

31. SVB Fin. Grp., Annual Report (Form 10-K). ↑

32. 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). ↑

33. Press Release, Fed. Deposit Ins. Corp., FDIC Acts to Protect All Depositors of the Former Silicon Valley Bank, Santa Clara, California (Mar. 13, 2023). ↑

34. Cong. Rsch. Serv., IF12378, Bank Failures: The FDIC’s Systemic Risk Exception (Apr. 11, 2023). ↑

35. Press Release, supra note 37. ↑

36. Press Release, Fed. Deposit Ins. Corp., First–Citizens Bank & Trust Company, Raleigh, NC, to Assume All Deposits and Loans of Silicon Valley Bridge Bank, N.A., from the FDIC (Mar. 26, 2023). ↑

37. Press Release, Fed. Rsrv. & Fed. Deposit Ins. Corp., Statement by Vice Chair for Supervision Michael S. Barr (July 27, 2023). ↑

38. Jonathan McKernan, Member, Fed. Deposit Ins. Corp. Bd. of Dirs., Statement on Resolution of First Republic Bank (May 1, 2023). ↑

39. Graham Steele, Assistant Sec’y for Fin. Insts., U.S. Dep’t of the Treasury, Remarks at the Americans for Financial Reform Education Fund (July 25, 2023). ↑

40. Press Release, Fed. Rsrv., Statement by Governor Michelle W. Bowman (July 27, 2023). ↑

41. Wessel, supra note 3. ↑

42. Early Remediation Reqs., supra note 7, at 601. ↑

43. 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. ↑

44. See Fed. Rsrv., Notice of Proposed Rulemaking: Regulatory Capital Rule: Amendments Applicable to Large Banking Organizations and to Banking Organizations with Significant Trading Activity (July 27, 2023). ↑

45. Regulatory Capital Rules, 78 Fed. Reg. 62,027 (Oct. 11, 2013). ↑

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:

1. 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.
2. The compliance function is an integral part of the M&A process.
3. 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.

1. 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.
2. 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.
3. 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.
4. 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

1. confirm the validity of the Company’s product approvals;
2. obtain and review the listing of the Company’s ongoing clinical trials;
3. briefly review the safety (including adverse event reports) and efficacy data of the Company’s products in question;
4. 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
5. 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.

1. Susan Bain, “Regulatory” Due Diligence: A Survey Investigation of Best Practices in the Medical Products Industry (Aug. 2011) (DRSc dissertation, University of Southern California). ↑

2. Peter Howson, Due diligence: The Critical Stage in Mergers and Acquisitions 8 (Gower Publishing, Ltd. 2003). ↑

3. Id. ↑

4. Id. ↑

5. Id. ↑

6. Id. ↑

7. Id. ↑

8. Criminal Div., U.S. Dep’t of Just., Evaluation of Corporate Compliance Programs 8 (updated Mar. 2023). ↑

9. FDA Debarment List (Drug Product Applications), FDA.gov (updated Aug. 3, 2023). ↑

10. Pub. L. No. 75-717, 52 Stat. 1040. ↑

11. United States v. Park, 421 U.S. 658 (1975). ↑

12. Criminal Div., U.S. Dep’t of Just., Evaluation of Corporate Compliance Programs (updated Mar. 2023). ↑

13. Criminal Div., U.S. Dep’t of Just., Voluntary Self-Disclosure Policy (last reviewed Aug. 2023). ↑

14. Criminal Div., U.S. Dep’t of Just., Regarding Compensation Incentives and Clawbacks, (updated Mar. 2023). ↑

The Federal Trade Commission (FTC) and Department of Justice (DOJ) jointly issued new Draft Merger Guidelines on July 19, 2023.^[1] The Draft Merger Guidelines were created with the goal “to better reflect how the agencies determine a merger’s effect on competition in the modern economy and evaluate proposed mergers under the law.” There are significant changes from the current guidelines both substantively and in form. These changes are consistent with the Biden Administration agencies’ public statements and reflect the FTC’s and DOJ’s approach to merger investigations and enforcement actions over the last two years. The draft is subject to a sixty-day comment period that closes on September 18.

The changes come on the heels of the agencies’ proposal on June 27 to update the premerger notification form under the Hart-Scott-Rodino (HSR) Act. The proposed form update, the first of its kind in forty-five years, would substantially increase the time, effort, and cost of making the filings of buyers and sellers.^[2] The FTC notice estimates that HSR filings would require an average of 144 hours to prepare as compared to the current average of thirty-seven hours. If the proposed changes are adopted, the FTC estimates that “complex” filings would require approximately 259 hours to complete. Many of the proposed changes appear aimed at providing substantial additional information related to the types of harm underlying the Draft Merger Guidelines.

Broadly, the draft confirms the agencies’ interest in increased enforcement, particularly in tech and labor markets; decreased mergers; skepticism regarding merger-related efficiencies; concern for nascent competitors; distrust of “big”; and preference for organic growth.

To better understand the proposed changes to the Merger Guidelines, we highlight some of the most significant changes below.

Reducing the threshold for a presumption of anticompetitive effects

Guideline 1 lowers the threshold for determining when a transaction results in a “highly concentrated market” to the level used by the guidelines issued in the 1980s and 1990s. Guideline 1 describes the use of the Herfindahl-Hirschman Index (“HHI”) to calculate market concentration. The HHI sums the squares of the market share of each competitor in the market. Under the 2010 merger guidelines, “[b]ased on their experience, the Agencies classif[ied] markets” with an HHI over 2,500 as “highly concentrated.” Transactions resulting in highly concentrated markets that involved an increase of more than 200 points were presumed to be likely to enhance market power.

Pursuant to draft Guideline 1, the agencies not only reduce the standard for a “highly concentrated” HHI to 1,800 from 2,500, but they also reduce the level of the post-transaction delta from 200 to 100. Accordingly, mergers in markets with HHIs greater than 1,800 and an increase of greater than 100 “cause[] undue concentration and trigger[] a structural presumption that the merger[s] may substantially lessen competition or tend to create a monopoly.”

Another change is the addition of the “structural presumption” that mergers leading to a market share in excess of 30 percent are illegal.

Creating a dominance concept under U.S. law

Dominance is not a concept enshrined in U.S. antitrust law, but it has been a part of merger analysis in Europe. Guideline 7 seeks to discourage any transaction that makes it harder for remaining competitors to compete. The guideline suggests a firm could be treated as “dominant” with a market share as low as 30 percent and also indicates that transactions that might increase switching costs, interfere with use of competitive alternatives, deprive rivals of economies of scale, eliminate a nascent competitive threat, or “in any other way” entrench the combined firm’s position could be challenged. The agencies will view any merger involving a dominant firm with intense scrutiny.

Focus on mergers that “further a trend” towards market concentration

Guideline 8 declares that the agencies will now scrutinize mergers in markets that have been trending toward concentrated, and thereby the proposed transaction may substantially lessen competition. The guideline sets forth two factors to establish this trend: (1) if a market has shown a history of consolidation, such as a market with an HHI exceeding 1,000 and approaching 1,800, or (2) if the merger would increase the rate of concentration, such as increases in HHI over 200.

Adding examination of serial acquisitions as a whole

Guideline 9 notes that the agencies have created another pathway to target mergers that might, in the past, have evaded agency scrutiny: challenging a pending transaction based on past lawfully consummated mergers and company documents reflecting a strategy of growth through acquisition. Specifically, if either of the parties has a pattern or strategy of consolidation through acquisition, the agencies will examine the impact of the cumulative strategy to determine if that strategy may substantially lessen competition or tend to create a monopoly. If the agencies find that the strategy or acquisition history of a firm is suspect, they may combine multiple acquisitions for the purposes of their analysis of other indicia of lessening competition. Many interpret Guideline 9 as a reflection of skepticism of private equity transactions.

Suggesting increased enforcement of mergers involving multi-sided platforms

In another warning shot at the tech industry, the agencies made clear in Guideline 10 that anticompetitive effects on a single platform may make a merger illegal. The agencies view such platforms as markets themselves and platform operators as having conflicts of interest to the extent they use their platform to sell products. Thus, a merger between a platform operator and a seller of goods who uses the platform will attract the attention of the agencies even if the merger would be totally innocuous if viewed only in the market of the products sold by the acquired seller.

Considering impacts on labor markets

Guideline 11 confirms that the agencies will consider labor markets as they would other supply markets in analyzing mergers, where employers are competing buyers for labor. When assessing the degree to which the merging firms compete for labor, the agencies will consider whether the merger may result in lower wages or slowed wage growth, worse benefits or working conditions, or any other degradation of workplace quality.

Market definition: Considering bundling

The agencies stated in an appendix detailing how they define markets that they will consider bundled products in a single relevant market, even if such conduct would not violate Section 2 of the Sherman Act. Bundling is conditioning the sale of a product in one market on the sale of a product in another market, or otherwise linking the sales of two products. By considering bundled products together, the agencies may be able to find that firms exceed the thresholds described above based on control of products outside the market directly affected by the transaction.

Efficiencies: Relegated to the appendix

While the current guidelines give an explanation of how efficiencies may “enhance the merged firm’s ability and incentive to compete, which may result in lower prices” and other consumer benefits, the proposed guidelines are less clear on the impact of efficiencies to the agencies’ analysis. The relevant section (IV.3.) begins with a quote from United States v. Philadelphia Nat’l Bank that “possible economies [from a merger] cannot be used as a defense to illegality.” 374 U.S. 321, 371 (1963). It goes on to identify certain “cognizable efficiencies” which “must be of sufficient magnitude and likelihood” to “prevent the creation of a monopoly.”

***

In sum, the draft Merger Guidelines should provide greater transparency to businesses considering acquisitions and enshrine evolving FTC and DOJ policies that have increased the risk of merger investigations and enforcement actions under the current administration.

Appendix of Significant Form Changes

• Parties. Identification of entities within the ultimate parent entity (UPE) or acquired entity, minority shareholders, and other non-controlling entities, and create new requirements to identify certain other interest holders that may exert influence, as well as officers, directors, and board observers.
  • Organize the list of entities held by the UPE or acquired entity by operating company, and for each such operating company or business, provide d/b/a(s) and f/k/a(s) within the three years preceding filing.
  • For the acquiring UPE, report minority holders of (1) the acquiring entity, (2) any entity directly or indirectly controlled by the acquiring entity, (3) any entity that directly or indirectly controls the acquiring entity, and (4) any entity within the acquiring person that has been or will be created in contemplation of, or for the purposes of, effectuating the transaction. For entities affiliated with a master limited partnership, fund, or investment group, the “doing business as” or “street name” of that group would also be required.
  • For the acquiring UPE, identify certain individuals (other than employees) or entities that, in relation to the acquiring entity or any entity it directly or indirectly controls or is controlled by, who (i) provide credit in conjunction with or result of the transaction, provided credit totaling 10% or more of the value of the entity; or (ii) are holders of non-voting securities, warrants, or options would be limited to those the value of which equals or exceeds 10% of the entity or could be converted to 10% or more of the voting securities or non-corporate interests of the company.
• Officers, Directors, and Board Observers. Identify the officers, directors, and board observers (or in the case of unincorporated entities, individuals exercising similar functions) of the acquired entity(s) and entities within acquiring person(s), as applicable, for the prior two years, and for each individual, identify any other companies for which those individuals would serve or have served during the prior two years as officers, directors, or board observers. Provide the same information for the prospective officers, directors, or board observers of the acquired and acquiring entities after the transaction, as well as for any officers, directors, or board observers of new entities created as a result of the transaction (and, in each case, for unincorporated entities, individuals serving those functions). If it would be impossible to identify the specific officers, directors, and board observers, filers should describe who would have the authority to choose them.
• Transaction Information. The acquiring UPE will be required to briefly describe the business operations of all entities within the acquiring person to provide a clear overview of all aspects of the acquiring person’s pre-transaction business.
  • The acquiring and acquired person will be required to submit a narrative describing all strategic rationales for the transaction, including, those related to competition for current or known planned products or services that would or could compete with a current or known planned product or service of the other reporting person, expansion into new markets, hiring the sellers’ employees (so-called acqui-hires), obtaining certain intellectual property, or integrating certain assets into new or existing products, services or offerings. Also, identification of which documents submitted with the HSR filing support the rationale(s) described in the narrative.
  • Provide a diagram of the deal structure along with a corresponding chart that would explain the relevant entities and individuals involved in the transaction.
• Agreements and Timeline. Require filing persons to produce (i) all agreements, inclusive of schedules, exhibits, and the like, that relate to the transaction, regardless of whether both parties to the transaction are signatories; (ii) all agreements between any entity within the acquiring person and any entity within the acquired person in effect at the time of filing or within the year prior to the date of filing, including but not limited to, licensing agreements, supply agreements, non-competition or non-solicitation agreements, purchase agreements, distribution agreements, or franchise agreements; and (iii) narrative timeline of key dates and conditions for closing.
• Competition and Overlaps. In addition to the transaction-related documents currently required under Item 4(c) and 4(d) prepared by or for officers and directors, filing persons would also need to submit (i) documents prepared by or for supervisory deal team lead(s) and (ii) drafts of responsive transaction-related documents if that document was provided to an officer, director, or supervisory deal team lead(s).
  • Periodic Plans and Reports. Submission of (i) semi-annual and quarterly plans and reports that discuss market shares, competition, competitors, or markets of any product or service that is provided by both the acquiring person and acquired entity, if those documents were shared with a chief executive of an entity involved in the transaction, or with certain individuals who report directly to a chief executive; and (ii) all plans and reports submitted to the board of directors (or, in the case of unincorporated entities, individuals exercising those functions) that discuss market shares, competition, competitors, or markets of any product or service that is provided by both the acquiring person and acquired entity.
  • Submission of an organizational chart(s) reflecting the position(s) within the filing person’s organization held by identified authors, and for privileged documents, the recipients of each document submitted with the HSR filing. Identification of the individuals searched for responsive documents.
• Competition Analysis. Each filing person would be required to list each current or known planned product or service that competes with (or could compete with) a current or known planned product of the other filer. For each such overlapping product or service, the filing person would provide sales, customer information (including contacts), a description of any licensing arrangements, and any non-compete or non-solicitation agreements applicable to employees or business units related to the product or service.
• Supply Relationships. Filing persons would report (i) sales to the other filing person and to any other business that, to the best of the filing person’s knowledge, uses its product, service, or asset as an input for a product or service that competes or is intended to compete with the other filing person’s products or services; (ii) information (including contact information and a description of the supply agreement) for other customers that use the product, service, or asset to compete with other filing person; (iii) similar information for purchases made from the other filing person and from any other business that, to the best of the filing person’s knowledge, competes with the other filing party to provide a substantially similar product, service, or asset.
• Labor Markets. Filers would need to classify their workers into occupational categories based on the Standard Occupational Classification (SOC) system, list the five largest categories of workers by the relevant 6-digit SOC classification, provide the total number of employees for each 6-digit code identified, and identify any penalties or findings that were issued against the acquiring person or acquired entity by the U.S. Department of Labor’s Wage and Hour Division, the National Labor Relations Board, or the Occupational Safety and Health Administration during the five-year period before the filing.
  • For each of the five largest SOC codes in which both parties employ workers, the filing persons would be required to list the overlapping Economic Research Service’s Commuting Zones from which the employees commute and the total number of employees within each commuting zone.
• NAICS Information. Filing persons would need to (i) list every NAICS code that describes the products or services offered and use end notes as needed to clarify selections and any potential overlap where the same revenues are reported in more than one NAICS code; (ii) require acquiring persons and acquired entities with more than one operating company or unit to identify which entity(s) derives revenue in each code; (iii) acquiring person would be required to identify any NAICS codes for products and services under development if those codes would overlap with the codes for current or known pipeline products or services of the acquired entity(s); and (iv) acquired person would identify the NAICS codes that would apply to the products or services of the acquired entity(s) that are under development or pre-revenue and anticipated to have annual revenue totaling mo re than $1 million within the following two years.
• Minority-Held Entity Overlaps. List all the minority-held entities of the acquiring person and its associates or acquired entity (as appropriate) and proposes once again to require identification of those that, to the filing person’s knowledge or belief, would derive revenue in the same NAICS codes or have operations in the same industry as the other filing person.
• Prior Acquisitions. Both the acquiring person and the acquired entity will be required to provide information about prior acquisitions for the previous ten years and eliminate the threshold for listing prior acquisitions, which currently limits reporting to only acquisitions of entities with annual net sales or total assets greater than $10 million in the year prior to the acquisition.
• Foreign Subsidies. Persons making an HSR filing would be required to disclose information about foreign subsidies from countries or entities that threaten U.S. strategic or economic interest.
• Defense Information. Both the acquiring and acquired person would identify whether they have existing or pending defense or intelligence procurement contracts, as defined by 10 U.S.C. 101(a)(6) and 50 U.S.C. 3033(4), valued at $10 million or more, and provide identifying information about the award and relevant DoD or IC personnel.
• Document Preservation. Filers would need to identify and list all communications systems or messaging applications on any device used by the acquiring or acquired person (as appropriate) that could be used to store or transmit information or documents related to its business operations and affirm that all necessary steps have taken to prevent destruction of documents and information related to the transaction, include suspension of auto-deletion protocols.
• Foreign Filings. Require parties to identify the foreign jurisdictions where each has already filed or is preparing notifications to be filed as well as a list of the jurisdictions where it has a good faith belief it will file.

1. The first merger guidelines were issued by the DOJ, Antitrust Division, in 1968. Different iterations of have been revised and refined in 1982, 1984, 1992, 1997, and 2010. ↑

2. A summary of many of the key changes to the form is provided as an appendix here. ↑

This case,^[1] heard before the U.S. District Court for the District of Columbia (“the court”), concerns the enforcement of an arbitral award against the Republic of Djibouti in favor of Doraleh Container Terminal SA (“DCT”), arising out of a dispute over the development and operation of a port. Parties entered into a Concession Agreement where DCT agreed to build and develop a new international container terminal on the Red Sea in Doraleh, Djibouti, in exchange for DCT’s exclusive right to handle container shipping in Djibouti and payment of royalties. The agreement also provided for arbitration of any dispute between the parties in London under London Court of International Arbitration (LCIA) Rules if it could not be amicably settled. 

A dispute arose, Djibouti commenced arbitration, DCT made a counterclaim, and ultimately, an award was issued in favor of DCT. DCT commenced this action in the District of Columbia to enforce the award.

Djibouti sought to vacate the award, arguing that (i) the tribunal exceeded its authority, (ii) the tribunal violated Djibouti’s due process rights, and (iii) the award would be contrary to U.S. public policy if enforced.

The court rejected all of Djibouti’s arguments and granted DCT’s petition to confirm the award. The court did not accept Djibouti’s argument that the court lacked subject matter jurisdiction over the petition.

In respect of the tribunal’s authority, the court found that the dispute resolution clause in the parties’ contract was broad enough to encompass the counterclaims raised by DCT, and that the tribunal did not exceed its authority by deciding on those counterclaims.

There were no surprises in this decision. Addressing Djibouti’s claim of violation of due process, the court found that Djibouti had actual notice of the proceedings and was given an opportunity to be heard, but chose not to participate. Therefore, the court held that Djibouti’s due process rights were not violated. Finally, with respect to Djibouti’s argument that enforcing the award would be contrary to U.S. public policy, the court held that this argument failed because a purely compensatory award does not violate U.S. public policy. The court noted that Djibouti’s argument relied solely on a case involving specific performance, which was not applicable here.

This case is significant because it reinforces the principle of deference to arbitral awards under the New York Convention. The court emphasized the strong public policy in favor of enforcing arbitral awards and noted that a party seeking to vacate an award faces a heavy burden of proof. The court also clarified that due process rights are satisfied by actual notice and an opportunity to be heard, and that a party’s failure to participate in the proceedings will not be grounds for vacating the award. A party who takes the risk by not participating in arbitration proceedings may be bound by the outcome of the arbitration even if they disagree with the result.

This case also reinforces the principle of finality of arbitration awards and the limited grounds upon which they can be challenged. The court’s decision emphasizes that challenges to an arbitral award must be based on specific, narrow grounds provided under the New York Convention, and not on a general dissatisfaction with the award. The court pointed out that its discretion in refusing to enforce an award could only be on the grounds explicitly set forth under Article V of the Convention.

The court discredited what it called Djibouti’s “disguised attempt to challenge the award on grounds that could have been brought before the arbitrator.”^[2] It noted that despite being invited to comment on DCT’s authority, Djibouti declined to respond and instead raised its argument of lack of authority before the court for the first time. In light of this, the court did not accept Djibouti’s argument as an authentic challenge to the court’s subject matter jurisdiction.

This outcome is very much in line with the consistent approach of U.S. courts to a very narrow interpretation of the scope of the few grounds for declining to enforce an arbitral award under the New York Convention. This case serves as a warning of the consequences that follow should a party choose not to participate in an arbitration when given the opportunity. A party’s refusal to participate will not be looked upon sympathetically by the court, as such a lost opportunity is “self-inflicted.”^[3] Parties should therefore use every opportunity to raise all arguments before the arbitral tribunal and not expect the court to entertain new arguments which could have been raised before the arbitral tribunal.

This article originally appeared in International Law News, the quarterly magazine of the ABA International Law Section, in the Spring 2023 issue (Volume 50, Issue 3). Join the International Law Section to read the full issue and access other resources regarding international law.

1. Doraleh Container Terminal SA v. Republic of Djibouti, No. 20-02571, 2023 WL 2016934. At the date of writing, this decision is pending appeal. ↑

2. Id. at *5. ↑

3. Id. at *7. ↑

Problems with lack of affordability and access to housing are longstanding in the U.S. The CFPB has indicated that “minority households… continue to lack fair and equitable access to credit,” including mortgage lending.^[1] These unmet needs, along with historical and ongoing discrimination such as redlining, exacerbate the racial wealth gap and leave many communities of color overlooked and underserved. However, equity and racial justice are policy priorities of the Biden Administration.^[2] Special Purpose Credit Programs (SPCPs) may fill the gaps in affordability and access to housing. Special-purpose credit programs provide unique standards to make loan qualification easier for underserved populations. While applicants must meet a clearly defined set of criteria to take advantage of these programs, the purpose of a SPCP is to provide access to credit for groups that might have a difficult time qualifying for credit because their communities were underserved in the past.

The Equal Credit Opportunity Act (ECOA) and its implementing regulation, Regulation B, permit creditors to offer or participate in SPCPs to meet special needs through:

• Any credit assistance program authorized by federal or state law for the benefit of an economically disadvantaged class of persons;
• Any credit assistance program offered by a non-for-profit organization for the benefit of its members or an economically disadvantaged class of persons; or
• Any SPCP offered by a for-profit organization, or in which such an organization participates to meet special social needs, if:
  • the program is established and administered pursuant to a written plan that identifies the class of persons that the program is designed to benefit under the procedures and standards for extending credit under the program; and
  • the program is established and administered to extend credit to a class of persons who, under the organization’s customary standards of creditworthiness, probably would not receive such credit or would receive it on less favorable terms than are ordinarily available to other applicants applying to the organization for a similar type and amount of credit.^[3]

In January 2021, the CFPB issued an Advisory Opinion (AO) indicating the content required in a written plan used by a for-profit organization that establishes and administers a SPCP under the ECOA and Regulation B.^[4] In addition, the AO clarifies the data that may be appropriate to inform for-profit organizations’ determination that an SPCP is needed to benefit a certain class of persons.

Nonetheless, some stakeholders expressed uncertainty as to the treatment of ECOA and Regulation B SPCPs under the Fair Housing Act (FHA). While SPCPs are specified under ECOA, they are not specified under the FHA. However, in December 2021 the Department of Housing and Urban Development issued guidance confirming SPCPs for real estate loans or credit assistance that are compliant with ECOA and Regulation B generally would not violate the FHA.^[5]

In February 2022, the CFPB joined with seven other federal agencies and released a statement appealing to lenders to consider ways to heighten credit access through SPCPs in ways that could enhance lenders’ serving historically disadvantaged communities.^[6]

Homeownership is one of the primary ways in which American families build and pass on wealth to the next generation. Lenders have an interest in meeting the credit needs of underserved communities while meeting and furthering business objectives. SPCPs can be used to expand credit access for underserved borrowers who have been overlooked but can repay their debt. SPCPs are one way to address this gap and bring fair access to financial services to additional potential homeowners.

Government agencies and lenders are identifying new ways to advance equity by increasing homeownership opportunities for underserved populations. Numerous financial institutions have dedicated billions of dollars to increasing ways to meet the needs of underserved communities. Further, lenders are increasingly interested in taking more proactive means to develop lending opportunities for members of communities of color that have faced discrimination and historically been excluded from access to credit and housing. These endeavors can be a fundamental part of a financial institution’s efforts to serve a broader community. However, lenders must be cognizant to undertake these activities in compliance with the obligations of ECOA, Regulation B, and the FHA.

Note that the applicable agencies do not determine whether a program qualifies for special purpose credit status. Accordingly, financial institutions must determine whether their programs qualify for special purpose credit status.

This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.

1. Tim Lambert, “Using special purpose credit programs to serve unmet credit needs.” Consumer Financial Protection Bureau blog, July 19, 2022. ↑

2. “Advancing Equity and Racial Justice Through the Federal Government,” The White House (last accessed Apr. 5, 2023). The Biden Administration has recognized that the housing affordability crisis is disproportionately impacting low-income communities and communities of color. Second, the Biden Administration believes that lack of affordable housing is a barrier to opportunity. Third, the Biden Administration has proposed a number of policies to address the affordable housing crisis, many of which are framed as equity issues.

   In his 2023 budget, President Biden proposed a number of initiatives to address racial and economic disparities in housing, such as expanding access to homeownership for Black and Hispanic families and providing rental assistance to families with children, including: (i) increasing funding for the Low Income Housing Tax Credit (LIHTC), (ii) further reforming the Affirmatively Furthering Fair Housing (AFFH) rule, and (iii) providing new Project-Based Rental Assistance (PBRA) to extremely low-income (ELI) renter households. See “FACT SHEET: President Biden’s Budget Lowers Housing Costs and Expands Access to Affordable Rent and Home Ownership,” The White House, Mar. 9, 2023. ↑

3. 12 C.F.R. § 1002.8. ↑

4. Equal Credit Opportunity (Regulation B); Special Purpose Credit Programs, 86 Fed. Reg. 3762 (Jan. 15, 2021). ↑

5. See “Office of General Counsel Guidance on the Fair Housing Act’s Treatment of Certain Special Purpose Credit Programs That Are Designed and Implemented in Compliance with the Equal Credit Opportunity Act and Regulation B,” U.S. Department of Housing and Urban Development General Counsel, Dec. 6, 2021. ↑

6. See “Interagency Statement on Special Purpose Credit Programs Under the Equal Credit Opportunity Act and Regulation B,” Feb. 22, 2022. ↑