In May and June, three new states enacted comprehensive consumer data privacy laws. On May 19, 2023, Montana Governor Greg Gianforte signed the Montana Consumer Data Privacy Act into law; the act takes effect on October 1, 2024. On June 18, 2023, Texas Governor Greg Abbott signed the Texas Data Privacy and Security Act into law, with most of its provisions taking effect on July 1, 2024. And on July 18, 2023, Oregon Governor Tina Kotek signed the Oregon Consumer Privacy Act into law; it will take effect on July 1, 2024. These are the newest states to enact comprehensive data privacy laws, following California, Virginia, Colorado, Utah, Connecticut, Iowa, Indiana, and Tennessee.
The Montana, Oregon, and Texas privacy laws generally impose similar obligations to those provided for under the comprehensive privacy laws that other states have passed. However, there are key distinctions in these laws that can have a large impact on a business’s data processing. Accordingly, potentially covered businesses should carefully evaluate the law’s applicability, disclosure obligations, specific requirements related to opt-out rights, and data protection assessment requirements.
The Montana Privacy Act generally applies to entities that both:
conduct business in Montana or produce products or services that are targeted to the residents of Montana; and
control or process the personal data of:
at least 50,000 consumers; or
at least 25,000 consumers and derive more than 25% of gross revenue from the sale of personal data.
The Oregon Consumer Privacy Act applies to any person that conducts business in Oregon or provides products or services to Oregon residents that in a calendar year:
controls or processes data of 100,000 or more consumers (except to the extent such data is processed solely for the purpose of completing a payment transaction); or
controls or processes data of 25,000 or more consumers, while deriving 25% or more of the person’s annual gross revenue from selling personal data.
Unlike the revenue and data volume thresholds in the Montana and Oregon laws, the Texas Data Privacy and Security Act has a small business exclusion. The Texas Data Privacy and Security Act generally applies to persons that conduct business in Texas or produce products or services consumed by residents of Texas and excludes small businesses as defined by the U.S. Small Business Administration (which applies to businesses with fewer than 500 employees). Further, while the Texas Data Privacy and Security Act does not apply broadly to small businesses, it does include a provision prohibiting small businesses from engaging in the sale of sensitive data without receiving prior consent from the consumer. All three new consumer data privacy laws include a number of exemptions, including for financial institutions subject to the Gramm-Leach-Bliley Act.
The Texas and Montana privacy laws impose separate responsibilities on controllers and processors. Both acts define a controller as an individual or legal entity that, “alone or jointly with others, determines the purpose and means of processing personal data.” A processor “processes personal data on behalf of a controller.” Determining whether a person is acting as a controller or processor with respect to a specific processing of data is a fact-based determination. A processor must adhere to the instructions of a controller and assist the controller in meeting its obligations, including obligations related to data security and breach notification, as well as providing necessary information to enable the controller to conduct and document data protection assessments.
Both the Montana and Texas privacy laws subject controllers to purpose specification and limitation requirements, data security requirements, disclosure requirements, nondiscrimination requirements, data protection assessment requirements, and opt-in consent requirements for sensitive data.
All three consumer data privacy laws provide consumers with a number of rights related to their personal data. Consumers, by submitting a request to the controller, have the right to know whether the controller is processing the consumer’s personal data; the right to correct inaccuracies; the right to delete their personal data; the right to receive access to the data; and the right to opt out from a controller’s processing of personal data used for the sale of the data, targeted advertising, or certain profiling.
The Oregon Consumer Privacy Act contains heightened protections (i.e., a requirement that data may not be processed without a consumer’s affirmative “opt-in” consent) for “sensitive data.” This includes personal data revealing racial or ethnic background; national origin; religious beliefs; mental or physical condition or diagnosis; sexual orientation; gender identity; crime victim status; citizenship or immigration status; genetic or biometric data; and precise geolocation data. The Oregon Consumer Privacy Act also requires controllers to provide a comprehensive privacy notice that includes: the categories of data processed; purposes for processing data; how to exercise consumer rights; categories of data shared with third parties and categories of third parties receiving data; and contact information.
Notably, none of the three new consumer data privacy laws provide consumers with a private right of action. The attorney general in each state holds the exclusive authority to enforce the law. In Texas and Montana, the attorneys general must provide written notice that includes the specific provisions that have been violated and an opportunity to cure the violation. The attorney general must provide thirty days’ written notice in Texas and sixty days’ written notice in Montana. If the controller or processor fails to cure the violation within the time period, the attorney general may initiate an enforcement action. In Oregon and Texas, the attorneys general can seek civil penalties of up to $7,500 for each violation.
Mortgage originators and secondary market issuers use automated valuation models (AVMs) in determining the worth of collateral securing mortgages on consumers’ principal dwellings. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which added section 1125 to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), Congress directed the Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Federal Housing Finance Agency (FHFA), and the Consumer Financial Protection Bureau (CFPB) (hereinafter, the “Agencies”) to develop regulations for quality control standards for AVMs.
Section 1125 of FIRREA requires that AVMs meet quality control standards designed to:
ensure a high level of confidence in the estimates produced by automated valuation models;
protect against the manipulation of data;
seek to avoid conflicts of interest;
require random sample testing and reviews; and
account for any other such factor that the Agencies determine to be appropriate.
On June 21, 2023, the Agencies published a proposed rule (hereinafter the “Proposal”) in the Federal Register to implement the required quality control standards. Under the Proposal, the Agencies would require institutions that engage in certain credit decisions or securitization determinations to adopt policies, practices, procedures, and control systems to: (i) ensure that AVMs used in transactions to determine the value of mortgage collateral adhere to quality control standards designed to ensure a high level of confidence in the estimates produced by AVMs; (ii) protect against the manipulation of data; (iii) seek to avoid conflicts of interest; (iv) require random sample testing and reviews; and, (v) comply with applicable nondiscrimination laws.
Comments must be received by August 21, 2023.
What Is an AVM?
As described in the Proposal, the term ‘‘automated valuation model’’ is “commonly used to describe computerized real estate valuation models used for a variety of purposes, including loan underwriting and portfolio monitoring.” Section 1125 of FIRREA defines an AVM as ‘‘any computerized model used by mortgage originators and secondary market issuers to determine the collateral worth of a mortgage secured by a consumer’s principal dwelling.’’ The Proposal defines an AVM as any computerized model used by mortgage originators and secondary market issuers to determine the value of a consumer’s principal dwelling collateralizing a mortgage.
Which Transactions Would Be Covered?
The quality control standards in the Proposal would be applicable only to AVMs used in connection with making credit decisions or covered securitization determinations regarding a mortgage (covered AVMs), as defined in the Proposal.
Other uses of AVMs, such as for portfolio monitoring, do not involve making a determination of collateral value and thus are not within the scope of the Proposal. The Proposal further would not cover the use of AVMs in the development of an appraisal by a certified or licensed appraiser, nor in the review of the quality of already completed determinations of collateral value (completed determinations).
The Proposal would, however, cover the use of AVMs in preparing evaluations required for certain real estate transactions that are exempt from the appraisal requirements under the appraisal regulations issued by the OCC, Board, FDIC, and NCUA, such as transactions that have a value below the exemption thresholds in the appraisal regulations. In this regard, the Proposal would not incorporate a transaction-based exemption threshold, such as loans under $400,000.
Credit decisions are defined in the Proposal to mean a decision regarding whether and under what terms to originate, modify, terminate, or make other changes to a mortgage. The proposed definition of credit decision would include a decision regarding whether to extend new or additional credit or change the credit limit on a line of credit. Monitoring the value of the underlying real estate collateral in the mortgage originators’ loan portfolios would not be a credit decision for the purposes of the Proposal.
The OCC, Board, FDIC, NCUA, and FHFA would define dwelling to mean a residential structure that contains one to four units, whether or not that structure is attached to real property. The term would include an individual condominium unit, cooperative unit, factory-built housing, or manufactured home, if any of these are used as a residence. The proposed definition of dwelling also would provide that a consumer can have only one principal dwelling at a time. Thus, a vacation or other second home would not be a principal dwelling. However, if a consumer buys or builds a new dwelling that will become the consumer’s principal dwelling within a year or upon the completion of construction, the new dwelling would be considered the principal dwelling.
The CFPB proposes to codify the AVM requirements in Regulation Z. The definition of dwelling proposed by the other agencies is consistent with the CFPB’s existing Regulation Z. Unlike the Truth in Lending Act (TILA), however, title XI generally does not limit its coverage to credit transactions that are primarily for personal, family, or household purposes. Because this rulemaking is conducted pursuant to title XI rather than TILA, the CFPB proposes to revise Regulation Z and related commentary to clarify that this rule would apply when a mortgage is secured by a consumer’s principal dwelling, even if the mortgage is primarily for business, commercial, agricultural, or organizational purposes.
The Proposal would define mortgage as fully as the statute appears to envision, in the language of section 1125(d). Consequently, for this purpose, the Agencies would adopt in part the Regulation Z definition of ‘‘residential mortgage transaction.’’
The Proposal would also cover instances where an appraisal waiver is granted by an investor (such as a government-sponsored enterprise like Fannie Mae or Freddie Mac) and the investor uses an AVM.
Prior Guidance and Which Entities Would Be Covered by Which Agencies under the Proposal
Since 2010, the OCC, Board, FDIC, and NCUA have provided supervisory guidance on the use of AVMs by their regulated institutions in Appendix B to the Interagency Appraisal and Evaluation Guidelines (hereinafter “Guidelines”).
The Guidelines recognize that an institution may use a variety of analytical methods and technological tools in developing real estate valuations, provided the institution can demonstrate that the valuation method is consistent with safe and sound banking practices. The Guidelines recognize that the establishment of policies and procedures governing the selection, use, and validation of AVMs, including steps to ensure the accuracy, reliability, and independence of an AVM, is a sound banking practice. In addition to Appendix B of the Guidelines, the OCC, Board, and FDIC have issued guidance on model risk management practices (hereinafter “Model Risk Management Guidance”) that provides supervisory guidance on validation and testing of models.
The NCUA is not a party to the Model Risk Management Guidance. The NCUA monitors the model risk efforts of federally insured credit unions through its supervisory approach by confirming that the governance and controls for an AVM are appropriate based on the size and complexity of the transaction; the risk the transaction poses to the credit union; and the capabilities and resources of the credit union. The CFPB and FHFA are also not parties to the Guidelines or the Model Risk Management Guidance. The FHFA has separately issued model risk management guidance that provides the FHFA’s supervisory expectations for its regulated entities in the development, validation, and use of models.
Section 1125(c)(1) of FIRREA provides that compliance with regulations issued under section 1125 shall be enforced by, “with respect to a financial institution, or subsidiary owned and controlled by a financial institution and regulated by a Federal financial institution regulatory agency, the Federal financial institution regulatory agency that acts as the primary Federal supervisor of such financial institution or subsidiary.’’
Section 1125(c)(1) applies to a subsidiary of a financial institution only if the subsidiary is (1) owned and controlled by a financial institution and (2) regulated by a federal financial institution regulatory agency. Section 1125(c)(2) provides that, with respect to other participants in the market for appraisals of one-to-four-unit single-family residential real estate, compliance with regulations issued under section 1125 shall be enforced by the Federal Trade Commission, the CFPB, and a state attorney general.
The NCUA has long acknowledged that subsidiaries of federally insured credit unions—also referred to as credit union service organizations (CUSOs)—and their employees are not subject to regulation by the NCUA as contemplated by Congress under statutory provisions similar to section 1125(c). Unlike the Federal banking agencies that do have supervisory and regulatory authority over subsidiaries of their regulated institutions, the NCUA does not have authority to supervise or examine subsidiaries owned and controlled by federally insured credit unions. Rather, the NCUA’s regulations only indirectly affect CUSOs. For example, NCUA’s regulations permit federally insured credit unions to invest only in CUSOs that conform to certain specified requirements.
The Proposal would not alter that position. If the Proposal is made final, given that in the context of federally insured credit unions the authority under section 1125(c)(1) applies to subsidiaries owned and controlled by a federally insured credit union and regulated by the NCUA, the NCUA would not take action to enforce the requirements of this rule under section 1125(c)(1) with respect to CUSOs. Rather, under section 1125(c)(2), the Federal Trade Commission, the CFPB, and state attorneys general would have enforcement authority over CUSOs—whether owned by a state or federally chartered credit union—in connection with a final AVM rule. Accordingly, the Proposal would provide that the NCUA’s regulations apply to credit unions insured by the NCUA that are mortgage originators or secondary market issuers.
The NCUA is also proposing to amend its regulations to clearly include the proposed AVM regulations in the NCUA’s list of regulatory provisions applicable to federally insured, state-chartered credit unions. Accordingly, the Proposal would provide that insured credit unions must adhere to these NCUA requirements.
Required Procedures and Prohibition on Discrimination
The Proposal would require adopting and maintain policies, practices, procedures, and control systems to ensure that AVMs used in relevant transactions adhere to quality control standards addressing the first four factors laid out in Section 1125 of FIRREA. This would allow mortgage originators and secondary market issuers flexibility to set quality control standards for covered AVMs “based on the size of their institution and the risk and complexity of transactions for which they will use covered AVMs.”
These quality control factors are consistent with practices that many participants in the mortgage lending market already follow and with the Guidance described above.
The Agencies considered whether to propose more prescriptive requirements for the use of AVMs and decided not to do so. The Agencies concluded that the statute does not require the Agencies to set prescriptive standards for AVMs. Further, because section 1125 provides the Agencies with the authority to ‘‘account for any other such factor’’ that the Agencies ‘‘determine to be appropriate,” the Agencies also propose to include a fifth factor that would require mortgage originators and secondary market issuers to adopt policies, practices, procedures, and control systems to ensure that AVMs used in connection with making credit decisions or covered securitization determinations adhere to quality control standards designed to comply with applicable nondiscrimination laws.
The Proposal notes that existing nondiscrimination laws apply to appraisals, and AVMs and institutions have a preexisting obligation to comply with all federal laws, including federal nondiscrimination laws. For example, the Equal Credit Opportunity Act (ECOA) and its implementing Regulation B bar discrimination on a prohibited basis in any aspect of a credit transaction. The Agencies have long recognized that this prohibition extends to using different standards to evaluate collateral, which would include the design or use of an AVM in any aspect of a credit transaction in a way that would treat an applicant differently on a prohibited basis or result in unlawful discrimination against an applicant on a prohibited basis. Similarly, the Fair Housing Act prohibits unlawful discrimination in all aspects of transactions related to residential real estate transactions, including appraisals of residential real estate.
The Agencies note that, as with models more generally, there are increasing concerns about the potential for AVMs to produce property estimates that reflect discriminatory bias, such as by replicating systemic inaccuracies and historical patterns of discrimination. Models could discriminate because of the data used or other aspects of a model’s development, design, implementation, or use. Attention to data is particularly important to ensure that AVMs do not rely on data that incorporate potential bias and create discrimination risks.
Because AVMs arguably involve less human discretion than appraisals, AVMs have the potential to reduce human biases. Yet without adequate attention to ensuring compliance with federal nondiscrimination laws, AVMs also have the potential to introduce discrimination risks. Moreover, if models such as AVMs are biased, the resulting harm could be widespread because of the high volume of valuations that even a single AVM can process.
While existing nondiscrimination law applies to an institution’s use of AVMs, the Agencies propose to include a fifth quality control factor relating to nondiscrimination to heighten awareness among lenders of the applicability of nondiscrimination laws to AVMs. Specifying a fifth factor on nondiscrimination would create an independent requirement for institutions to establish policies, practices, procedures, and control systems to specifically address nondiscrimination, thereby further mitigating discrimination risk in use of AVMs. Specifying a nondiscrimination factor may also increase confidence in AVM estimates and support well-functioning AVMs. In addition, specifying a nondiscrimination factor could help protect against potential safety and soundness risks, such as operational, legal, and compliance risks, associated with failure to comply with nondiscrimination laws.
The Agencies propose that institutions would have the flexibility to design fair lending policies, procedures, practices, and control systems that are in compliance with fair lending laws and take into account their business models regarding the first four quality control factors listed above.
Proposed Implementation Period
The Agencies propose an effective date of the first day of a calendar quarter following the twelve months after publication in the Federal Register of any final rule based on the Proposal.
One thing you can do this summer to advance the Rule of Law is to take the recently launched American Bar Association (ABA) research survey on AI & Economic Justice, and share it widely with your networks, on your listservs, and in your community forums.
The question of how AI and AI regulation impact low-income and marginalized people is important for ensuring the Rule of Law. At its core, the Rule of Law is a political ideal that all citizens and institutions within a country, state, or community are accountable to the same laws. The Rule of Law is essential to a stable and healthy business environment, as it facilitates the social, political, and legal stability necessary for such an environment. As technology fundamentally transforms what people can do and how they interact, ensuring accountability at all levels of society, across all pockets and corners of society, becomes essential to the very fabric, integrity, and stability of our legal system. As issues of access to justice most often impact those with limited means, taking extra efforts to account for equal enforcement of the laws at the margins of society helps us better assess whether our system is, in fact, holding everyone accountable to the same standards. This injects our legal system, and our society at large, with considerable stability.
This bar year, through the leadership of the ABA’s Civil Rights and Social Justice Section (CRSJ) Chair Juan Thomas, the ABA has been focused on shedding light on economic justice issues that are inextricably connected to the CRSJ’s broader civil rights agenda. In line with the theme of economic justice, through collaboration between its Economic Justice and Privacy and Information Protection committees and with support and cooperation from across the ABA, CRSJ developed a project that focused on understanding how artificial intelligence impacts low-income people and other marginalized groups. According to CRSJ Chair Thomas, the project aims to “promote public policy solutions that understand and support the important balance between technological advancement and social justice.”
Initial research by the project leadership team showed that public attention on this issue was moving from one hot topic to the next, without any information on the overall or systematic harms and benefits that AI is creating for marginalized groups. There was a palpable need for an organized mapping of the impacts and touchpoints of AI and AI regulation for low-income people and other marginalized groups. To begin the work, CRSJ designed the AI & Economic Justice Survey.
To take the survey, please visit ambar.org/ai, the online landing page for the survey. Here, you will find more information about the project, a recording of a webinar where members of the AI & Economic Justice Project provide guidance on how to take the survey, and a link to the survey itself. Project leader Marilyn Harbur, co-chair of the Economic Justice Committee, emphasizes the importance of sharing the survey broadly with others as well as filling it out yourself. Alert your friends and colleagues, especially those working with clients located in remote areas. Project leader Alfred Mathewson sees that survey “as your opportunity to help the legal profession assure that no one is unfairly burdened by the A.I. explosion.” He encourages people to take the survey and to spread the word to colleagues and friends.
According to Chair Thomas, “The ABA Section of Civil Rights & Social Justice has launched the ‘AI & Economic Justice Project’ because artificial intelligence (AI) is shaping and changing aspects of our society in innovative ways. From facial recognition to deepfake technology to criminal justice, and health care, these applications are seemingly endless, and more is to come. However, with advances in AI, we must also be focused on protecting vulnerable communities, because in recent years, algorithmic decision-making has produced unfair bias: inequitable, discriminatory, and otherwise problematic results in significant areas of the American economy.”
The survey is a first-of-its-kind ABA research survey designed to identify the ways that AI and automation are impacting low-income and marginalized populations. It is an iterative survey that works to map out what remains a relatively unknown territory. What is learned this year will contribute to improving the survey for next year. Through iterative and annual surveys, the aim is to establish the ABA as a repository for important and time-sensitive information about the impact of technological change on low-income people and other marginalized groups. In addition to helping the ABA set and fine-tune policy, from a business perspective, such a repository would also support business lawyers by flagging areas of potential business risk and opportunity.
With the support and direction of CRSJ Chair Thomas and CRSJ Section Director Paula Shapiro, the project was lifted to the attention of the broader ABA community and has, thus, benefitted from the knowledge and skill of the broader ABA membership. A call for volunteers and support resulted in more than one hundred responses from members across the ABA and an ABA-wide convening on the proposed format and content of the survey. The convening was organized and facilitated by project leaders, including Christopher Frascella, Grant Fergusson, Susan Berstein, and Rubin Roy, with coordination from CRSJ Associate Director Alli Kielsgard and help from CRSJ interns.
In addition to being supported by a sizeable leadership team with members from across various ABA Sections and committees, the survey owes particular thanks to enthusiastic and expert partners from the Cybersecurity Legal Task Force, Judge Alvin Thompson and John Stout of the Business Law Section’s Rule of Law Working Group, and the Science and Technology Law Section, among others.
As an illustration of the project‘s approach, project leader James Pierson, co-chair of the Economic Justice committee, points to comments from FTC Commissioner Rebecca Kelly Slaughter in an August 2021 article on “Algorithms and Economic Justice.” There, Slaughter points out the need for balance, as the new technology is “neither a panacea for the world’s ills nor the plague that causes them.” Slaughter cites the words of MIT-affiliated technologist R. David Edelman, “AI is not magic; it is math and code.” She goes on to caution that “just as the technology is not magic, neither is any cure to its shortcomings. It will take focused collaboration between policymakers, regulators, technologists, and attorneys to proactively address this technology’s harms while harnessing its promise.”[1]
In that spirit, the project leaders ask you to join them in focused collaboration in completing the survey and supporting the ABA AI & Economic Justice project with your expertise so that all members of society, particularly those who may be of a more vulnerable socioeconomic status or in a protected category under the law, may be beneficiaries and not targets or victims of advances in artificial intelligence.
This article is part of a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
“ESG” refers to the three broad pillars of Environmental, Social, and Governance considerations, which have become increasingly important in assessing certain for-profit businesses, especially publicly traded ones. With ever-intensifying demands from regulators, investors, and the public for attention to ESG issues, for-profit companies are increasingly focused on ESG considerations, initiatives, and compliance. ESG-related shareholder and class-action litigation, governmental investigations, and enforcement actions in the corporate world have expanded at a rapid clip. In addition, regulators both in and outside of the United States have promulgated new mandatory rules, disclosure obligations, and enforcement mechanisms for ESG-related conduct. The Securities and Exchange Commission (“SEC”), the Federal Trade Commission (“FTC”), and state attorneys general have taken the regulatory enforcement lead domestically.
While there are no universal definitions of ESG, the three primary ESG pillars generally involve the following issues, among others:
Environmental: climate change, resource depletion, waste and pollution, and deforestation.
Social: working conditions, employee relations and DEIA, health and safety, interaction with local communities (including indigenous communities), and conflict and humanitarian crises.
Governance: board diversity and structure, executive compensation, and ethics.
While ESG is a broader concept than Diversity, Equity, Inclusion, and Accessibility (“DEIA”), it includes and incorporates DEIA. DEIA programs fostering the hiring and promotion of African American employees and other underrepresented workers have been prominent in corporate America in recent years. For-profit corporations have been under enormous scrutiny of late regarding their hiring and promotion policies and practices—from both the left and right sides of the political aisle. A number of states have passed laws and issued executive orders requiring, or in some cases prohibiting, DEIA practices. Most recently, the U.S. Supreme Court’s June 2023 decision banning race-conscious college admissions—and the rationale underlying it—have raised concerns about the ruling’s potential broader implications, particularly in federal employment law, and perhaps even more broadly, such as in connection with federal funding. And even in advance of future court rulings, concerns have been raised about the possibility of some employers’ curtailing current diversity efforts in the workplace and halting new ones.
ESG and DEIA are controversial in some circles. There is a growing attack from the political right on corporate policies aimed at diversity in hiring and promotion and other social and environmental goals, with that attack taking the form of lawsuits, requesting agency investigations, congressional investigations, public pressure, and more.
So, what does any of this have to do with nonprofits? While nonprofit organizations are not subject to the specific ESG regulatory requirements and legal standards applicable to certain for-profit companies (such as those enforced by the SEC), nonprofits have incorporated DEIA into their programs, activities, governance, and operations for years, and they are increasingly voluntarily incorporating ESG principles and practices into their organizations. They may do so under pressure from their boards of directors, employees, grant-makers, donors, sponsors, advertisers, and other third parties. They also may do so in order to attract and retain a younger generation of staff that is increasingly sensitized to and mindful of ESG principles.
In doing so, nonprofits expose themselves to potential legal jeopardy in a wide array of areas. This article explains the legal risks inherent to ESG-related initiatives for nonprofit organizations and provides practical tips and guidance on how nonprofits can effectively mitigate those risks.
The Primary Legal Risks of Nonprofit ESG Programs
When a nonprofit organization voluntarily decides to weave ESG principles and practices into its organizational and operational fabric, it is taking on a certain degree of legal risk. To be sure, that risk is not anything remotely like the risk faced by for-profit companies—particularly publicly traded companies—that are subject to ESG statutory and regulatory mandates from the SEC and elsewhere. Nonprofits are not subject to such mandates. Nonetheless, nonprofits do face ESG-related legal risks. A non-exhaustive list of such risks follows.
Employment Law: ESG initiatives—particularly those that involve DEIA issues—can involve changes to hiring and promotion practices, workplace diversity, and employee compensation and benefits, which can trigger employment-related legal risks such as discrimination, harassment, and wrongful termination claims. This is nothing new, and laws like Title VII of the federal Civil Rights Act and state equivalents have been applied to nonprofit employers for more than fifty years. But what is new is the potential impact of the U.S. Supreme Court’s June 2023 ruling (Students for Fair Admissions v. Harvard and Students for Fair Admissions v. University of North Carolina) rejecting race-conscious admissions in higher education. While the new decision does not impede employers from pursuing diversity in their workforces (as it is limited solely to higher education admissions), many experts maintain that, as a practical matter, the ruling will likely discourage some employers from putting in place ambitious diversity policies in hiring and promotion—or prompt them to rein in existing policies—by encouraging new lawsuits in the employment arena under the new legal standard. In principle, the logic of the Court’s ruling on college admissions could threaten employer programs that, as of today, can take race into account if workers were previously excluded from a job category based on race or can do so to remove obstacles (such as unconscious bias) that prevent employers from having a more diverse workforce. But the more meaningful effect of the Court’s decision is likely to be greater pressure on policies that were already on questionable legal ground. These could include, for instance, staff leadership acceleration programs or internship programs that are open only to members of underrepresented groups. It also would not be surprising to see the Court use the ruling’s rationale to limit race-conscious initiatives in other aspects of nonprofit governance and management in the future, such as if federal funds are involved.
State Laws and Executive Orders Restricting DEIA Policies, Trainings, and Practices: Effective July 2022, Florida’s Individual Freedom Act, or the so-called “Stop WOKE” law, restricts diversity-related training in private Florida workplaces—including nonprofits based in Florida or (presumably) that have Florida-based employees—and also bars the teaching of critical race theory in K-12 schools and universities. That law is currently the subject of litigation that is working its way through the courts. In February 2023, Texas Governor Greg Abbott issued a memorandum to state agencies warning them to not use any DEIA programs in hiring that are “inconsistent” with Texas law, including setting diversity goals or interview targets for diverse candidates. While the memorandum is limited to public employers, it is unclear whether the governor may take similar action toward private employers in Texas. While California had adopted laws requiring certain racial, ethnic, and gender diversity on boards of directors of public companies headquartered in California, both laws have been struck down by courts, and appeals are underway. Observers widely expect a proliferation of such laws and executive orders restricting DEIA policies, trainings, and practices in a variety of “red” states. Beyond the employment realm, it would not be surprising to see new state laws and executive orders that could effectively prohibit DEIA initiatives in other aspects of nonprofit governance and management, such as board composition, volunteer leader selection, and grantmaking, as well as government grants, contracts, and cooperative agreements.
Misrepresentation and Greenwashing: There is a risk of publicly misrepresenting or overstating a nonprofit’s ESG performance, which could lead to charges of “greenwashing” or otherwise engaging in deceptive or misleading conduct. This could result in donor or funder backlash, reputational damage, and potentially even regulatory enforcement by state attorneys general, as well as private litigation. While nonprofits should always be mindful of these longstanding risks of making misleading or non-substantiated claims in connection with all of their programs and activities—well beyond ESG—the legal and public relations risks can be particularly acute here.
“Derivative” Suits:Nonprofits that incorporate ESG into their investment policy statement and base investment decisions, in part, on ESG criteria and then face material investment losses may risk being on the opposite end of “derivative”-type lawsuits alleging that the nonprofit’s board of directors and/or investment committee were not prudent stewards of the organization’s resources.
Data Privacy and Security: Nonprofits’ ESG activities often involve, in part, collecting, processing, and storing sensitive data about volunteer leaders, employees, donors, funders, and other stakeholders. There is a risk of data breaches or mishandling of information, which could result in legal action, regulatory penalties, and reputational harm. If a data breach occurs, there is an ever-increasing web of requirements imposed by state, federal, and international laws that must be followed.
Mitigating the Legal Risks of Nonprofit ESG Programs
To mitigate these legal risks, there are a number of proactive steps that nonprofit organizations can take. Below is a non-exhaustive list:
Ensure that your nonprofit’s employment policies and practices are fully compliant with all current federal and state legal standards in areas involving discrimination, harassment, wrongful termination, and otherwise. This necessarily means ensuring that any current or future employment diversity initiatives are narrowly tailored as permitted by current law and do not result in discrimination. It also means not overreacting to the June 2023 U.S. Supreme Court decision involving race-conscious college admissions but keeping a close eye on future legal developments in the employment context. For those nonprofits with remote employees in different states, remember that state employment laws generally apply to any employee who regularly works from the state, irrespective of where the organization is based. Be sure to always consult with employment counsel fluent in both federal law and the laws of the applicable states. Finally, outside of the workplace setting, keep an eye on future rulings from the U.S. Supreme Court that could apply the rationale underlying the college admission decision to other aspects of nonprofit governance and management, for instance if federal funds are involved.
While Florida’s Individual Freedom Act includes nonprofits based in Florida (and presumably those with Florida-based employees) in its restrictions on diversity-related training in private Florida workplaces, most other state laws and executive orders to date that restrict DEIA policies, trainings, and practices do not apply to nonprofits. That may well change in the coming months and years, however, particularly in certain “red” states. It is important to stay on top of all new state developments in this area—both those affecting the workplace and those potentially affecting other aspects of nonprofit governance and management—and take all necessary steps to comply with them.
Ensure that all public statements regarding your nonprofit’s ESG performance are accurate, fully substantiated with appropriate data and documentation, and not in any way overstated, misleading, or deceptive.
Working with a professional investment advisor, adopt an investment policy statement that reflects the nonprofit’s priorities, goals, risk tolerance, and financial needs but that is defensible as being reasonable, prudent, and appropriate. Be sure to revisit it on a regular basis and update it as needed.
Implement strong data privacy and security measures to protect sensitive information about nonprofit volunteer leaders, employees, donors, funders, and other stakeholders and to mitigate the risk of data breaches or mishandling of such information. If a data breach occurs, be sure to closely follow the ever-increasing requirements imposed by state, federal, and international laws.
Develop clear and consistent ESG policies and practices that align with your nonprofit’s values and mission, as well as expectations of donors, funders, and other stakeholders.
Regularly engage with stakeholders such as donors, funders, and employees to ensure that your nonprofit’s ESG initiatives are transparent and meet their needs.
Maintain up-to-date knowledge of applicable state, federal, and international ESG-related laws and regulations, and ensure full compliance with them.
As with all areas of legal risk management, work with experienced legal counsel to help your nonprofit navigate the complex and ever-changing legal landscape governing ESG initiatives.
Conclusion
While ESG initiatives are thus far not mandated for nonprofit organizations as they are for certain for-profit companies, for a variety of reasons, increasingly nonprofits are voluntarily incorporating ESG principles and practices into their organizations and operations. In doing so, nonprofits can gain certain benefits but also expose themselves to potential legal risk in a wide array of areas. That being said, if properly understood and appreciated by nonprofit executives and leaders, those risks can be effectively mitigated by incorporating a number of practical tips and suggestions.
The purpose of this commentary is twofold: (1) to identify deficiencies in the 340B statute[1] related to the use of multiple contract pharmacies and delivery to them—deficiencies that have resulted in the need for courts to resolve issues through judicial interpretation, and (2) to encourage policymaker action to address these deficiencies.
Overview of 340B Program
Under the 340B program, the federal government requires drug manufacturers participating in Medicare or Medicaid to sell certain covered drugs to qualifying health-care organizations at discounted prices.[2] Health-care organizations that qualify to enter the program—referred to as covered entities—include hospitals and providers serving low-income or rural populations.[3] The maximum price that drug manufacturers may charge a covered entity for covered drugs is the average manufacturer price for the preceding quarter minus a statutorily mandated rebate.[4] The discounts provided to covered entities typically range from 20 to 50 percent off the market price of eligible drugs.[5] As of 2020, there were approximately 50,000 registered 340B covered entity sites, with 2021 discounted drug purchases totaling $44 billion,[6] or approximately 7.6 percent of the $576.9 billion of nationwide pharmaceutical purchases in 2021.[7]
Conceptually, covered entities can stretch scarce resource dollars by profiting from the difference between their 340B drug resales—paid at full Medicare and insurance reimbursement rates—and the discounted drug acquisition costs. Covered entities can use the profits to finance affordable patient care for underserved communities.[8]
Misconduct
However, there are risks that covered entities and drugmakers may operate in ways that contradict Congress’s intentions. For example, of the 189 audits of covered entities performed by regulators in 2022, sixty-six—more than one-third—included findings of misconduct.[9] Likewise in 2022, regulators issued at least thirty-four citations to drug manufacturers requiring refunds to covered entities.[10]
Part of this contradiction can be attributed to statutory silence—the 340B statute does not require covered entities to use their profits in a way that subsidizes needed-but-unprofitable care.[11] But even where the statute expressly prohibits abusive activities, certain business practices by covered entities have amplified the risks of abuse.[12]
Covered Entities’ Use of Multiple Contract Pharmacies
Of particular concern is the covered entity practice of using multiple contract pharmacies to handle the delivery and dispensing of purchased 340B drugs.[13]
When the 340B program first began, few covered entities had their own in-house pharmacies to manage purchased drugs.[14] Thus, in order to expand the reach of the 340B program, the Department of Health and Human Services (“HHS”) allowed covered entities to dispense 340B drugs through contract pharmacies—pharmacies not owned or operated by covered entities.[15]
The extent to which covered entities can use contract pharmacies to dispense medications purchased under the 340B program for their patients raises some concerns.[16] Drug manufacturers have alleged that covered entities use multiple contract pharmacies to engage in prohibited practices,[17] such as diversion of discount drugs to ineligible patients[18] or duplicative discounting.[19]
Federal Support for Covered Entities’ Use of Multiple Contract Pharmacies
Despite these concerns, federal regulators have required drugmakers to accept covered entity demands for use of multiple contract pharmacies. Under the HHS “ship to, bill to” process, the covered entity owns the drugs after purchase and is billed directly for them, but the drugmaker must physically deliver the drugs to all contract pharmacies that the covered entity designates.[20] Beginning in 2010, HHS permitted covered entities to use an unlimited number of contract pharmacies as long as applicable legal requirements were satisfied. Drugmakers objected to the practice out of fears that it enables covered entities to avoid compliance mechanisms.[21]
Pushback from Drugmakers
The 340B statute says nothing about contractual delivery terms, where drugmakers must physically deliver drugs sold, or what party has the right to make the delivery determination. Rather, the statute only imposes price restrictions on drugmakers.[22] Thus, in 2020, three drugmakers—Sanofi, Novo Nordisk, and AstraZeneca—began requiring 340B covered entities to accept the drugmakers’ conditions for place of delivery.[23] Essentially, the three drugmakers offered to deliver purchased drugs to either an in-house pharmacy or a single contract pharmacy of the covered entity’s choosing, but not multiple contract pharmacies.[24]
HHS: Advisory Opinion No. 20-06
HHS responded by issuing Advisory Opinion No. 20-06, which stated that once drugs have been “purchased by” covered entities, the delivery point is irrelevant to the agreement.[25] Likewise, because contract pharmacies have long been used in connection with the 340B program, HHS found that drugmaker-imposed restrictions on their use was impermissible.[26] Thus, according to HHS, covered entities should be free to require physical delivery to contract pharmacies—and drugmakers must comply.[27]
HHS: Lack of Broad Rulemaking and Interpretive Authority
Unfortunately for federal regulators, HHS lacks broad rulemaking or interpretative authority to achieve its policy goals.[28] In general, a federal agency’s administrative powers are limited to those powers delegated to it statutorily by Congress.[29] Furthermore, while courts will generally defer to reasonable agency interpretations of ambiguous statutes,[30] such deference is granted only when the agency acts under statutorily delegated rulemaking authority.[31] If an agency adopts a statutory interpretation beyond its statutory authority, the interpretation lacks the force of law.[32]
Regarding the 340B program, HHS has only narrow rulemaking authority pertaining to three specific administrative functions. First, Congress authorized HHS to establish an administrative dispute resolution process for drugmakers and covered entities contesting the conduct of their counterparties.[33] Second, the statute allows HHS to establish by regulation a schedule of civil monetary penalties for violations.[34] Neither of these provisions grants HHS the authority to create contractual rights or impose contractual duties upon drugmakers or covered entities in their dealings with each other.
Finally, the statute directs HHS to issue regulations to define the standards and methodology for calculating the maximum price that drugmakers can charge covered entities—referred to as the ceiling price in the statute.[35] This provision deals with the complex process of determining the average manufacturer price and the statutorily mandated rebate to which covered entities are entitled for each drug covered by the statute.[36] Thus, HHS does have some authority to create substantive contractual rights between covered entities and drugmakers—the agency establishes the maximum price for any sale. But the authority to calculate the ceiling price is not necessarily a grant of authority to regulate other aspects of the contractual relationship between the drugmaker and the covered entity.
Third Circuit Ruling
Clearly, regulators are limited in their ability to achieve policy goals via regulatory guidance. Thus, after HHS issued Advisory Opinion No. 20-06 and then violation letters to Sanofi, Novo Nordisk, and AstraZeneca (on the basis that the companies were in violation of the contract pharmacy delivery requirement as specified by the advisory opinion), the drugmakers challenged the regulatory actions in court.[37] In January 2023, the U.S. Court of Appeals for the Third Circuit ruled in favor of the plaintiffs in Sanofi Aventis U.S. LLC v. U.S. Department of Health & Human Services.[38] The case consolidated conflicting federal district court rulings over whether Advisory Opinion No. 20-06 and the resulting violation letters were valid.[39]
According to HHS, the ability to regulate the delivery point was inherent to its statutory authority to regulate the “purchase” of eligible drugs.[40] HHS relied on the Uniform Commercial Code (U.C.C.) for its logic.[41] Under the U.C.C., by default, ownership of goods passes from seller to buyer when the seller’s delivery responsibilities are complete.[42] According to HHS, because a “purchase” by a covered entity necessarily requires a transfer of ownership, HHS may dictate that the covered entity gets to designate how it takes title by designating the place of delivery.[43]
Furthermore, in Advisory Opinion No. 20-06 and before the Third Circuit, HHS conceded its limited regulatory rulemaking authority[44]—but that was of little consequence, according to the agency. Because it had long required that drugmakers sell to contract pharmacies, HHS claimed Advisory Opinion No. 20-06 did not create any new substantive rights or duties.[45] HHS argued that this long-standing practice, combined with the statutory authority inherent in its role of regulating 340B sales relationships between drugmakers and covered entities, justified its regulatory actions.[46]
The Third Circuit disagreed, finding that HHS’s requirements on drugmakers exceeded what the statute permits:
The “purchased by” provision imposes only a price term for drug sales to covered entities, leaving all other terms blank. HHS has suggested that covered entities get to fill in those blanks so long as they foot the bill. However, when Congress’s words run out, covered entities may not pick up the pen.[47]
Essentially, because the statute’s language states nothing about how the parties are to handle physical shipment and delivery of purchased drugs, there is no indication that Congress intended to give covered entities the authority to dictate those terms in their purchase agreements with drugmakers.
Implicit in the Third Circuit’s opinion were concepts from the U.C.C. distinguishing different rights under a contract for the sale of goods.[48] An understanding of these distinct rights is key to understanding the flaws in HHS’s logic, as HHS was essentially dictating what rights must arise in a sales contract between covered entities and drugmakers without the statutory authority to do so.
Under the U.C.C., a contract may exist even if the parties do not agree on all terms, with “gap filler” provisions operative only when the parties do not have express agreement on the specific term.[49] Among the U.C.C. gap filler terms are default provisions on price[50] and place of delivery.[51] Under those provisions, the parties’ express agreement trumps the U.C.C. default terms.
The Third Circuit opinion acknowledged that the 340B program allowed HHS to restrict the parties’ abilities to set their prices—drugmakers must sell at no more than the ceiling price set by HHS.[52] But because the 340B statute is silent regarding place of delivery, there is no corresponding restriction on negotiating delivery terms.[53]
The HHS advisory opinion misconstrued the U.C.C. provisions on this point. By default, under the U.C.C., ownership of goods transfers when the seller’s delivery obligations are complete. But contractual parties are free to negotiate an alternative moment of title transfer.[54] Furthermore, if the parties do not agree on a place of delivery, delivery of goods is deemed to occur at the seller’s place of business.[55]
Thus, under the default U.C.C. provisions, ownership of goods transfers at the seller’s place of business, and delivery to the buyer’s chosen location is not required by the U.C.C. for transfer of title or completion of sale. Contrary to HHS’s interpretation, the U.C.C. expressly contemplates that the buyer and seller can negotiate these terms.
HHS took the position that because it is responsible for enforcing the parties’ rights and duties with regard to the sale as a whole, it can regulate these sale terms.[56] But, as the Third Circuit held, the 340B statute does not empower HHS to impose these contractual terms on the parties.[57] The statute only expressly permits HHS to regulate price.[58] HHS’s limited 340B rulemaking and interpretive authority prevents it from conflating other sale rights to reconcile ambiguity in the statute and otherwise achieve policy goals.
Other Court Action
As of February 2023, similar cases were pending in the U.S. Court of Appeals for the Seventh Circuit and the U.S. Court of Appeals for the D.C. Circuit, and court watchers do not expect a circuit split.[59]
Likewise, other courts have ruled in favor of drugmakers that received violation letters from HHS for imposing contract pharmacy restrictions. For example, in November of 2021, in a lawsuit by Novartis and United Therapeutics, the district court found that the plaintiffs’ conditions imposed on qualifying 340B entities did not violate Section 340B as alleged in HHS’s violation letters.[60] The court also found that the drugmakers provided “credible evidence” that using multiple contract pharmacies “increased the potential for fraud in the 340B program.”[61] The court recognized, however, that HHS has “legitimate concerns about the degree to which the manufacturers’ new conditions have made it difficult for covered entities to obtain certain drugs at discounted prices.”[62]
Significant Challenges for Covered Entities
If, as the Third Circuit held, the 340B statute imposes restrictions only on price, drugmakers can force acceptance of all other contract terms—and will have gained significant leverage in negotiating purchase agreements with covered entities.
A 2022 survey of 482 covered entities with contract pharmacy relationships details an anticipated $448,000 per entity annual loss for critical-access hospitals and a $2.2 million per entity annual loss for more extensive facilities after fourteen drugmakers announced restrictions, with more than 75 percent of covered entities needing to cut programs and services if the restrictions remain permanent.[63]
Congressional Action Needed
Drugmakers, pharmacy benefit managers, and covered entities have competing interests related to the profit on the drug sales. In between, federal regulators seek to control their own Medicare reimbursement costs while promoting the congressionally intended benefits to health-care providers. Unfortunately, ambiguity in the 340B statute raises questions about the appropriate interpretation of the statute and the scope of HHS’s authority to ensure compliance with program goals.
While the 340B program has the attention of some lawmakers, proposed legislation does not address the specific issues with contract pharmacies or the general issues of regulatory empowerment. For example, on April 6, 2023, Representatives Abigail Davis Spanberger and Dusty Johnson introduced the “PROTECT 340B Act of 2023” in the U.S. House of Representatives.[64] The bill primarily addresses reimbursement discrimination against covered entities by health insurers and pharmacy benefit managers.[65] While the bill acknowledges the use of contract pharmacies, it does not give HHS the explicit statutory authority to direct when and how contract pharmacies may be used in the delivery of drugs.[66]
The multitude of policy questions surrounding the 340B program will not be answered through litigation alone. These questions go beyond the use of contract pharmacies by covered entities and restrictions by drugmakers. Like a loose thread on a sweater, the more one pulls on 340B, the more the legislation unravels. For example, it is unclear whether the program fulfills its goal of expanding care to needy communities.[67] And from a policy standpoint, observers question the appropriate use of the revenue generated by covered entities from 340B discounted drugs and who should qualify as a “patient” of a covered entity.[68]Other commentators have highlighted the numerous administrative difficulties associated with the 340B program.[69]
Courts are only willing to implement HHS’s reforms with explicit statutory authority.[70] As courts strike down HHS efforts to pursue policy goals, congressional inaction may signal implicit acquiescence of a paralyzed administrative agency. To preserve the long-standing and often critical role of contract pharmacies in the 340B system, Congress must pass legislation expressly empowering HHS to coordinate their use.
The views expressed in this publication represent those of the author(s) and do not necessarily represent the official views of HCA Healthcare or any of its affiliated entities.
Public Health Service Act § 340B, 42 U.S.C. § 256b (2022). ↑
42 U.S.C. § 256b(a)(1)–(2). The 340B program incorporates pricing mechanics of § 1927(c) of the Social Security Act (codified at 42 U.S.C. § 1396r-8(c)) for calculating the required rebates. ↑
Eric M. Tichy et al., National Trends in Prescription Drug Expenditures and Projections for 2022, 79 Am. J. Health-Sys. Pharmacy 1158 (2022). ↑
See Joseph D. Bruch & David Bellamy, Charity Care: Do Nonprofit Hospitals Give More than For-Profit Hospitals?, 36 J. Gen. Internal Med. 3279 (2021); see also, Baker, supra note 3; Am. Hosp. Ass’n v. Becerra, 142 S. Ct. 1896, 1905–06 (2022). ↑
SeeStuart Wright, OEI-05-13-00431, Memorandum Report: Contract Pharmacy Arrangements in the 340B Program 3 (2014); see also 340B Reporting and Accountability Act, S. 1182, 118th Cong. § 2 (2023), which would require covered entities to pass savings on to patients upon the resale of the drugs. ↑
See Sanofi Aventis U.S. LLC v. U.S. Dep’t of Health & Hum. Servs., 58 F.4th 696, 700 (3d Cir. 2023). ↑
59 Fed. Reg. 25,110, 25,111–12 (May 13, 1994) (In response to a comment requesting that the use of contract pharmacies be disallowed, HHS stated, “It is a customary business practice for manufacturers to sell to intermediaries as well as directly to the entity. Entities often use purchasing agents or contract pharmacies, or participate in GPOs [group purchasing organizations]. By placing such limitations on sales transactions, manufacturers could be discouraging entities from participating in the program. Manufacturers may not single out covered entities from their other customers for restrictive conditions that would undermine the statutory objective.”); see alsoSanofi, 58 F.4th at 700. ↑
Sanofi, 58 F.4th at 700. While HHS does have the ability to audit covered entities, including those that have a contract pharmacy model in place, it is unclear how effective this practice is at preventing unlawful activities. See Program Integrity: FY22 Audit Results, supra note 9. ↑
Dep’t of Health & Hum. Servs. Off. Gen. Couns., Advisory Op. 20-06 on Contract Pharmacies Under the 340B Program 2–3 (Dec. 30, 2020) [hereinafter Advisory Op. 20-06]. Note that HHS rescinded Advisory Opinion 20-06 while the litigation was pending. Nevertheless, the U.S. Court of Appeals for the Third Circuit considered the advisory opinion because HHS continued to hold the positions asserted therein. See Sanofi, 58 F.4th at 703. ↑
See Pharm. Rsch. & Mfrs. of Am. v. U.S. Dep’t of Health & Hum. Servs., 43 F. Supp. 3d 28 (D.C. Cir. 2014). ↑
See id. at 35 (citing Bowen v. Georgetown Univ. Hosp., 488 U.S. 204, 208 (1988); Atl. City Elec. Co. v. Fed. Energy Regul. Comm’n, 295 F.3d 1, 8 (D.C. Cir. 2002)). ↑
Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837 (1984). ↑
United States v. Mead, 533 U.S. 218, 226–27 (2001). ↑
See Pharm. Rsch. & Mfrs. of Am., 43 F. Supp. 3d at 36–37 (citing Mead, 533 U.S. at 234). ↑
42 U.S.C. § 256b(d)(3)(A) (2022). This authority is limited to just six functions expressly enumerated in the statute—(1) designating or establishing a decision-making official or decision-making body to review and resolve claims by covered entities concerning overcharges, (2) establishing deadlines and procedures to make sure that claims are resolved fairly and expeditiously, (3) establishing discovery procedures for covered entities in connection with such claims, (4) requiring drugmakers to conduct audits of covered entities prior to initiating any claim for misconduct, (5) allowing consolidation of claims by more than one drugmaker against the same covered entity, and (6) allowing joint claims by multiple covered entities against the same drugmaker. See 42 U.S.C. § 256b(d)(3)(B); see alsoPharm. Rsch. & Mfrs. of Am., 43 F. Supp. 3d at 42. ↑
AstraZeneca Pharms. LP v. Becerra, 2022 U.S. Dist. LEXIS 27842 (D. Del. Feb. 16, 2022); Sanofi-Aventis U.S., LLC v. U.S. Dep’t of Health & Hum. Servs., 570 F. Supp. 3d 129 (D.N.J. 2021). ↑
Seeid. § 2-204(3) (“Even though one or more terms are left open, a contract for sale does not fail for indefiniteness if the parties have intended to make a contract and there is a reasonably certain basis for giving an appropriate remedy.”). ↑
U.C.C. § 2-401(2) (“Unless otherwise explicitly agreed title passes to the buyer at the time and place at which the seller completes his performance concerning the physical delivery of the goods.” (emphasis added)). ↑
Id. § 2-308(a) (“Unless otherwise agreed . . . the place for delivery of goods is the seller’s place of business.” (emphasis added)). ↑
See Lowell M. Zeta, Comprehensive Legislative Reform to Protect the Integrity of the 340B Discount Program, 70 Food & Drug L.J. 481 (2015). ↑
See Novartis Pharms. Corp. v. Espinosa, 2021 U.S. Dist. LEXIS 214824, at *30 (D.D.C. Nov. 5, 2021) (“[A]ny future enforcement action must rest on a new statutory provision, a new legislative rule, or a well-developed legal theory that Section 340B precludes the specific conditions at issue here.”). ↑
Start-ups and emerging companies are always seeking future investment opportunities. In recent years, a financing alternative called Simple Agreements for Future Equity (“SAFEs”) has gained popularity and proven useful for emerging companies when conducting their early-stage raises. SAFEs offer an efficient mechanism for raising capital in the early stages of an emerging company.
SAFEs emerged due to the need to bridge the financing gap during early-stage investments where the value of the company was unknown or difficult to determine. SAFEs enable companies to raise capital by granting investors the right to receive equity in the future, upon the occurrence of specific triggering events. This article explores the key provisions and advantages of utilizing SAFEs in comparison to other financing instruments. Additionally, this article will outline some of the key issues emerging companies should be aware of when structuring SAFEs and how to best avoid pitfalls that may arise when utilizing this financing option.
What Are SAFEs?
SAFEs are company-friendly investment contracts between the company and each investor that give the investor the right to receive equity of the company in the future upon the occurrence of certain triggering events. The main purpose of a SAFE is to enable an early-stage investment in a company to bridge finances until the occurrence of a larger financing round. Upon such future financing round, the advance investment will convert into shares, with the investor benefiting either from a discount in purchase price or a capped value.
SAFEs have gained popularity in recent years due to their distinct advantages over convertible notes, a topic that will be covered in a future article. Convertible notes often create conflicts with existing debt obligations and involve complex negotiations among different investors and institutions. Conversely, SAFE agreements offer a streamlined model that eliminates the need for intricate discussions surrounding interest rates and specific terms. This simplified process benefits both companies and SAFE holders, making SAFEs an attractive financing option.
Structuring the SAFE
It is important to note that SAFEs come in different variations, such as post-money SAFEs and pre-money SAFEs. Post-money SAFEs provide investors with a predetermined ownership percentage in the company after the occurrence of a future financing round. On the other hand, pre-money SAFEs do not account for the valuation of the future financing when determining the ownership percentage. Companies should carefully consider which type of SAFE best aligns with their financing goals and the expectations of their potential investors, as post-money SAFEs may lead to unintended anti-dilution protection on a full-ratchet basis in the event of a down round.
Key Provisions
In order to understand the benefits of and potential drawbacks to utilizing SAFEs, companies should be aware of the key provisions in a SAFE agreement, namely provisions relating to triggering events, valuation caps, discount rates, and most favored nations clauses.
Triggering Events
One of the main characteristics of a SAFE is that equity rights are granted whereby if the company undergoes a triggering event (which is defined in each SAFE agreement), the SAFE will convert into securities of the company. Triggering events tend to be subsequent financings of the company or liquidity events, such as the company commencing the bankruptcy or dissolution process. When a triggering event occurs, the holder has the benefit of the SAFE converting to equity at the negotiated discount in the SAFE, which allows the holder to obtain rights as a shareholder. Upon a dissolution, SAFE holders who have not converted their SAFE into securities would be paid the purchase amount they were guaranteed by the company before common shareholders are paid.
Discount Rate
This is a discount to the price per share outlined in the SAFE agreement that will be issued by the company to SAFE holders upon a triggering event. It is an incentive for investors to enter into a SAFE agreement, because purchasing the SAFE at earlier stages locks investors in to convert their SAFEs at a lower price upon a triggering event.
As an example, a company may incentivize early-stage investors through offering a SAFE that will convert at a price per share of $1.00. Upon the occurrence of a future financing at $1.20/share, the SAFE holder will receive the upside because the financing (which would constitute a triggering event) allows the SAFE holder to convert their SAFE into shares at $1.00/share.
Valuation Caps
Valuation caps are often used to establish the upper limit on the valuation of the company at which a SAFE will convert into shares. This has the effect of creating a floor for the percentage of the company the investor is purchasing. The valuation cap ensures that the SAFE holder receives a lower price per share than subsequent investors.
Most Favored Nations Clause
Most favored nations clauses may be used to provide a SAFE holder with certainty that, upon a future financing, if the terms of the future financing are more favorable to the investors than the SAFE is to the SAFE holder, the SAFE holder will receive the benefit of receiving the best terms for themselves. This serves as another incentive for investors to acquire SAFEs, because they won’t face the repercussions of investing too early if subsequent financings contain better terms.
Investor Protection
To ensure investor protection, SAFEs can incorporate provisions that grant transparency and information rights to SAFE holders. Regular updates on the company’s financials, milestones, and progress can be provided to investors, enabling them to make informed decisions about their investment. By fostering a relationship of trust and transparency, companies can attract and retain investors who feel confident in the growth trajectory of the company.
Tax Implications
Companies and investors should be mindful of the potential tax implications associated with SAFEs. The tax treatment of SAFEs can vary depending on the jurisdiction and individual circumstances. It is advisable to consult with tax professionals who can provide guidance on the specific tax implications of SAFEs, including any applicable capital gains taxes, reporting obligations, and potential tax advantages or disadvantages. By understanding the tax implications, companies and investors can effectively plan and strategize their financial decisions, ensuring compliance and optimizing their tax positions.
Exit Strategies
SAFE holders should consider the potential exit strategies available to them. While SAFEs provide the opportunity to convert into equity upon triggering events, investors may also seek liquidity through other avenues. Acquisition by another company, initial public offerings (IPOs), or secondary market sales are possible exit strategies for investors. Companies can proactively communicate their long-term plans and potential exit scenarios to investors, allowing them to evaluate the feasibility of realizing their investments and potential returns. By understanding the available exit strategies, investors can make informed decisions about their participation in early-stage companies.
Limitations and Considerations
It is important to acknowledge that SAFEs may not be suitable for all companies or industries. While SAFEs offer advantages, institutional investors or certain industries may prefer more traditional financing instruments, such as convertible notes or preferred stock. Companies should carefully assess their financing goals, investor preferences, and industry norms before deciding to adopt SAFEs. Additionally, legal and regulatory considerations, including compliance with securities laws and the enforceability of SAFEs, should be evaluated. Consulting legal professionals can help companies navigate the legal landscape and ensure that SAFEs are structured and implemented in a legally compliant manner.
Conclusion
For start-ups and emerging companies, SAFEs provide a compelling capital raising alternative, particularly in the early stages or when the company’s valuation is not yet established. SAFEs offer a simplified process, company-friendly provisions, and lower costs compared to other financing instruments. Investors are incentivized to participate early through discounted rates upon conversion of the SAFE into securities and potential preferential treatment during insolvency scenarios. By leveraging SAFEs, companies can access streamlined capital and fuel their growth without hindering immediate progress.
The creation and implementation of SAFEs should involve consultation with legal professionals. Legal counsel can provide guidance on complying with applicable securities laws, assessing the enforceability of SAFEs in different jurisdictions, and addressing any jurisdiction-specific regulations. By seeking legal advice, companies can mitigate potential legal risks, ensure compliance, and protect the rights of both the company and the investors. Legal professionals can also assist in drafting and negotiating the terms of SAFEs to accurately reflect the intentions and expectations of the parties involved, further enhancing the legal robustness of the agreements.
“I have not failed. I’ve just found ten thousand ways that won’t work.” — Thomas Edison
Failed ideas and inventions, also known as “negative information,” can be economically valuable because anyone starting with knowledge of the dead ends can avoid spending time and resources on attempts that are ultimately going to fail. Clearly, negative information is valuable, but how does an economist value negative information? In this article, we explore techniques to overcome the challenges of determining the value of negative information, and show how negative information can inform allegations of trade secret theft in IP disputes.
Edison’s quote implies that failed ideas and inventions are valuable because they embody information on what does not work when creating something new. Unlike successful ideas and inventions, however, negative information is not priced by the market and is unlikely to directly generate any income. And yet a need to value negative information can arise in trade-secret-related disputes. In fact, the Uniform Trade Secrets Act from 1979 explicitly recognizes negative information as “information that has commercial value from a negative viewpoint, for example the results of lengthy and expensive research which proves that a certain process will not work could be of great value to a competitor.”[1]
Waymo’s February 23, 2017, lawsuit[2] against Uber for alleged theft of its trade secrets illustrates both the existence of and the need for valuing negative information. According to Waymo, Uber tried and failed to develop its own technology for a self-driving car, so it acquired Otto, a company started by a former Waymo employee who allegedly misappropriated Waymo’s technology. Waymo alleged that its employee’s theft of its intellectual property, including information about “dead-end designs,” allowed Uber (through Otto) to save a substantial amount of development time and cost. Waymo also claimed that its “extensive experience with ‘dead-end’ designs” and research findings that were unsuited for the market continued to be critical for its ongoing development[3] and likely underpinned Otto’s $680 million valuation at acquisition despite having been on the market for only six months. In this example, negative information consists of Waymo’s dead-end designs and know-how of what does not work when developing technology for a self-driving car.
Cases similar to Waymo are common in the technology space, where cutting-edge research can often be unfruitful or unmarketable and yet informative for product development.[4] In addition to ventures that are successful but only after many failed attempts (as in the Waymo example), negative information is often present in ventures that are ultimately deemed unsuccessful. Negative information can also be present in the valuation of ventures with significant research investments but prior to the development of any income-generating intellectual property.
The rationale for why negative information can be valuable is fairly intuitive; however, quantifying the value of negative information in general and particularly in the context of a trade secret dispute can be less straightforward. In the absence of comparables in the market and any attributable income, the only viable method for valuing negative information is a “cost to replicate” analysis.
A “cost to replicate” analysis attempts to answer a key “but-for” question: absent the alleged infringement of negative information, how much would it have cost the defendants to replicate the at-issue trade secret on their own? Importantly, the value of negative information is not how much it cost the plaintiffs in “creating” the negative information—a relatively simple accounting exercise—but what it would have cost the defendants to replicate it—an unknown counterfactual.
We begin in the next section with a brief note on recent trends in trade secret cases that underscore the importance of appropriately measuring the value of negative information.
Recent Trends in Trade Secret Cases in the US
Trade secret disputes in general—and particularly those in the technology space—have become more frequent due to a confluence of economic, legal, and regulatory factors. First, as the US workforce becomes increasingly more mobile—as has been the trend since the Great Recession[5]—trade secret disputes are expected to increase. This is particularly true in the technology sector, where increasing demand and compensation have resulted in the largest churn in employees relative to all other job sectors.[6] Negative information is at issue when an employee moves to a competitor and uses their knowledge of mistakes from their prior work to avoid making the same mistakes at their new place of employment. For example, in Novell, Inc. v. Timpanogos Research Group, Inc.,[7] following a settlement between the parties, the defendant recognized that he “mistakenly believed that, because [he and others] had developed certain technology while employed by Novell, [they] could take elements of that technology with [them] when [they] left.”[8]
Second, recent court decisions invalidated the patentability of certain types of subject matter (including patents related to software), thereby increasing reliance on trade secrets as an alternative for protecting intellectual property.[9] All else being equal, a general increase in trade secrets implies a concurrent increase in trade secret disputes, including ones involving negative information.
Third, the Defend Trade Secrets Act of 2016 (DTSA) enabled business to sue and seek remedies for theft of trade secrets in either state or federal courts, thereby further increasing the likelihood of trade secret cases.[10] And finally, trial outcomes for trade secret cases appear to be heavily skewed in favor of plaintiffs—almost 70% of the time in favor of plaintiffs—thus incentivizing plaintiffs to continue bringing their cases to court.[11]
Typical Approaches to IP Valuation
As trade secrets disputes increase in volume and prominence, analysts need guidance for appropriately valuing the negative information components of these disputes. Valuation methods for intangible assets like intellectual property include income approaches, market approaches, or cost approaches.[12] In the context of valuing negative information, the income and market approaches are typically inapplicable.
Income Approaches. Income approaches value intellectual property based on its potential to generate revenue or decrease future costs. For example, intellectual property that adds value to a product and increases its selling price can be valued by a discounted cash flow analysis of incremental profits. Negative information, however, does not manifest as any value-adding feature in a product or service and therefore lacks any attributable income. Market approaches value intellectual property based on arm’s-length transactions. For example, the price for licensing a patent can be informed by the licensor’s past or existing licenses for the same patent. Trade secrets are valuable in part because they are held in secret, and so it is rare for trade secrets in general to be licensed at arm’s length—and anyway it is difficult to imagine a traded market could exist for negative information.
Cost Approaches. Cost approaches are the valuation methods that can be applied to valuing negative information. A cost approach values intellectual property based on development costs. For negative information, cost approaches consider the costs avoided from not having to have invested in dead-end designs or failed procedures. For example, the costs incurred to develop intellectual property can inform on the cost savings proffered to a potential user of such intellectual property. Cost approaches don’t require consideration of future profits resulting from the use of intellectual property, which is useful because negative information is generally not associated with generating profit streams.
Academic studies of cost approaches distinguish between creation costs and re-creation costs.[13] The former refers to the original development costs of intellectual property, while the latter are what it would cost to develop intellectual property at a later point in time, which may be different for multiple reasons, for instance changes in labor or materials prices, or advances in public knowledge.[14]
A cost to replicate analysis aims to estimate re-creation costs, because it considers the cost the defendant would have incurred to replicate the intellectual property had they developed it themselves. In other words, the defendant saved itself development costs by misappropriating intellectual property. This can be considered unjust enrichment, and it can be calculated. In the Waymo-Uber matter, Waymo’s expert witness opined on Uber’s savings on development time by analyzing “the time periods that relate to the value of each of the trade secrets” and “the work that was foregone by virtue of… acquisition of the trade secrets.”[15]
Cost to Replicate Analyses Can Be Complicated by Negative Information
Negative information can be valued with a cost to replicate analysis; however, there are complications unique to negative information. Academic studies have noted “the difficulty in proving that the nonuse of a mistake or dead-end experiment damaged the plaintiff or unjustly enriched the defendant.”[16] When assessing economic harm, economic experts attempt to model the “but-for” world absent the alleged infringement. But it may be unreasonable to assume that defendants would have necessarily made the same mistakes or followed the same dead-ends as the plaintiffs did—in fact, defendants might have committed more errors, or made fewer mistakes. To illustrate using Waymo, let’s assume that Waymo undertook ten failed attempts prior to the successful development of its self-driving technology. Further, let’s assume that Uber acquired knowledge of these ten failed attempts, and with this negative information in hand, proceeded directly to developing its own successful technology for a self-driving car.
In this scenario, the value of Waymo’s negative information depends on how many of the ten failed attempts Uber would have undertaken in the but-for world. In part, that depends on the degree of interconnectedness of the failed attempts. Some efforts may necessitate sequential and iterative attempts, each new attempt learning from the prior ones; for other efforts the order may be random, making it imprudent to assume that the defendant in the but-for world would have undertaken the same number of attempts and in the same order as the plaintiff. So, while we can estimate the cost to replicate each of the attempts, we also have to have a choice framework to determine which of these failed attempts defendants would have pursued in the but-for world.
As a starting point for such a choice framework, we can examine plaintiffs’ failed attempts to identify which are relevant negative information. Waymo may have undertaken many failed experiments, not all of them necessarily linked to the development of its self-driving technology. Therefore, even before determining the potential mistakes the defendants would have likely made, experts must assess which failed experiments were undertaken in pursuit of the relevant goal (i.e., the product being replicated by the defendant).
Among plaintiffs’ relevant failed experiments, the damages expert must assess which ones would have been undertaken by the defendants in the but-for world, and which ones would have been undertaken in parallel or in sequence. In the Waymo case, Waymo’s expert analyzed the specific time periods for each trade secret before opining that some of the trade secrets, but-for the alleged misappropriation, “might have been done in a series,” while other trade secrets “probably would have gone in parallel.”[17] If it appears that the plaintiff chose from several approaches at random until arriving at last at the successful one, it may be appropriate to assume that the defendant would have followed a different order of approaches, and so would not have made all the same mistakes before finally finding the successful approach. Damages experts should account for the defendants’ existing knowledge—for example, a more advanced incumbent competitor, already equipped with relevant knowledge, may perform fewer failed experiments than a new entrant in the market.
In deriving the choice framework, the expert should also be informed by the age of the negative information. Mistakes made in research many years ago may be less relevant to current technology, and therefore less likely to be repeated. Academic studies support such consideration of obsolescence when valuing intellectual property.[18]
Similarly, changes in public knowledge will affect whether it is reasonable to assume a failed approach would have been tried in the but-for world. Since public knowledge by definition cannot be a trade secret, if any dead ends become publicly known before the alleged misappropriation by a defendant, then they should not be included in the analysis. This is especially relevant when plaintiffs release products into the market that make public certain results of their research. An example of this is when a company releases a product which incorporates a specific method, then the public may conclude that alternative methods are less desirable, making negative information about those alternative methods less valuable.
Determining which of the defendant’s projects were undertaken in pursuit of the relevant intellectual property requires understanding the defendant’s intent at the time of development. To this end, case-specific information in the form of documents produced in the usual course of business and testimony from those involved in the projects can be instrumental. Such information can guide the expert when modeling her choice framework. For instance, internal documents and testimony could indicate that defendants considered and were most likely to pursue a particular subset of the plaintiff’s full list of failed experiments. In such situations, the expert’s cost to replicate analysis would be deterministic and include the cost for the specific subset of experiments. Alternatively, when the testimony and documents do not identify a clear subset, the expert can resort to a probabilistic model. For example, if the defendants considered two experiments but did not indicate which one they would undertake, the expert could assign a 50 percent probability to both and calculate an expected value for her cost to replicate analysis.
Concluding Remarks
A well-supported valuation of negative information cannot be approached as a one-size-fits-all solution. Factors discussed in this article—including the number of potential failed ventures, the ordering of these ventures, and age of the technology in question—can vary from one case to another, which in turn impacts the expert’s modeling choices and final valuation. Nonetheless, identifying the relevant set of factors for consideration and appropriate means to account for them provides a useful framework for conducting the necessary individualized valuation of negative information.
Ideas and inventions that fail have economic value. We may associate market success with value, but the existence of negative information raises the possibility that some failed ideas and inventions can be valued in the right context. When Sir Isaac Newton said “if I have seen further, it is by standing on the shoulders of giants,” he was likely referring to those responsible for giant insightful failures as much as successful ones.
The opinions expressed are those of the authors and do not necessarily reflect the views of the firm or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
Waymo LLC v. Uber Techs. Inc. No. C 17-00939 WHA (N.D. Cal. Jan. 29, 2018). ↑
Waymo LLC v. Uber Techs., Inc., Complaint, at 10.
Waymo also created a vast amount of confidential and proprietary intellectual property via its exploration of design concepts that ultimately proved too complex or too expensive for the mass market; Waymo’s extensive experience with “dead-end” designs continues to inform the ongoing development of Waymo’s LiDAR systems today. The details actually used in Waymo’s LiDAR designs as well as the lessons learned from Waymo’s years of research and development constitute trade secrets that are highly valuable to Waymo and would be highly valuable to any competitor in the autonomous vehicle space. ↑
See, e.g., Fitbit v. Jawbone (three separate lawsuits: D. Del. 15-cv-775 and D. Del. 15-cv-0990, and N.D. Cal 15-cv-4073); Genentech, Inc. v. JHL Biotech, Inc., No. C 18-06582 WHA (N.D. Cal. Mar. 1, 2019). ↑
Over the past year, rising interest rates and stifling market conditions have contributed to a slowdown of leveraged transactions and overall deal-making in private equity. We’ve seen a historically deep decline in exits that poses a potential long-lasting drag on limited partner returns. As a result, there is a growing number of private equity funds (PE funds) looking for the right opportunity to exit existing investments.
This article explores the various strategies commonly employed by PE funds to achieve profitable exits for their portfolio companies and how PE funds can navigate the challenging landscape of exits to optimize their investments.
Structuring the Initial Investment
To maximize returns and control the exit process, private equity sponsors should plan for the exit during the initial investment stage. This includes ensuring sufficient control and liquidity through agreements like board control or veto rights, registration rights, redemption rights, drag-along rights, and tag-along rights. Management incentives are crucial for a successful exit, and equity incentive plans can align the interests of management and the sponsor fund. These plans may include time or performance vesting equity awards, which incentivize management to stay with the portfolio company after the sponsor exits.
When looking to exit, PE funds will need to review how the investment was structured to understand what rights it has to facilitate the exit of the investment and understand how the exit should be structured.
Strategic Sale
One of the most prevalent exit strategies is a strategic sale. This approach involves selling a portfolio company to a strategic buyer within the same industry or a related one. Strategic sales offer several advantages, including the realization of potential synergies between the strategic buyer and the target company. By integrating the portfolio company with the strategic buyer, the selling fund can often secure a higher return, thanks to the premium paid for the acquisition. Moreover, strategic sales generally have shorter transaction timelines, providing a quicker path to completion and increased deal certainty when compared to other exit strategies, such as initial public offerings (IPOs) or secondary buy-outs. When looking to execute on a strategic sale, the sponsor fund can choose to negotiate with a single buyer or shop the portfolio company in an auction process and receive multiple offers from bidders. While an auction typically provides the selling fund with more control over the sale and the drafting of the transaction documents, the process can take longer to complete as compared to a single-buyer negotiation.
Strategic sales tend to result in a complete exit by the selling fund, which typically effects the sale of the target portfolio company in exchange for cash consideration. Partial strategic sale exits are less common and usually result in the selling fund receiving shares in the strategic buyer instead of straight cash. From a structuring perspective, strategic sales can be effected either though a share sale or asset sale. Alternatively, the parties may decide to execute the sale through a merger of the target portfolio company and the strategic buyer. There are several considerations that may impact the type of transaction structure employed by the parties, including regulatory and tax matters that are beyond the scope of this article.
Secondary Buy-Outs
Another popular exit strategy is the secondary buy-out, which entails selling a portfolio company to another PE fund. In this scenario, the selling fund achieves a full exit, while the target company remains a private entity. Secondary buy-outs are favored for various reasons. For instance, the selling fund may opt to divest its ownership interest in a particular portfolio company to focus on other investments that better align with its strategy. Alternatively, the selling fund may believe that the portfolio company has reached a stage of growth or value where another PE fund is willing to pay a premium for the business. Moreover, the limited availability of exit opportunities through IPOs may influence the decision to pursue a secondary buy-out as the most viable exit option at a given time. Successful secondary buy-outs require rigorous due diligence, effective communication, and alignment of interests between the buying and selling parties.
Challenges posed by a secondary buy-out exit include a limited buyer pool, which can put constraints on the competitive bidding process and potentially result in fewer options for sellers. There may also be resistance from company management, as the purchasing fund will often replace existing management with members of its own team. Furthermore, financial buyers like PE funds may not be able to pay as much as strategic buyers because financial buyers cannot factor synergies into their cost and are less likely to pay a higher premium as a result.
Initial Public Offerings
When structuring the initial investment, PE funds will generally seek to retain the flexibility to sell their ownership stake in a portfolio company. This will typically include the right to cause the portfolio company to undertake an IPO. PE funds often prefer IPO exits because IPOs typically result in higher valuations for portfolio companies as compared to other possible exits. It also allows the PE fund to judge when to exit due to real-time fluctuations in value of the company based on open trading of shares on the public market. When an exit transaction is consummated via an IPO, the PE fund will often continue to maintain a significant stake in the company for a period of time following closing, allowing the fund to benefit from any post-IPO increase in the company’s valuation. Consequently, the PE fund will be subject to exchange rules and securities laws relating to resale restrictions on the post-IPO shares and certain types of related party transactions. In many cases, the PE fund will also be subject to lock-up agreements with the underwriters of the IPO.
In addition, the nature of the ownership stake retained by the PE fund will often impact the approach taken in connection with the rights the fund may want to retain following a portfolio company IPO. Most underwriters will seek to place significant limitations on the rights of PE funds following an IPO over concerns that retaining such rights may negatively impact the marketability of the offering. For this reason, certain rights that benefit the PE fund—such as pre-emptive rights, rights of first refusal, and drag-along and tag-along rights—usually do not survive a portfolio company IPO. However, PE funds will often retain board nomination rights, registration rights, and information rights post-IPO, and they may retain certain veto rights, depending on the level of board control and the size of the retained ownership stake. It is important to note, however, that exiting via an IPO also presents a number of disadvantages. These disadvantages include a lack of a complete exit, increased execution risk, increased transaction timelines, increased transaction costs, and increased regulatory scrutiny and disclosure obligations under various securities regulatory regimes.
Partial Exits
In addition to these strategies, PE funds can leverage recapitalizations for partial exits by restructuring the capitalization of portfolio companies. Recapitalizations involve financial maneuvers such as issuing dividends or raising additional debt against the company’s assets. By adjusting the capital structure, PE funds can distribute cash to investors while retaining an ownership stake. Recapitalizations are effective exit strategies when the portfolio company has stable cash flows, valuable assets, and growth potential. However, careful analysis of the company’s financial position, its debt capacity, and market conditions is crucial in implementing this strategy. Another option to partially exit the portfolio company is where the PE fund has a redemption right that allows it to require the portfolio company to repurchase the PE fund’s shares. This right is typically negotiated at the time of initial investment and would require the company to have assets available to repurchase all or a portion of the shares the PE fund holds.
Conclusion
Successful exits are critical for PE funds to achieve their desired returns. By carefully considering the various exit strategies available and analyzing the specific circumstances of each portfolio company, PE funds can optimize their exits and maximize profitability. The key is to understand the market dynamics, assess the potential for synergies, and adapt to changing conditions to execute the most appropriate exit strategy for each investment. Through strategic planning and meticulous execution, PE funds can navigate the complex exit landscape and deliver successful outcomes for themselves and their investors.
Since the release of ChatGPT in November 2022, there has been a seemingly endless onslaught of coverage about the chatbot and generative AI software like it. These stories range from the fear-inducing (the world will be taken over by AI-controlled bots) to the ridiculous (a lawyer relied on ChatGPT to draft a brief and had to face a very mad judge when it turned out that the software fabricated cases). In the legal realm, much of the focus of conversations around ChatGPT has been on the intersection between copyright law and AI, and rightly so. From questions around whether a work generated by AI qualifies for copyright protection to investigations around if an AI app’s ingestion of copyrighted works is covered by fair use, generative AI technology has introduced a lot of big issues, and answers are being decided in real time.
One often overlooked area of intellectual property where AI is poised to have a big impact is the right of publicity. By way of background, the right of publicity allows individuals to control the commercial exploitation of their identity and reap the rewards associated with their fame or notoriety by requiring others to obtain permission (and pay) to use their name, image, or likeness. As the law in this area develops along with the technology, there are several key issues practitioners need to be aware of.
The challenge with generative AI is that it makes the creation of a credible simulacrum of a celebrity much, much easier. In the past, this would have required finding a real person who could sound like a celebrity or be done up like a celebrity. Generative AI allows users to skip this. For example, earlier this year, an anonymous creator operating under the name Ghostwriter uploaded a song in the style of musicians Drake and The Weeknd. The song, which effectively mimicked the real artists, quickly went viral and was played millions of times on TikTok, Spotify, and YouTube before being removed at the behest of Universal Music Group, which is home to both the artists.
While in this case, there was no action for violation of Drake and The Weeknd’s right of publicity, this will not necessarily be the case going forward, particularly as the technology continues to evolve and its output becomes even more sophisticated.
Practitioners representing entities that make and use generative AI need to be aware of the contours of the right of publicity so they can minimize risk of such claims or appropriately address them when they arise. Here are five things to keep in mind as the technology develops:
Right now, there is no federal cause of action for the right of publicity. For the time being, the right of publicity is a creature of state law, with about two-thirds of states recognizing some form of this claim. This means that there is some variation between states and that many right of publicity claims are brought in state—not federal—court.
It’s not just a replica of a celebrity’s face or body that is protected. Rather, the courts may give plaintiffs a bit of leeway to proceed where a defendant has used characteristics that call a celebrity to mind. For example, the Ninth Circuit, applying California law, recognized that an ad featuring a robot dressed in a long gown, wearing a blonde wig, and turning block letters as part of something that looked like a game show was meant to depict Vanna White and infringed her right of publicity by appropriating her identity. Similarly, the Ninth Circuit found that Bette Midler could bring a right of publicity action against an advertiser and its ad agency for creating a commercial with a singer who was hired to sound like Midler.
The output of a generative AI platform may be protected by the First Amendment. This means that, as with other forms of intellectual property, an individual’s interest in protecting their right of publicity must be balanced against the rights of users to creative or self-expression. This is true even if the product of generative AI is being sold for a profit. Taking a non-AI example, the Sixth Circuit concluded that Tiger Woods could not maintain a right of publicity claim against the painter of a painting entitled The Masters of Augusta that commemorated Wood’s 1997 victory at the Masters. In this case, the Sixth Circuit found that, although the painter sold prints of the painting, the work was protected by the First Amendment because there was substantial “creative content” that outweighed Woods’s interest in profiting from his image.
It is unclear if Section 230 applies. This section of the Communications Decency Act can limit a platform’s liability for its users’ conduct. However, at least for now, there is no case law saying that this law applies to AI-generated materials. There are also questions of what that would look like, such as who is the creator of a work generated by an AI platform based on user prompts and whether right of publicity claims fall within an exception to Section 230 for intellectual property claims. Until these details become clearer, platforms should be wary of hosting AI-generated materials featuring a celebrity.
The nature and extent of the license granted by a celebrity may mean that the celebrity’s right of publicity claims are preempted. Thus, for example, in late 2022 the Second Circuit Court of Appeals affirmed a district court’s dismissal of a lawsuit against Sirius XM by John Melendez, who used to appear on The Howard Stern Show under the moniker “Stuttering John.” The plaintiff claimed that Sirius XM breached his right of publicity by airing past episodes and ads that featured him. The court found that, in light of Sirius XM’s license to these materials, the plaintiff’s claims were preempted by the federal Copyright Act.
Practitioners need to monitor each of these areas for new developments, particularly as the technology continues to improve and change.
On June 22, 2023, the United States Supreme Court decided two consolidated cases that may have a significant impact on the enforcement of foreign arbitral awards in the United States. In a majority opinion authored by Justice Sonia Sotomayor, the Supreme Court held that in certain circumstances, a foreign plaintiff may bring a private action under the Racketeer Influenced and Corrupt Organizations Act (“RICO”) for the purpose of collecting an international arbitration award. The Court’s decision in these cases—Yegiazaryan v. Smagin (No. 22-381) & CMB Monaco v. Smagin (No. 22-383)—dealt primarily with RICO’s “domestic injury” requirement, finding that a party’s actions to delay and prevent the execution of a U.S. judgement confirming a foreign arbitral award can satisfy that requirement. In doing so, the decision may pave the way for a powerful new avenue for foreign individuals and companies to reach U.S.-based assets for the purpose of collecting foreign arbitration awards.
What Is RICO?
RICO is a criminal and civil statute that Congress enacted in 1970 to combat the influence of “organized crime” on American commerce. Congress initially conceived RICO as a way “to prevent ‘known mobsters’ from infiltrating legitimate businesses.”[1] RICO penalized any person involved in an enterprise of racketeering activity in violation of certain federal and state criminal laws (called “predicate acts”) such as bribery, fraud, embezzlement, and money laundering.[2] To prove a RICO claim, based on any combination of predicate acts, a RICO plaintiff must show that the conduct of an enterprise, through a pattern of racketeering activity, caused injury to the plaintiff’s business or property.[3]
RICO also provides a private right of action to “[a]ny person injured in his business or property by reason of a violation of” RICO.[4] There is strong incentive for a civil plaintiff to bring a RICO claim because Congress mandated that prevailing civil RICO plaintiffs shall recover triple the actual damages caused by the defendant’s racketeering activity plus the costs of litigation, including attorneys’ fees.[5] Accordingly, over the years RICO has taken on countless interpretations. It has been described as “one of the nation’s most powerful laws.”[6] Courts have noted its “breathtaking scope,”[7] labeled it “an unusually potent weapon,”[8] and described it as “the litigation equivalent of a thermonuclear device.”[9]
The Domestic Injury Requirement for Civil RICO Claims and “Tangible Property”
RICO is notorious for its numerous elements and, thus, rigorous pleading standards. But there is an additional step for individual plaintiffs who are not U.S. residents or corporate plaintiffs that do not have their principal place of business in the United States. To establish standing under RICO, such a foreign plaintiff must demonstrate that it suffered a “domestic injury” to its business or property. That is, the plaintiff must establish an injury that was suffered in the United States, rather than abroad.
The Supreme Court first addressed RICO’s “domestic injury” requirement in RJR Nabisco, Inc. v. European Community.[10] There, foreign plaintiffs filed a RICO suit against the tobacco corporation RJR Nabisco alleging international money laundering (including acts involving foreign drug traffickers and the sale of cigarettes to Iraq). The Supreme Court established that for foreign plaintiffs asserting a RICO claim there is a presumption against extraterritoriality, and that presumption requires a plaintiff to prove a “domestic injury” in support of a RICO action.[11] The Court found that RICO is not limited solely to domestic schemes, but it remains that “not . . . every foreign enterprise will qualify.”[12]
In 2017, the Second Circuit addressed the “domestic injury” requirement in Bascuñán v. Elsaca. In that case, the plaintiff, a resident of Chile, alleged a RICO claim based on allegations that his cousin stole millions of dollars from his U.S. bank account through various schemes.[13] The district court concluded that there was no “domestic injury” because the plaintiff suffered economic injuries only that he felt at his place of residence, which was Chile, not the United States.[14]
The Second Circuit, however, reversed this decision, holding that “[w]here the injury is to tangible property [money in a U.S. bank account], we conclude that, absent some extraordinary circumstance, the injury is domestic if the plaintiff’s property was located in the United States when it was stolen or harmed, even if the plaintiff himself resides abroad.”[15] Because there was a domestic injury to tangible property, the Second Circuit’s decision in Bascuñán allowed the RICO claim to proceed.[16]
Neither Bascuñán nor RJR Nabisco, however, addressed how the presumption against extraterritoriality applies to intangible property belonging to a foreign plaintiff, thus leaving an open question that the Supreme Court addressed in Yegiazaryan v. Smagin, which involved the intangible property of a judgment enforcing a foreign arbitral award.
Armada in the Seventh Circuit—Where Does the Plaintiff Live?
In 2018, the Seventh Circuit, in Armada (Sing.) PTE Ltd. v. Amcol Int’l Corp., affirmed that a judgment of a United States District Court recognizing a foreign arbitral award is “intangible property.”[17] Per the decision in Armada, the “location” of an injury to that intangible property had to be the foreign claimant’s home abroad.[18]
The plaintiff in Armada (a Singaporean shipping company) was awarded more than $70,000,000 in two awards in ad hoc arbitration in London.[19] The Southern District of New York recognized those awards and entered a judgment, and the plaintiff sought to enforce its judgment by filing maritime attachment proceedings.[20] When those efforts proved unsuccessful, the plaintiff filed a RICO action alleging that it suffered an injury to its property (i.e., its recognized judgment) and that the defendants “by means of racketeering activity, injured that property by divesting [the defendant] of assets, thereby making the judgment and other claims against [the defendant] uncollectable.”[21]
The Seventh Circuit held that the foreign plaintiff’s “principal place of business [was] in Singapore, so any harm to [the plaintiff’s] intangible bundle of litigation rights was suffered in Singapore.”[22] Therefore, there was no domestic injury to the plaintiff’s intangible property and the plaintiff “failed to plead a plausible claim under civil RICO.”[23]
Humphrey in the Third Circuit—Where Did the Plaintiff Suffer?
Later in 2018, the Third Circuit scrutinized Armada and departed from it in Humphrey v. GlaxoSmithKline PLC.[24] The plaintiffs in Humphrey were American cofounders of an investigation firm based in China.[25] Following a Chinese regulatory investigation that resulted in the arrest, conviction, and deportation of the plaintiffs back to the United States,[26] the plaintiffs sued for civil RICO, alleging that their business was “destroyed and their prospective business ventures eviscerated.”[27] The district court found there was no domestic injury because “Plaintiffs’ business was in China, their only offices were in China, no work was done outside of China, Plaintiffs resided in China, and … any destruction of Plaintiffs’ business occurred while Plaintiffs were imprisoned in China by Chinese authorities.”[28]
The Third Circuit affirmed. In doing so, however, it rejected the residency-based rule from Armada and opted instead for a multi-factor test to determine when injury to intangible property is a “domestic injury.”[29] The court’s inquiry “focus[ed] primarily upon where the effects of the predicate acts were experienced.”[30] There were several factors the Humphrey court deemed relevant to consider, including (but not limited to):
where the injury arose;
the plaintiff’s residence or principal place of business;
where any alleged services were provided;
where the plaintiff received or expected to receive benefits of those services;
where any business agreements were entered into;
the laws binding those agreements; and
the location of the activities in the underlying dispute.[31]
Applying these factors, the Third Circuit concluded there was no domestic injury because the alleged harm to the plaintiffs’ business occurred mainly abroad.[32]
Smagin in the Ninth Circuit—A “Context-Specific” Inquiry
The Seventh Circuit’s decision in Armada and the Third Circuit’s decision in Humphrey set the stage for the Supreme Court’s June 22, 2023, decision in Yegiazaryan v. Smagin and CMB Monaco v. Smagin.
These cases arose from a Ninth Circuit appeal involving the enforcement of an $84,000,000 arbitral award from the London Court of International Arbitration (“LCIA”).[33] In December 2014, the California federal court confirmed the LCIA arbitral award, entered judgment against Ashot Yegiazaryan for $92,000,000 (the award plus interest), and issued a temporary protective order freezing Yegiazaryan’s assets in California.[34]
After Yegiazaryan’s continued refusal to pay, the claimant Vitaly Ivanovich Smagin filed a civil RICO action alleging that Yegiazaryan and other defendants conducted a RICO enterprise to prevent Smagin from enforcing the arbitral award.[35] In his suit, Smagin sought not only actual damages (i.e., the amount of his LCIA award), but also attorneys’ fees and treble damages as authorized under RICO. The Central District of California dismissed the complaint for lack of domestic injury.[36] In deciding, the district court noted the relevant Humphrey factors, but found it “most significant” that Smagin is a resident and citizen of Russia—and thus not the subject of a domestic injury.[37]
The Ninth Circuit reversed, adopting a “context-specific” approach.[38] Applying that approach, the Ninth Circuit concluded that Smagin had pleaded a domestic injury. Smagin, the appellate court reasoned, was trying to execute on a California judgment, in California, against a California resident. He alleges that his efforts were foiled by a pattern of racketeering activity that “occurred in, or was targeted at, California” and was “designed to subvert” enforcement of that judgment in California.[39]
The court concluded there was a domestic injury, and noted that Smagin’s “central allegation is that those predicate acts injured his right to seek property in California from a California resident under the California Judgment.”[40] Rejecting the Seventh Circuit’s bright-line rule in Armada and embracing the Third Circuit’s factor-based approach in Humphrey, the Ninth Circuit held that “whether a plaintiff has alleged a domestic injury is a context-specific inquiry that turns largely on the particular facts alleged in a complaint.”[41]
Yegiazaryan in the Supreme Court—A Context-Specific Inquiry Prevails over a Bright-Line Rule
After the Ninth Circuit denied petitions for an en banc rehearing, Yegiazaryan and one of the other defendants, CMB Monaco (a foreign bank), both filed petitions for certiorari. On January 13, 2023, the Supreme Court granted the petitions and consolidated the cases. During argument on April 25, 2023, Chief Justice John Roberts and Justice Sonia Sotomayor seemed to favor affirming the Ninth Circuit’s decision, with Chief Justice Roberts noting “the plaintiff obtained a California judgment to collect California property against someone living in California based on conduct in California. Right? Why can’t we consider, with all those connections, that . . . a domestic injury?”[42]
For her part, Justice Elena Kagan seemed uncomfortable with how this foreign dispute came before the Court: “It is a little bit odd . . . yes, there’s a California judgment and acts, alleged acts, taken to avoid that judgment. But all of that is derivative on a dispute that was fundamentally foreign in nature between foreign parties involving foreign conduct initially adjudicated in another foreign country, so the fact that this has migrated, if you will, to the United States, you know, comes about only with respect to enforcing the first judgment.”[43]
In the end, the justices affirmed the Ninth Circuit and permitted Smagin to pursue his RICO claim to try to enforce his $92 million judgment. Justice Sotomayor authored the majority opinion, which the Court issued on June 22, 2023. The Court held that Smagin’s allegations showed the alleged racketeering activity occurred in or was targeted at California, thus creating a domestic injury sufficient to establish RICO standing for the foreign plaintiff.
The Court rejected the bright-line residency rule from Armada, opting instead to follow the Ninth Circuit’s context-specific inquiry. “[D]epending on the allegations, what is relevant in one case to assessing whether the injury arose may not be pertinent in another,” the majority held. “While a bright-line rule would no doubt be easier to apply, fealty to the statute’s focus requires a more nuanced approach.”[44] The Court emphasized the facts surrounding the California judgment and Yegiazaryan’s “domestic actions” taken to avoid enforcement.[45]
The rights that the California judgment provide to Smagin exist only in California, and “[t]he alleged RICO scheme thwarted those rights, thereby undercutting the orders of the California District Court and Smagin’s efforts to collect Yegiazaryan’s assets in California.”[46] Looking to what the Court viewed as the relevant factors, the Court concluded there was a domestic injury.
Three justices dissented. Justice Samuel Alito was joined fully in his dissent by Justice Clarence Thomas and joined in part by Justice Neil Gorsuch. Their concern was that a context-specific inquiry offers little help to future courts grappling with this issue.[47] “Of course, under the majority’s all-factors-considered approach, many other features of this very suit could be relevant,” the dissent opined.[48] It was unclear from the majority’s opinion which factors are relevant, and in what context.
The dissenting justices also raised concerns about overreach, noting that this decision gives foreign plaintiffs with arbitral awards significant power. “A thrust of our international-comity jurisprudence is that we should not lightly give foreign plaintiffs access to U.S. remedial schemes that are far more generous than those available in their home nations,” the dissent noted. “In light of RICO’s unusually plaintiff-friendly remedies, that concern applies in spades here.”[49]
Takeaways
The Supreme Court’s decision is significant, and there are several key takeaways of which international arbitration and RICO practitioners should be aware.
First, the Supreme Court has recognized—for the first time—that a United States judgment confirming a foreign arbitral award is “property” within the meaning of RICO. Thus, a plaintiff who can allege an injury to that foreign arbitral award can satisfy the damages requirement of the RICO statute (i.e., injury to one’s “business or property”). This holding gives claimants who are successful in international arbitration proceedings a new weapon to enforce arbitral awards against reluctant defendants with U.S.-based assets.
Second, by allowing Smagin’s RICO claim to proceed, the Supreme Court opened a path for Smagin to recover treble damages and attorneys’ fees, and thus significantly increase the value of his arbitration victory. As we have seen in other areas, plaintiffs are very eager to use RICO whenever possible in order to take advantage of these provisions. It would not be surprising at all to see other plaintiffs try to emulate Smagin’s success here, thus creating an uptick in lawsuits in U.S. courts seeking foreign arbitral award enforcement under the cover of civil RICO.
Third, given the context-specific approach the Supreme Court endorsed, it would likewise not be surprising to see other federal courts try to place limitations and/or guardrails on the application of this decision. Courts will still require foreign plaintiffs to meet the rigorous civil RICO standards, including establishing predicate criminal offenses and a connection to an “enterprise.” And while the threat alone of treble damages and attorneys’ fees may motivate debtors to pay up when they might otherwise be reluctant, the context-specific analysis of this opinion does leave them escape hatches that a bright-line rule likely would not have.
This, in part, is the dissenting justices’ concern. Smagin may have received the blessing he needed to pursue a private RICO action. But the defendant in this case is a California resident with assets in California. The context-based analysis changes considerably if the defendant, for example, does not reside in California, or did not have assets in California. If these circumstances are changed, even slightly, that may prove to be enough for other federal courts to distinguish such a case and not be bound by these Supreme Court precedent.
It is too early to tell the practical impact of the Supreme Court’s decision. Regardless, beyond the question of enforcing foreign arbitral awards against U.S.-based assets, this decision will be of interest to all seeking clarity on when and under what circumstances non-U.S. plaintiffs may invoke RICO.
[7] R.A.G.S. Couture, Inc. v. Hyatt, 774 F.2d 1350, 1355 (5th Cir. 1985).
[8] Turner v. New York Rosbruch/Harnik, Inc., 84 F. Supp.3d 161, 167 (E.D.N.Y. 2015) (quoting Miranda v. Ponce Fed. Bank, 948 F.2d 41, 44 (1st Cir.1991)).
[10] 579 U.S. 325, 326 (2016) (“A private RICO plaintiff therefore must allege and prove a domestic injury to its business or property.”).
[11]Id. at 335 (noting that “[a]bsent clearly expressed congressional intent to the contrary, federal laws will be construed to have only domestic application.”).
[16]Id. at 824 (“…with respect to the particular type of property injury alleged here—the misappropriation of Bascuñán’s trust funds from a specific bank account located in the United States—we conclude that the location of the property and not the residency of the plaintiff is the dispositive factor.”).
[29]Id. at 708–09 (“Although the ease with which [Armada’s] bright-line rule can be applied gives it some surface appeal, we resist the temptation to adopt it as the law of this circuit.”).
[32]Id. at 707–08 (noting “Plaintiffs lived in China; had their principal place of business in China; provided services in China (albeit to some American companies – but even they were operating in China); entered the Consultancy Agreement in China and agreed to have Chinese law govern it; met with Defendants’ representatives only in China; and themselves indicated on the civil cover sheet that the underlying incident arose in China.”).
[36] Smagin v. Compagnie Monegasque de Banque, Case No. 2:20-cv-11236-RGK-PLA, 2021 WL 2124254 (C.D. Cal. May 5, 2021).
[37]Id. at *4 (“Though the Court here considers all of the relevant Humphrey factors, the Court places great weight on the fact that Smagin is a resident and citizen of Russia and therefore experiences the loss from [his] inability to collect on his judgment in Russia.”) (internal quotations omitted).
[47]Id. at *9 (“This analysis offers virtually no guidance to lower courts, and it risks sowing confusion in our extraterritoriality precedents. Rather than take this unhelpful step, I would dismiss the writ of certiorari as improvidently granted.”).
