Business Law Today’s winter video collection explores topics from sustainable finance to books and records demands, bringing together experts to share cutting-edge insights. The videos delve deeper into in the subjects of CLE programs at the ABA Business Law Section’s recent Hybrid Annual Meeting, talk with authors of newly released business law books, and discuss topical issues relevant to both novices and seasoned practitioners. Watch now!
Read more about the three business law video series and thirteen videos in the collection below.
Bankruptcy filings are currently at historic lows. In this wide-ranging discussion, U.S. Bankruptcy Judge Christopher M. Alston discusses potential drivers of this change, from new state laws to Subchapter V of Chapter 11 of the U.S. Bankruptcy Code, as well as other notable developments and trends in the world of bankruptcy law. The video delves into the continuing effects of the pandemic on bankruptcy and foreclosures; efforts to make bankruptcy courts more diverse; mass tort bankruptcy cases; and more.
In this engaging discussion, Emily V. Burton and Oderah C. Nwaeze explore books and records demands under Section 220 of the Delaware General Corporation Law, which gives stockholders the right to inspect corporate books and records for certain proper purposes. Providing insights from both the stockholder and corporate sides, they discuss everything from the specificity needed for a demand to notable Section 220 litigation and its impact on best practices for corporate record production. They also touch on the role of directors, including the unique dynamics of their inspection rights and when director emails are produced. Throughout, Burton and Nwaeze highlight tips and strategies for the reality of this area of practice.
This discussion with Commodity Futures Trading Commission (CFTC) Commissioner Kristin N. Johnson features excerpts of her appearance at the ABA Business Law Section’s Hybrid Annual Meeting in September 2022. In Commissioner Johnson’s keynote fireside chat with the Section’s Private Equity and Venture Capital Committee, she offered thoughts on the legal and regulatory framework for cryptocurrency and digital assets, collaboration with the Securities and Exchange Commission, and more.
Interested in a career in M&A? This video will provide an understanding of not only the role of the corporate lawyer in M&A deals but the numerous elements that encompass a typical M&A transaction. The featured speakers—Samantha Horn, Matthew B. Swartz, and Daniel Rosenberg—are seasoned M&A lawyers who have a firm grasp of this unique legal practice. In this video, they identify the legal issues and key players involved in an M&A deal and offer tips for getting started in the field. With so many moving parts, the attorney must have the knowledge and skills to navigate the legal due diligence of an M&A transaction.
With cyberattacks on the rise, every organization needs to be proactive in cybersecurity incident response planning. Such planning is essential to formulate policies to help resolve cyberattacks and meet legal obligations. In this video, two cybersecurity specialists, Garylene (Gage) Javier and Romaine Marshall, describe the current threat landscape, in which increasingly sophisticated cybercriminals treat ransomware attacks as a “business.” They walk viewers through best practices for incident response plans and recovering from an attack—highlighting how responsible governance requires understanding and planning for a robust response that will safeguard the organization.
Nathaniel M. Cartmell III, Nicholas D. Mozal, Youmna Salameh, and former Vice Chancellor of the Delaware Court of Chancery Joseph R. Slights III provide keen insight into recent decisions under Delaware law that address controlling stockholders, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). Their conversation delves into the determination of whether a control group exists, considerations around trading process for price in the context of the MFW decision, key differences in negotiating with a controller stockholder, and more.
Kyriakoula Hatjikiriakos, Lisa Mantello, Robert J. Lewis, and Sara Gerling explore recent market trends in the rapidly evolving world of sustainable finance loan transactions, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). These experts reflect on the current landscape in the US, European, and Canadian markets, including emerging regulatory developments. Topics covered include the role of sustainability coordinators, key performance indicators used in sustainability linked loans and what within ESG they focus on, and more.
Maritza T. Adonis, Bruce F. Freed, and Jason Kaune delve into the new pressures on corporations to engage with social movements and environmental, social, and governance criteria, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). “Companies today really have to address what they’re associated with through their spending,” Freed said. Their conversation touches on what those counseling corporate leadership need to consider in planning how to address these issues, the role of different stakeholders, and the education and foundational work attorneys can undertake in this space.
Gary J. Ross and Alan J. Wilson explore the securities law framework for capital raising by early stage and other private businesses, extending the discussion of a CLE program at the ABA Business Law Section’s 2022 Hybrid Annual Meeting (now available as on-demand CLE). In a conversation ranging from the impact of the JOBS Act to tricky aspects of blue sky requirements to the evolution of SAFEs, Ross and Wilson highlight useful practice tips and share insights from their varied experience. The program their discussion draws on was part of Business Law Essentials, a curated selection of CLE programs designed to provide practice area updates, developments, and primers on key business law issues.
Jody R. Westby was spurred to writeD&O Guide to Cyber Governance: Fiduciary Duties in the Digital Age in a time of increasingly sophisticated cyberattacks. “Boards and CEOs are not aware of what really needs to be done,” she said. “I wanted to develop a book that would tell boards and C-suites, here’s what you do to manage cyber risks, and to do it right according to the law and to best practices.” In this conversation, Westby highlights key points where board members get tripped up, delves into the book’s practical resources, and explains why she dedicated the book to E. Norman Veasey, former Chief Justice of the Delaware Supreme Court and former Chair of the Business Law Section.
As terrorist groups and tactics evolve, government authorities and the private sector have focused on preventing financial and commercial systems from being leveraged and abused to fund terrorist activities. Leading experts came together to create Countering the Financing of Terrorism: Law and Policy after they realized there was a “gap in the literature” on this subject, says editor John M. Geiringer. The result is a comprehensive overview of the key legal tools and strategies used to combat this dynamic challenge. In this conversation, Geiringer discusses the extent of the terror financing problem; the role of financial institutions and banking lawyers in countering it; and the book’s insights into terror financing typologies.
“You need to understand fraudulent transfer law because of its broad scope. It might be an old, ancient law, but it is more than capable of handling today’s modern, sophisticated transactions,” says David J. Slenn. In The Fraudulent Transfer of Wealth: Unwound and Explained, Slenn outlines steps that planners can take to minimize a transaction’s exposure to avoidance and proactive measures that creditors can take to reduce the chance of losing assets. Here, Slenn discusses the risks of misunderstanding fraudulent transfer law, the book’s step-by-step guide to key issues, and top lessons learned.
With intellectual property rights assuming greater importance in today’s world and licensing issues and developments constantly evolving, The Practical Guide to Software Licensing and Cloud Computing, 7th Edition is an essential resource. In this conversation, author H. Ward Classen discusses the new edition’s expanded discussion of cloud computing, how he tracks new developments, and the evolution of the book over nearly twenty years. As the practice of software law has expanded, “It’s blossomed,” Classen said. “It’s much more comprehensive, and it seems to resonate with practitioners endlessly.”
ABA Model Rule 4.2 is seeing an apparent renewed emphasis in 2022. Rule 4.2—commonly known as the “no contact rule”—provides: “In representing a client, a lawyer shall not communicate about the subject of the representation with a person the lawyer knows to be represented by another lawyer in the matter, unless the lawyer has the consent of the other lawyer or is authorized to do so by law or a court order.” The stated purpose behind this Rule is “protecting a person who has chosen to be represented by a lawyer in a matter against possible overreaching by other lawyers who are participating in the matter, interference by those lawyers with the client-lawyer relationship and the uncounselled disclosure of information relating to the representation.” ABA Model Rule 4.2, cmt. 1.
This renewed emphasis on Rule 4.2 is evidenced by the ABA Standing Committee on Ethics and Professional Responsibility issuing two consecutive ABA Formal Ethics Opinions in quick succession addressing different aspects of the lawyer’s ethical obligations under the “no contact rule.”
Application of the “No Contact Rule” to the Self-Representing Lawyer
On September 28, 2022, the Committee issued ABA Formal Opinion 502 addressing “Communication with a Represented Person by a Pro Se Lawyer.” Early on, the Opinion recognized that Rule 4.2 does not prohibit parties from communicating directly with one another. See ABA Formal Op. 502, at 2-3, citing ABA Model Rule 4.2, cmt. 4. In fact, in a previous ABA Formal Ethics Opinion, the Committee opined that it is not a violation of Rule 4.2 to help coach a client about communications that the client can have with a represented opposing party. See ABA Formal Op. 11-461 (“Advising Clients Regarding Direct Contacts with Represented Persons”) (Aug. 4, 2011).
However, in Formal Opinion 502, a majority of the Committee concluded—based on both the text of Rule 4.2 itself and the purposes behind the Rule—that a lawyer proceeding in a matter pro se is “representing a client,” namely himself or herself, and therefore, the “no contact rule” applies. Specifically, the majority stated that:
When a lawyer is self-representing, i.e., pro se, that lawyer may wish to communicate directly with another represented person about the subject of the representation and may believe that, because they are not representing another in the matter, the prohibition of Model Rule 4.2 does not apply. In fact, both the language of the Rule and its established purposes support the conclusion that the Rule applies to a pro se lawyer because pro se individuals represent themselves and lawyers are no exception to this principle.
ABA Formal Op. 502, at 1.
In reaching this conclusion, the majority admitted that “when a lawyer is acting pro se, application of Model Rule 4.2 is less straightforward” and that in applying Rule 4.2 “to pro se lawyers, the scope of the rule is less clear.” ABA Formal Op. 502, at 2 and 3. Despite reliance on the principles behind Rule 4.2, the majority also acknowledged: “This opinion does not address the related question of applicability of Rule 4.2 when a lawyer is represented by another lawyer and the represented lawyer wishes to communicate with another represented person about the matter.” Id., at 3, n. 10. The majority even recognized that its stance about the language “in representing a client” applying to the self-representing lawyer may create an ambiguity when applied to a pro se lawyer and that its stance is contrary to that of the Restatement of the Law Governing Lawyers. Id., at 5 and 5, n. 25.
In a somewhat unusual move, not only was there dissent within the Committee on this issue, but the Committee published the dissenting opinion. From the outset, the dissenting minority disagreed with the notion that the language of Rule 4.2 itself supports the majority’s conclusion: “While the purpose of the rule would clearly be served by extending it to self-represented lawyers, its language clearly prohibits such application.” ABA Formal Op. 502, dissenting op. at 6–7 (italics in original). The dissent further explained:
But it is, I hope, unusual for a committee to nullify plain language through interpretation, especially when the committee has jurisdiction to propose rule amendments.
***
Applying Rule 4.2 to pro se lawyers is supported by compelling policy arguments. It is not the result I object to, it is the mode of rule construction that I cannot endorse. Self-representation is simply not “representing a client,” nor will an average or even sophisticated reader of these words equate the two situations. Rather, this is an “ingenious bit of legal fiction.” Further, this approach to construing the rule’s language renders the phrase “in representing a client” surplusage, contrary to a basic canon of construction.
It is also simply wrong to perpetuate language that was clear but has been made misleading by opinions effectively reading that language out of the rule. When an attorney consults the rule, it is highly unlikely that the phrase “in representing a client” will be considered to include self-representation. If the attorney goes further and consults Comment [4], the Comment will assure the attorney that, “Parties to a matter may communicate directly with each other.” Given this apparent clarity, what will tip off the attorney that further research is required? The lesson here must be that nothing is clear. Clear text cannot be relied upon but may only be understood by reading ethics opinions and discipline decisions. Does the text mean what it actually says, as it does in Connecticut, Kansas, and Texas? Or, does it mean what we wish it said, as several other states have declared?
ABA Formal Op. 502, dissenting op. at 7–8 (internal citations omitted) (italics in original).
Indeed, if Rule 4.2 is to be applied to a lawyer representing themself, that applicability is certainly less than clear from the language of the Rule or its Commentary. As the dissent suggests, if this is how the Rule is to be applied, then perhaps the Rule itself should be revised through the Rule amendment process to provide the clarity that the majority appears to see but that others do not. Otherwise, as it stands, ABA Formal Opinion 502 appears to set an ethical trap for the unsuspecting pro se lawyer who does not think they are “representing a client” when representing themself.
Rule 4.2 and the “Reply All” Email
On November 2, 2022, the Committee subsequently issued ABA Formal Opinion 503 addressing the issue of “‘Reply All’ in Electronic Communications.” Formal Opinion 503 addresses the ethical propriety of an opposing counsel recipient (“receiving counsel”) sending a “reply all” email when the originating attorney (“sending counsel”) copies their client on the original email. The Opinion addresses the extent to which the sending counsel, by copying their client, has impliedly authorized the recipient counsel to respond to all recipients of the original email (including the sending counsel’s client).
While acknowledging that a number of jurisdictions take the position that the sending counsel has not impliedly consented to a “reply all” response under these circumstances, the Committee concluded: “given the nature of the lawyer-initiated group electronic communication, a sending lawyer impliedly consents to receiving counsel’s ‘reply all’ response that includes the sending lawyer’s client, subject to certain exceptions [discussed therein].” ABA Formal Op. 503, at 2. The Committee supported its conclusion by noting that consent under Rule 4.2 need not be express but may be implied. The Committee also placed responsibility on the sending counsel for initially including their client on the communication, noting that such placement of responsibility on the sending counsel was fairer, especially if the list of recipients in the group email is large and especially where the sending counsel can avoid this issue altogether (and likewise avoid the possibility of the client also sending a “reply all” which may disclose “sensitive or compromising information”) by forwarding the client the original email in a separate email solely between the client and the lawyer. Id., at 3–4. In fact, the Committee itself noted that forwarding the email to the client—as opposed to “bcc’ing” a client—may be safer “because in certain email systems, the client’s reply all to that email would still reach the receiving counsel.” Id., at 4, n. 14.
Formal Opinion 503’s focus on the sending counsel’s responsibility, as opposed to that of the receiving counsel, is consistent with the 2002 amendment to ABA Model Rule 4.4(b) with respect to the duties of the unintended recipient of information relating to the representation of a client. Prior to 2002, the unintended recipient’s ethical obligations were to refrain from reading the document, notify the sender, and abide by the sender’s instructions. The 2022 amendment of Rule 4.4 limited the unintended recipient’s ethical obligation to only that of notifying the sender. See ABA Model Rule 4.4(b); ABA Formal Op. 05-437 (“Inadvertent Disclosure of Confidential Information: Withdraw of Formal Op. 92-368 (Nov. 10, 1992)”) (Oct. 1, 2005). As such, greater responsibility is placed on the sender to take care not to misdirect the communications in the first place.
As to the exceptions to this implied authorization to “reply all,” Formal Opinion 503 noted that an express oral or prominent written instruction from the sending counsel to receiving counsel that receiving counsel is not to send a “reply all” email that includes the client will eliminate any suggestion that the sending counsel has impliedly authorized such direct communication with the client. See ABA Formal Op. 503, at 4. The Opinion also noted that this implicit authorization for the receiving counsel to “reply all” should be limited to email and other group electronic communications. Seeid., at 4. In other words, the same implicit authority is not present if the sending counsel carbon copies their client on a traditional paper letter.
And again, some jurisdictions disagree with the position taken by ABA Formal Op. 503 with respect to the sending counsel impliedly authorizing the receiving counsel’s direct communication with the carbon copied client via a “reply all” response email. For example, Kentucky Bar Association Ethics Opinion E-442 (Nov. 17, 2017) took the opposite approach: “A lawyer who, without consent, takes advantage of ‘reply all’ to correspond directly with a represented party violates Rule 4.2. Further, showing a ‘cc’ to the client on an email, without more, cannot reasonably be regarded as consent to communicate directly with the client.” See KBA E-442, at 1–2. The KBA Opinion also cautioned that the sending counsel, without the client’s express or implied consent, may be violating Rule 1.6’s duty of confidentiality when copying the client because doing so provides the following information to the receiving counsel: “1) the identity of the client; 2) the client received the email including attachments, and 3) in the case of a corporate client, the individuals the lawyer believes are connected to the matters and the corporate client’s decision makers.” Id., at 2.
Conclusion
Perhaps the lesson behind both of these ABA Formal Ethics Opinions addressing Rule 4.2 is this: it has always been true that a lawyer should pause whenever wanting to communicate directly with a person represented by counsel. But there are grey areas in the application of this Rule, and different jurisdictions interpret the Rule differently. Some jurisdictions would follow ABA Formal Opinion 502 and apply Rule 4.2 to self-representing lawyers, while other jurisdictions would not. Some jurisdictions would follow ABA Formal Opinion 503 and maintain that, generally speaking, a sending counsel who copies their client on an email has impliedly authorized the receiving counsel to send a “reply all” response email, while other jurisdictions would not. As such, when a lawyer finds themself in these grey areas, it is important to determine how the applicable jurisdiction applies Rule 4.2. Finally, if all else fails, the lawyer can always attempt to secure the explicit consent of opposing counsel to allow for direct communication with opposing counsel’s client, with such consent preferably confirmed in writing to eliminate any confusion.
On October 26, 2022, the U.S. Securities and Exchange Commission (the “SEC” or the “Commission”) adopted final rules (the “Final Rules”)[1] implementing the clawback provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). In particular, the Final Rules require:
national securities exchanges (“exchanges”) and national securities associations to establish listing standards that require listed companies to develop and implement policies providing for the recovery of “erroneously awarded” incentive-based compensation received by current or former executive officers where such compensation is based on erroneously reported financial information and an accounting restatement is required (a “clawback policy”); and
listed companies to provide disclosures about their clawback policies and how they are being implemented.
Historical Background and Commissioners’ Views
Section 954 of the Dodd-Frank Act added Section 10D to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Section 10D directed the SEC to adopt a rule requiring companies to develop, implement, and disclose clawback policies designed to recover “erroneously awarded” incentive-based compensation from current or former executive officers during the three-year period preceding the date on which the company was required to prepare an accounting restatement due to the company’s material noncompliance with any financial reporting requirement under the securities laws.
The SEC first proposed clawback rules on July 1, 2015, and received significant public comment. After the proposal languished for years, and in light of regulatory and market developments since 2015, the Commission reopened the comment period for these rules on October 14, 2021. On June 8, 2022, the Commission released a memo prepared by the staff in its Division of Economic and Risk Analysis that contained additional analyses and data relevant to the proposed clawback rules and reopened the comment period again. The SEC adopted the Final Rules on October 26, 2022, in a 3-2 vote.
SEC Chair Gary Gensler and Commissioners Caroline Crenshaw and Jaime Lizárraga voted in favor of the Final Rules. Their statements indicated that they supported the Final Rules largely because they believe the Final Rules will benefit investors and promote accountability, including by, among other things, “strengthen[ing] the transparency and quality of corporate financial statements, investor confidence in those statements, and the accountability of corporate executives to investors.”[2]
Commissioners Hester Peirce and Mark Uyeda dissented from the adoption of the Final Rules. Their statements included concerns that the Final Rules are overly broad by, among other things, applying to so-called “little r” restatements (rather than only “Big R” restatements),[3] covering too broad a swath of company executives (rather than only individuals involved in the events leading to the restatement), applying to all listed companies (rather than excluding or providing exemptions for emerging growth companies [“EGCs”], smaller reporting companies [“SRCs”], and foreign private issuers [“FPIs”]), and defining “incentive-based compensation” too broadly (rather than limiting it to compensation based on accounting-based metrics). Commissioner Uyeda also expressed his concern that the Final Rules may misalign the interests of shareholders and corporate executives, as companies may restructure executive compensation arrangements to decrease incentive pay vulnerable under clawback policies in favor of increasing discretionary bonuses.[4]
Important Things to Know
The Final Rules will require companies to adopt clawback policies and provide related disclosures. Below are questions highlighting issues of note for companies, directors, and advisors about the Final Rules, which are separated into sections discussing the Final Rules generally, clawback policies, and disclosure requirements.
General Information
1. Which companies are affected?
All listed issuers—including EGCs, SRCs, FPIs, Canadian companies reporting under the multijurisdictional disclosure system, and controlled companies—will be subject to the Final Rules.
2. When will this new regime go into effect?
The Final Rules, which, as noted, are structured to direct the exchanges to adopt new listing standards, will become effective on January 27, 2023. Exchanges will need to file proposed listing standards no later than February 26, 2023, and these listing standards must then be effective no later November 28, 2023. A listed company must adopt a clawback policy no later than sixty days following the date on which the applicable listing standard becomes effective and must begin to comply with the Final Rules’ disclosure requirements in proxy and information statements and annual reports filed on or after the effective date of the applicable listing standard.
3. May companies indemnify or otherwise assist their executive officers in mitigating the impact of the clawback policy?
No. Companies are prohibited from insuring or indemnifying their executive officers with respect to recoverable amounts, including from paying or reimbursing the executive officer for premiums on an insurance policy covering recoverable amounts.
Clawback Policies
4. What must be included in a company’s clawback policy?
A listed company will be required to adopt and comply with a written policy providing that the company:
will recover reasonably promptly the amount of erroneously awarded incentive-based compensation in the event that the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, including any required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements, or that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period. (Final Rules; emphasisadded to highlight defined terms.)
5. Which employees need to be covered by the clawback policy?
A company’s current and former executive officers will be subject to the clawback policy.
“Executive officers” in the new Rule 10D-1(d) are the same as officers as defined by Rule 16a-1(f) for Section 16 purposes and therefore broader than the definition of “executive officer” provided in Rule 3b-7 under the Exchange Act. So, for domestic issuers, the group covered will include any executives subject to Form 4 reporting. The group includes a company’s president; principal financial officer; principal accounting officer (or if there is no such accounting officer, the controller); any vice president of the company in charge of a principal business unit, division, or function (such as sales administration or finance); any other officer who performs a policy-making function; or any other person who performs similar policy-making functions for the company.
Importantly, the definition of executive officer is broader than the definition of “named executive officer” (NEO) and the group of executives subject to clawback under the Sarbanes-Oxley Act of 2002. The company’s principal accounting officer (or controller if the listed company does not have a principal accounting officer) is covered by the Final Rules even if the company does not otherwise consider that person to be among its executive officers.
Note that the definition of executive officer is not limited to executive officers who may be “at fault” for, or have knowledge of, errors that led to a restatement or those who are directly responsible for the preparation of the financial statements. Recovery of compensation received while an individual was serving in a non-executive capacity prior to becoming an executive officer will not be required, but for an employee who served as an executive officer and then returned to employee status, recovery for compensation following service as an executive officer would be required.
The Final Rules do not apply to non-employee directors.
6. What is incentive-based compensation?
The Final Rules define incentive-based compensation broadly as “any compensation that is granted, earned or vested based wholly or in part upon the attainment of any financial reporting measure” and includes cash awards, bonuses from a “pool” the size of which is determined based on financial reporting measures, equity awards, and proceeds from shares acquired pursuant to such equity awards. Notably, however, incentive-based compensation excludes equity awards that were not granted based on the attainment of any financial reporting measure and vest solely based on continued service.[5]
Note that compensation contracts or arrangements that existed at or prior to the Final Rules’ effective date must be subject to clawback policies if any incentive-based compensation is received on or after the effective date of the listing standards (e.g., a performance-based equity award granted in 2021 with a performance period that ends in 2025). In other words, currently existing compensation contracts are subject to potential clawback if any applicable compensation will be received on or after the effective date of the exchanges’ standards.
7. What are financial reporting measures?
Financial reporting measures are:
measures that are determined in accordance with the accounting principles used in the company’s financial statements, whether presented in or outside of the company’s financial statements,
any measures derived wholly or in part from such measures (including non-GAAP measures and other measures, metrics, and ratios that are not non-GAAP measures, e.g., same-store sales), and
other performance measures—including stock price, Total Shareholder Return (“TSR”), and relative TSR—that are affected by accounting-related information.[6]
8. When is incentive-based compensation deemed to have been erroneously awarded?
Incentive-based compensation will be deemed erroneously awarded and subject to a company’s clawback policy if the compensation was tied to financial performance measures and the issuer is required to restate or correct the financial statements upon which the payouts were based (i.e., the payout was a higher amount than it would have been had the corrected financial statements been the ones initially prepared).[7]
This means that clawback policies must cover both “Big R” and “little r” restatements. The Final Rules do not provide a separate definition for either “materiality” or “accounting restatements”; instead, the Final Rules look to existing accounting standards and guidance to define such terms in order to help ensure standards are consistently applied across companies and over time.[8]
9. What time period must the clawback policy cover?
The clawback policy must provide for a three-year look-back period, which comprises the three completed fiscal years (rather than the preceding thirty-six months) immediately preceding the date when the company is required, or should have reasonably concluded that it was required, to prepare an accounting restatement for a given reporting period.[9]
This means that if a company with a December 31 fiscal year-end determines in November 2024 that a restatement is required going back to 2021 and files restated financial statements in January 2025, the clawback policy would apply to incentive-based compensation received in 2023, 2022, and 2021 (see next section for the definition of “received”). If a company changed its fiscal year-end during the three-year look-back period, it must recover incentive-based compensation received during the transition period occurring during, or immediately following, that three-year period in addition to during the three-year look-back period (i.e., a total of four periods).
Notwithstanding the three-year lookback, the Final Rules apply only to (i) incentive-based compensation received after a person began service as an executive officer and served as an executive officer at any time during the performance period for that incentive-based compensation, and (ii) incentive-based compensation received while the company’s securities are listed.
10. When is incentive-based compensation “received” for purposes of the three-year lookback?
Incentive-based compensation is deemed to be “received” in the fiscal year during which the financial reporting measure included in the incentive-based compensation award is attained or satisfied, regardless of whether the payment or grant occurs after the end of that period or if the executive officer has established only a contingent right to payment at that time. The Adopting Release notes that ministerial acts or other conditions necessary to effect issuance or payment (e.g., calculating the amount earned or obtaining the board of directors’ approval of payment) do not extend the date of receipt.
11. What portion of erroneously awarded compensation must be recovered?
“[T]he amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the restated amounts”[10] is subject to recovery.
The Adopting Release provides the following, non-comprehensive, guidance for calculating the amount of erroneously awarded compensation:
For equity awards, if the equity award or shares are still held at the time of recovery, the number of such securities received in excess of the number that should have been received based on the accounting restatement (or the value of that excess number), provided that if options or SARs have been exercised, but the underlying shares have not been sold, the erroneously awarded compensation is the number of shares underlying the excess options or SARs (or the value thereof).
The SEC did not clarify if by “the value thereof” it intends to capture the value at the time of grant or at the time of clawback.
For cash awards paid from bonus pools, the erroneously awarded compensation is the pro rata portion of any deficiency that results from the reduction in the aggregate bonus pool based on applying the restated financial reporting measure.
For incentive-based compensation attained only partially based on the achievement of financial reporting measures, recalculate only the portion of such compensation based on or derived from the financial reporting measure that was restated.
If the erroneously awarded compensation is not able to be calculated from information in an accounting restatement (e.g., TSR, relative TSR,[11] or stock price measures), a reasonable estimate of the effect of the accounting restatement on such measure should be used (with documentation of such determination provided to the relevant exchange).
All amounts of erroneously awarded compensation would be calculated on a pre-tax basis (i.e., without respect to any tax liabilities that may have been incurred or paid by the executive).
12. How and when must recovery occur?
As noted above, the Final Rules mandate recovery on a no-fault basis, without regard to any “scienter” on the part of relevant executive officers and with very limited discretion by the board of directors to forgo recovery. The Final Rules provide that recovery need not be pursued if the compensation committee (or in the absence of a compensation committee, a majority of the board’s independent directors) determines recovery is impracticable in light of one of the following three conditions:
the direct cost paid to a third party to assist in enforcing recovery would exceed the amount of recovery, provided that the company has first made a reasonable attempt to recover such erroneously awarded compensation, has documented such reasonable attempt(s) to recover, and has provided that documentation to its listing exchange;
the recovery would violate a home country law that was adopted prior to November 28, 2022, provided that the company has obtained an opinion of home country counsel acceptable to the company’s listing exchange that recovery would result in such a violation and the company has provided such opinion to its listing exchange; or
the recovery would likely cause an otherwise tax-qualified retirement plan, under which benefits are broadly available to employees of the registrant, to fail to meet the requirements of 26 U.S.C. 401(a)(13) or 26 U.S.C. 411(a) and regulations thereunder.
Absent a finding of impracticability, companies are permitted to exercise discretion in what specific means to use to accomplish recovery, but generally must pursue recovery and should endeavor to prevent executive officers from retaining the full amount of compensation to which they were not entitled under the company’s restated financials. Partial recovery can only be sufficient with a showing of impracticability, as described above.
Recovery must occur “reasonably promptly.” The Final Rules do not define “reasonably promptly,” but the Adopting Release notes that companies may consider costs related to recovery efforts when determining what is “reasonable.” For example, it may be reasonable, depending on the facts and circumstances, to establish a deferred payment plan allowing an executive officer to repay erroneously awarded compensation as soon as possible without unreasonable economic hardship or to establish compensation practices that account for the possibility of the need for future recovery (e.g., holdbacks).
There are no de minimis exceptions for small amounts of recovery (except to the extent it may implicate the impracticability analysis described above).
13. What happens if a company does not adopt a clawback policy?
A company will be subject to delisting if it does not adopt and comply with a clawback policy that meets the requirements of its exchange’s listing standards, and no exchange will be able to list the company’s shares until it has adopted a compliant policy.
Disclosure Requirements
14. Where do clawback policies and related information need to be disclosed?
Disclosures will need to be provided in proxy and information statements, as well as in companies’ annual reports.
15. What disclosures does a company need to make regarding its clawback policy?
The Final Rules require companies to provide a number of new disclosures related to their clawback policies. A listed company will be required to:
file its clawback policy as an exhibit to its annual report; and
include check boxes on the cover of its Form 10-K, 20-F, or 40-F, as applicable, disclosing whether the financial statements included in the report reflect the correction of an error to previously issued financial statements and whether any such error corrections are restatements that required a compensation recovery analysis pursuant to the company’s clawback policy.
A listed company that has prepared an accounting restatement that triggered its clawback policy, along with any company that has an outstanding balance of excess incentive-based compensation relating to a prior restatement, will also be required to provide the following disclosures in its proxy or information statement or annual report containing executive compensation disclosures pursuant to Item 402 of Regulation S-K:
the date the accounting restatement was required to be prepared, the aggregate amount of any related erroneously awarded compensation, and a description of how the recoverable amount was calculated or why the amount has not yet been determined;
the aggregate amount of the erroneously awarded compensation outstanding at the end of the last fiscal year;
if the erroneously awarded incentive compensation was determined based on stock price or TSR metrics, the estimates used to determine the amount of erroneously awarded compensation attributable to an accounting restatement and an explanation of the methodology used for those estimates;
the amount of recovery forgone and a description of the reasons recovery was not pursued if recovery would be impracticable; and
for each covered current or former executive, the amount of any erroneously awarded compensation that is owed and has been outstanding for 180 days or longer after the company determined the amount owed.
Disclosure would also be required if an accounting restatement occurred and the registrant concluded recovery of erroneously awarded compensation was not required under the clawback policy.
Next Steps
16. What steps should be taken now to ensure compliance with the Final Rules?
Companies should work with counsel to update existing clawback policies or adopt new clawback policies to comply with the Final Rules. Companies should also review existing contracts and forms (e.g., employment agreements, separation agreements, bonus plans, and equity award agreements) and consider updates addressing the company’s clawback policy. Members of management should expect to engage with both their nominating and governance committees as well as compensation committees on efforts to comply with the Final Rules. Members of these committees should make appropriate inquiries of management to understand the timing and nature of any changes that might be required in a company’s clawback policies.
A version of this publication originally appeared as a Cravath, Swaine & Moore LLP client memo.
The text of the final rule and the Commission’s related adopting release (the “Adopting Release”) can be found on the SEC’s website. ↑
“Big R” restatements are restatements where historical financial statements are restated to correct errors material to previously issued financial statements. “Little r” restatements are restatements that correct errors that are not material to previously issued financial statements, but would result in a material misstatement if (a) the errors were left uncorrected in the current report or (b) the error correction was recognized in the current period. ↑
The Adopting Release provides non-exhaustive examples of compensation that is not incentive-based compensation, including salaries; bonuses paid solely at the discretion of the compensation committee or board that are not paid from a bonus pool determined by satisfying a financial reporting measure performance goal; bonuses paid solely upon satisfying one or more subjective standards (e.g., demonstrated leadership) and/or completion of a specified employment period; non-equity incentive plan awards earned solely upon satisfying one or more strategic measures (e.g., consummating a merger or divestiture) or operational measures (e.g., opening a specified number of stores, completion of a project, increase in market share); and equity awards for which the grant is not contingent upon achieving any financial reporting measure performance goal and vesting is contingent solely upon completion of a specified employment period and/or attaining one or more nonfinancial reporting measures. ↑
The Adopting Release provides a non-exhaustive list of financial reporting measures, including revenue; net income; operating income; profitability of one or more reportable segments; financial ratios; net assets or net asset value per share; earnings before interest, taxes, depreciation and amortization; liquidity measures; return measures; earnings measures; sales per square foot or same-store sales, where sales are subject to an accounting restatement; revenue per user, or average revenue per user, where revenue is subject to an accounting restatement; cost per employee, where cost is subject to an accounting restatement; any of such financial reporting measures relative to a peer group where the company’s financial reporting measure is subject to an accounting restatement; and tax basis income. ↑
When errors are both immaterial to previously issued financial statements and immaterial to the current period, they are often corrected in the current period in so-called “out-of-period” adjustments. The Adopting Release explains that an out-of-period adjustment should not trigger a compensation recovery analysis under the Final Rules, because it is not an “accounting restatement.” ↑
The Adopting Release does, however, provide a list of changes to a company’s financial statements that do not represent error corrections, and therefore do not trigger application of its clawback policy, including retrospective application of a change in accounting principle; retrospective revision to reportable segment information due to a change in the structure of a company’s internal organization; retrospective reclassification due to a discontinued operation; retrospective application of a change in reporting entity, such as from a reorganization of entities under common control; retrospective adjustment to provisional amounts in connection with a prior business combination (for international financial reporting standards only); and retrospective revision for stock splits, reverse stock splits, stock dividends, or other changes in capital structure. ↑
Accounting restatements are required to be prepared on the earlier of (1) the date the board of directors, a committee of the board of directors, or the officer(s) of the company authorized to take such action concludes, or reasonably should have concluded, that the company is required to prepare an accounting restatement due to the material noncompliance of the company with any financial reporting requirement under the securities laws, or (2) the date a court, regulator, or other legally authorized body directs the company to prepare an accounting restatement. ↑
Note that with respect to relative TSR, only an accounting restatement by the issuer, not accounting restatements by other issuers in the peer group, would result in application of the Final Rule and potential recovery. ↑
Commercial disputes are a fact of life in every industry. From counterparties that fail to honor contracts, to companies that use deceitful tactics, to individuals who misappropriate proprietary information for their own benefit, running a business regularly requires consultation with an attorney and frequently involves the business in litigation. Historically, businesses faced with a legal conflict had just three options: fight a lawsuit by hiring counsel on expensive retainer, instead find a lawyer who offers “no win, no fee” contingency billing, or abandon the case (by either paying a settlement or giving up on a claim). More recently, third-party litigation funding has given attorneys and their clients a powerful alternative to these traditional solutions.
The costs of hiring a lawyer, discovery procedures, arranging depositions, and retaining experts can snowball quickly—especially in cases that span several years. Wrongdoers know this. They therefore can, and often do, weaponize any financial superiority in court, much to the detriment of plaintiffs who cannot, or prefer not, to pay full litigation costs upfront. It is no surprise, then, that corporate legal departments are frequently perceived by management as cost centers necessary to put out legal fires—not as the strategic revenue sources they can become.
With litigation finance, however, businesses can lift the financial burden of litigation, reduce financial risk, build a stronger case, and achieve fairer legal outcomes in court.
What, exactly, is litigation finance?
Litigation finance is the practice of a third party providing capital to a plaintiff, such as a business or individual. This third party, known as a litigation funder, is a specialty finance firm that is otherwise unrelated to the lawsuit in question. The litigation funder invests in the action and, in return for this investment, is promised a portion of any monetary recovery. Typically, this is structured either a multiple of the original investment, or a percentage of the gross recovery.
Commercial litigation finance is almost always a non-recourse arrangement wherein the only collateral for the investment is a single case or portfolio of cases. If the case does not resolve favorably, the recipient of the funds owes the litigation funder nothing. If the claim is successful, the litigation funder will usually receive first dollar in until it is repaid, while the remainder of the proceeds will be divided between the claimant and the attorneys as agreed between them.
How can businesses use litigation finance?
Litigation finance investments are highly customizable, rendering them suitable for a wide variety of needs. Bespoke agreements are common, especially as the size of the investment increases and the relationship between funder and company deepens. In that vein, businesses can use funding to pay for case-related legal expenses, including attorney fees, expert witness fees, depositions, court reporter fees, arbitration filing fees, discovery, appeals, and more.
In addition, as litigation progresses, companies can also use the funds received to cover business operating expenses when existing sources of working capital are insufficient. This option can be critical for companies that have been actively harmed by the actions of the defendant(s) and would otherwise find it challenging to continue doing business while the lawsuit is pending if not for additional sources of capital.
Thus, litigation finance can support both the pursuit of meritorious litigation and ensure the financial survival of thinly capitalized commercial claimants.
How can litigation finance help manage corporate balance sheets?
Under Generally Accepted Accounting Principles, litigation costs are reflected as expenses. Carrying and reporting such expenses can negatively impact a company’s financials and quarterly performance. This is especially true for public companies that are valued on earnings or cash flow or require certain financial criteria to be met to comply with credit obligations.
For companies in that position, litigation costs paid from company funds must be recorded as expenses when incurred, thereby diminishing reportable earnings. Moreover, even if litigation results in a favorable outcome (whether via judgment or settlement), such outcomes sometimes take months or years to enforce and actually pay out, leaving a temporary gap in a company’s cash flow despite obtaining a ruling in their favor. Worse yet, recoveries from successful legal matters may not offset the adverse impact of lawsuit-related costs because such recoveries are generally treated as below-the-line items that do not increase earnings. General counsel and in-house legal departments can shift both the risk and financial burden of litigation to third-party funding specialists in exchange for a portion of any recoveries.
For instance, litigation finance companies can make funds available in a segregated account so that law firms bill against those funds, rather than through the business, keeping the ongoing expenses off the company’s balance sheets until resolution of the matter. In this way, businesses do not have to carry and report expenses on an ongoing basis but will only have to do so at the end of the dispute. Further, once the matter resolves, the company incurs the liability of having to repay the investment but can then simultaneously report the funds received from resolution of the matter. This simultaneous reporting creates a more accurate accounting of the events because the payment to the litigation finance company (which subsumes the expenses) appears on the claimant-business’s financial statements at the same time as any recovery realized from the underlying litigation.
Ultimately, securing third-party funding for operating expenses can transform otherwise illiquid liquid claims into a valuable source of capital.
What types of cases do litigation funders invest in?
Litigation finance companies invest in a wide range of cases that varies based on their particular risk profile, expertise, and available capital. Whether a company’s dispute revolves around trade secrets, contracts, shareholders, IP, or some other matter, litigation finance can support virtually any claim type.
In October, LexShares published “The Litigation Funding Barometer,” an analysis of the types of cases that are often best suited for non-recourse financing. The data presented in the Barometer report was based on data produced by the firm’s proprietary Diamond Mine software, which in 2021 scored more than 30,000 state and federal cases based on several different factors. Among other conclusions, the report found that a higher percentage of strong funding opportunities existed among federal cases than state cases. Federal trade secrets, antitrust, and contract disputes also presented some of the strongest funding opportunities across jurisdictions. While this data represents the investment potential of various case types, we feel it is nevertheless a valuable gauge of how the funding industry generally views the U.S. litigation landscape.
Notably, litigation finance companies are also not limited to investing in contingency cases. Financing can be made available to hourly representation, usually requiring deferral of a portion of the hourly attorney’s rate and ongoing billing against segregated amounts.
What are some attributes of reputable litigation finance companies?
Evidently, the idea of receiving funding—at some times substantial amounts of funding—from a third party can raise some concerns. Attorneys seeking out and recommending litigation finance to their clients should watch for the following things:
First, a reputable litigation finance company will implement a demanding due diligence process. While this is frustrating while already dealing with the litigation process, a robust underwriting process signals a serious partner. The old adage holds true: if something is too good to be true, it probably is.
Second, a litigation finance company should never attempt to control or direct the litigation. There are a number of reasons for this, including rules of ethics pertaining to an attorney’s duty of loyalty. If a litigation finance company attempts to insert itself into the actual litigation, this is a sign that another funder may be a better choice.
Reputable litigation finance companies are an excellent resource for savvy businesspeople and their legal advisors. Careful vetting and selection of that tool is of paramount importance.
In-house legal departments leveraging a powerful new tool for accessing justice.
Maya Steinitz, a legal scholar and University of Iowa College of Law professor, refers to litigation finance as “likely the most important development in civil justice of our time.” As founders and executives grow more familiar with commercial litigation finance as a useful financial resource, the potential appeal of offsetting litigation risk and optimizing corporate balance sheets for legal action stands to become more mainstream. For CEOs and founders weighing the prospect of litigation, the ultimate question is no longer why they should be using litigation finance. The real question is: why not?
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Contributors
Julia Hanson
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Alistair McIntyre
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Nyja Prior
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Clint Saylor
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
Michelle Ziperstein
Knobbe Martens 2040 Main St., 14th Floor Irvine, CA 92614 [email protected]
§ I. Patent Cases
I.a. Supreme Court decisions
Minerva Surgical, Inc. v. Hologic, Inc., 141 S. Ct. 2298 (2021)
Facts: This case concerns the conditions for applying assignor estoppel where a party who assigns its patent rights later asserts an invalidity defense to that patent.
In the late 1990s, Csaba Truckai invented a device for treating abnormal uterine bleeding using a moisture-permeable applicator head and assigned the patent application to his company Novacept. Hologic later acquired Novacept. Truckai also founded Minerva Surgical, and obtained a patent directed to an improved device to treat abnormal uterine bleeding using a moisture-impermeable applicator head. Meanwhile, Hologic filed for another patent in the same patent family as the Novacept application, and obtained a broad patent claim to applicator heads, without regard to whether they are moisture permeable.
Hologic sued Minerva for patent infringement of this newly obtained claim. In response, Minerva argued that Hologic’s patent was invalid because the new, broad claim to applicator heads did not correspond to the invention’s written description, which addressed applicator heads that were water permeable. Hologic then invoked the doctrine of assignor estoppel, arguing that Truckai and Minerva could not challenge patent validity. The District Court granted summary judgment to Hologic, holding that assignor estoppel barred Minerva’s invalidity defense, and the Court of Appeals for the Federal Circuit affirmed in relevant part. The Supreme Court granted certiorari.
Held: The doctrine of assignor estoppel is upheld, but the judgment was vacated and remanded. Assignor estoppel applies only when the assignor’s assertions of invalidity contradicts explicit or implicit representations the assignor made in assigning the patent.
Reasoning: The doctrine of assignor estoppel, which limits an inventor’s ability to assign a patent to another for value and later contend in litigation that the patent is invalid, is based on equitable principles. Assignor estoppel reflects a demand for consistency and fair dealing with others. A person should not be able to sell his or her patent rights—making an implicit representation that the patent at issue is valid—and later raise an invalidity defense, disavowing that implied warranty. But when an assignor has made neither explicit nor implicit representations in conflict with an invalidity defense, then there is no unfairness in the assertion of invalidity and no ground for applying assignor estoppel.
The Court noted three situations where this may occur: 1) when an employee assigns patent rights to his or her employer in any future inventions he or she may develop during his or her employment; 2) when a later legal development renders the warranty given at the time of assignment irrelevant; and 3) when the assignees of a patent application make a post-assignment change that materially broadens the patent claims. In the last situation, relevant here, the assignor could not have warranted the validity of the broader claims. The Court noted that as long as there is no inconsistency in the assignor’s positions, then there is no basis for estoppel, and he or she can challenge the new claims in litigation. As a result, the Court vacated the decision and remanded the case to the Federal Circuit to determine whether Hologic’s new patent claim was materially broader than the claims originally assigned by Truckai.
The Court further noted that beyond promoting fairness, patent assignor estoppel furthers some policy goals, because assignors—with their knowledge of the relevant technology—are especially likely to be infringers. By preventing assignors from raising an invalidity defense in a later infringement suit, the doctrine gives assignees confidence in the value of what they have purchased. The Court further noted that even when an assignor is barred from asserting in an infringement suit that the patent is invalid, the assignor can still argue about how to construe the patent’s claims.
Justice Alito filed a dissenting opinion, stating that the question in this case cannot be decided without deciding whether Westinghouse Elec. & Mfg. Co. v. Formica Insulation Co., 266 U.S. 342 (1924)—which approved the use of assignor estoppel in the U.S.—should be overruled. Justice Barrett also filed a dissenting opinion, in which Justices Thomas and Gorsuch joined. The dissent noted that this case turned on whether the Patent Act of 1952 incorporated the doctrine of assignor estoppel and concluded that it did not.
I.b. Federal Circuit Decisions
Bot M8 LLC v. Sony Corp. of Amer., 4 F.4th 1342 (Fed. Cir. 2021)
Facts: This case concerns the pleading requirements for patent infringement.
Bot M8 owns five patents directed to video game machines. Bot M8 sued Sony for patent infringement based on Sony’s PlayStation 4 (“PS4”) console and accompanying game software. Following a transfer to the Northern District of California, a case management conference resulted in the district court sua sponte directing Bot 8 to file an amended complaint detailing “every element of every claim that [Bot M8] say[s] is infringed and/or explain why it can’t be done.” Bot M8 filed its 223-page first amended complaint. Sony moved to dismiss for failure to state a claim of infringement. The district court granted Sony’s motion as to four of the five patents.
The court then denied Bot M8’s second motion for leave to amend, reasoning that Bot M8 failed to raise concerns about the legality of reverse engineering Sony’s software at the time it was first ordered to file an amended complaint. For the same reasons, the court also denied Bot M8’s motion for reconsideration.
Applying Alice, the district court also found one claim of the last remaining patent to be patent ineligible. Alice Corp. v. CLS Bank International, 573 U.S. 208, 217-18 (2014).
Bot M8 and Sony then entered a joint stipulation dismissing the remaining claims without prejudice, and with Bot M8 reserving its right to appeal. On appeal, the Federal Circuit affirmed in part and reversed in part.
Held: Patent owners do not need to prove their entire case at the pleading stage, but they cannot rely solely on conclusory statements of infringement.
Reasoning: The Federal Circuit affirmed (1) dismissal of the infringement allegations as to two patents for being conclusory; (2) denial of leave to file a second amended complaint as to four patents; and (3) summary judgment in favor of Sony on one patent in view of the claims being directed to patent ineligible subject matter. The Court reversed and remanded as to the remaining two patents because the infringement claims were found to plausibly state a claim at the early pleading stages.
The panel acknowledged the district court’s authority to request an amended complaint, but disagreed with its requirement that Bot M8 explain “every element of every claim” because a plaintiff “need not prove its case at the pleading stage.” The panel explained that any district court approach that employs a “blanket element-by-element” requirement for patent infringement cases exceeds the scope of the Supreme Court’s pleading standard set forth in Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) and Bell v. Twombly, 550 U.S. 544, 570 (2007). Instead, plaintiffs must only articulate a “plausible claim for relief.”
However, the panel stated that merely reciting claim elements and concluding that an allegedly infringing product has each element will not be enough to meet this pleading standard, as there must be some factual allegations suggesting a plausible claim. Under this reasoning, allegations of infringement for two patents were deemed conclusory and lacking in factual allegations. Similarly, the panel found no error in the district court’s application of Alice, and affirmed summary judgment in favor of Sony. But the panel determined that the district court erred by dismissing the other two patents for failure to state a claim of infringement by demanding highly specific allegations too early in the proceedings. The panel found that Bot M8 alleged specific instances of infringement sufficient to meet the plausibility requirements for Bot M8’s claim.
The Federal Circuit also found no abuse of discretion in the district court’s denial of Bot M8’s request for leave to file a second amended complaint. While the court acknowledged that requiring reverse engineering of the accused device may not have been necessary, Bot M8 waived any objection to this requirement by volunteering to complete the task without suggesting that compliance would be difficult in terms of labor or obtaining legal permissions.
Yu v. Apple Inc., 1 F.4th 1040 (Fed. Cir. 2021)
Facts: This case concerns whether claims directed to a device that implements an abstract idea are patent ineligible under 35 U.S.C. § 101.
Yu owns U.S. Patent No. 6,611,289 (“the ‘289 patent”) titled “Digital Cameras Using Multiple Sensors with Multiple Lenses.” Yu sued Apple Inc. and Samsung Electronics Co., Ltd. (“Defendants”) for infringement of claims 1, 2, and 4. Claim 1 is representative and recites:
1. An improved digital camera comprising:
a first and a second image sensor closely positioned with respect to a common plane, said second image sensor sensitive to a full region of visible color spectrum;
two lenses, each being mounted in front of one of said two image sensors;
said first image sensor producing a first image and said second image sensor producing a second image;
an analog-to-digital converting circuitry coupled to said first and said second image sensor and digitizing said first and said second intensity images to produce correspondingly a first digital image and a second digital image;
an image memory, coupled to said analog-to-digital converting circuitry, for storing said first digital image and said second digital image; and
a digital image processor, coupled to said image memory and receiving said first digital image and said second digital image, producing a resultant digital image from said first digital image enhanced with said second digital image.
Defendants filed a Rule 12(b)(6) motion to dismiss. The district court found that the asserted claims were directed to “the abstract idea of taking two pictures and using those pictures to enhance each other in some way,” decided that each asserted claim was patent ineligible under § 101, and granted the motion to dismiss. Yu appealed to the Federal Circuit.
Held: Affirmed. The claims are directed to an abstract idea and lack an inventive concept sufficient to transform the abstract idea into a patent-eligible invention.
Reasoning: The Court applied 9th Circuit law, which reviews a district court’s grant of a Rule 12(b)(6) motion de novo. It also applied its own law and reviewed the district court’s determination of patent ineligibility under § 101 de novo.
The Court used the Mayo/Alice two-step framework to analyze whether a patent claim is eligible under § 101. The first step analyzes whether “a patent claim is directed to an unpatentable law of nature, natural phenomenon, or abstract idea.” Alice Corp. v. CLS Bank Int’l, 573 U.S. 208, 217 (2014). If it is, then the court determines “whether the claim nonetheless includes an ‘inventive concept’ sufficient to ‘transform the nature of the claim’ into a patent-eligible application.” Id. (quoting Mayo Collaborative Servs. v. Prometheus Labs., Inc., 566 U.S. 66, 72 (2012)).
At step one, the Court found that “claim 1 is directed to the abstract idea of taking two pictures (which may be at different exposures) and using one picture to enhance the other in some way.” Reading the claim language in view of the specification, the Court noted that claim 1 results in “producing a resultant digital image from said first digital image enhanced with said second digital image,” and that “Yu does not dispute that . . . the idea and practice of using multiple pictures to enhance each other has been known by photographers for over a century.”
The Court further found that “[o]nly conventional camera components are recited to effectuate the resulting ‘enhanced’ image” and that “it is undisputed that these components were well-known and conventional.” It therefore concluded that “[w]hat is claimed is simply a generic environment in which to carry out the abstract idea.”
Yu asserted that claim 1 is “directed to a ‘patent-eligible improvement in digital camera functionality’ by ‘providing a specific solution’ to problems such as ‘low resolution caused by low pixel counts’ and ‘inability to show vivid colors caused by limited pixel depth.’” The Court, however, found that “claim 1’s solution to these problems is the abstract idea itself—to take one image and ‘enhance’ it with another.”
Yu also argued that parts of the specification provide support that the patentable advance in the claims is “the particular configuration of lenses and image sensors.” The Court, though, found that “[e]ven a specification full of technical details about a physical invention may nonetheless conclude with claims that claim nothing more than the broad law or abstract idea underlying the claims.” ChargePoint, Inc. v. Sema-Connect, Inc. 920 F.3d 759, 769 (Fed. Cir. 2019). For instance, the specification refers to a “four-lens, four-image-sensor configuration” as an advance over the prior art, where “three of the sensors are color-specific while the fourth is a black-and-white sensor.” Claim 1, however, is limited only to a “two-lens, two-image-sensor configuration in which none of the image sensors must be color.” The Court found “the mismatch between the specification . . . and the breadth of claim 1 underscores that the focus of the claimed advance is the abstract idea and not the particular configuration discussed in the specification that allegedly departs from the prior art.”
At step two, the Court found that there was no inventive concept sufficient to transform the claimed abstract idea into a patent-eligible invention. The Court reasoned that claim 1 failed under step two because it is “recited at a high level of generality and merely invokes well-understood, routine, conventional components to apply the abstract idea.” Yu asserted that the prosecution history shows that the claim was allowed over multiple prior art references. The Court, however, found that “even if claim 1 recites novel subject matter, that fact is insufficient by itself to confer [patent] eligibility” and went on to explain that “[t]he claimed [two-lens, two-image-sensor] configuration does not add sufficient substance to the underlying abstract idea of enhancement—the generic hardware limitations of claim 1 merely serve as ‘a conduit for the abstract idea.’” In re TLI Commc’ns LLC Pat. Litig., 823 F.3d 607, 612 (Fed. Cir. 2016).
Additionally, the Federal Circuit found that the district court’s recognition of a “century-old practice” at the pleadings stage was appropriate, that the 12(b)(6) motion could properly be determined without hearing expert testimony, and that it was not error for the district court to consider only the intrinsic record (the patent itself) to conclude that it was patent ineligible.
The Federal Circuit therefore affirmed the district court’s decision that the claims of Yu’s patent are ineligible under § 101 and affirmed the order granting the 12(b)(6) motion.
Judge Newman dissented and argued that the majority was “further enlarge[ing] . . . and further obfuscat[ing] the statute.” She argued that the claimed “camera is a mechanical and electronic device of defined structure and mechanism; it is not an ‘abstract idea.’ Observation of the claims makes clear that they are for a specific digital camera . . . . not for the general idea of enhancing camera images.” Such a device “easily fits the standard subject matter eligibility criteria.” While the patent specification describes the superior image definition capabilities of the claimed camera, “[a] statement of purpose or advantage does not convert a device into an abstract idea.”
Trimble Inc. v. PerDiemCo LLC, 997 F.3d 1147 (Fed. Cir. 2021)
Facts: This case concerns whether a patentee is subject to specific personal jurisdiction in the federal district where an alleged infringer is headquartered, when the alleged infringer files a declaratory judgment action in that district after the parties have engaged in licensing negotiations.
PerDiemCo LLC (“PerDiemCo”) is a Texas LLC. It owns eleven patents all related to electronic logging devices and/or geofencing designed to help employers track commercial vehicles and drivers. PerDiemCo’s sole owner, officer, and employee lives and works in Washington, D.C. PerDiemCo rents office space in Marshall, TX, but its sole owner, officer, and employee has never visited the space and it has no employees there.
Trimble Inc. (“Trimble”) and its wholly owned subsidiary Innovative Software Engineering, LLC (“ISE”) make and sell GPS navigation products and services, which include electronic logging and geofencing devices and services. Trimble is a Delaware Corporation with its headquarters in the Northern District of California. ISE is an Iowa LLC with its headquarters and principal place of business in Iowa.
PerDiemCo sent a letter to ISE in Iowa alleging that ISE was infringing PerDiemCo’s patents. This letter was forwarded to Trimble’s Chief IP Counsel in Colorado. Between October and December 2018, the parties engaged in licensing negotiations, and PerDiemCo threatened to sue Trimble and ISE for patent infringement in the Eastern District of Texas. During these negotiations, PerDiemCo communicated with Trimble at least twenty-two times via letter, email, or telephone.
In January 2019, Trimble and ISE filed a complaint in the Northern District of California, where Trimble is headquartered. They sought a declaratory judgement that they did not infringe any of the patents PerDiemCo asserted.
PerDiemCo moved to dismiss for lack of personal jurisdiction under Red Wing Shoe Co. v. Hockerson-Halberstadt, Inc., 148 F.3d 1355 (Fed. Cir. 1998), which states that “[a] patentee should not subject itself to personal jurisdiction in a forum solely by informing a party who happens to be located there of suspected infringement” because “[g]rounding personal jurisdiction on such contacts alone would not comport with principles of fairness,” id. at 1361.
The district court found that while PerDiemCo had established sufficient minimum contacts with California through its negotiations with Trimble, it would be constitutionally unreasonable to exercise personal jurisdiction over PerDiemCo in view of Red Wing. It therefore dismissed Trimble and ISE’s complaint. Trimble and ISE appealed to the Federal Circuit.
Held: Reversed and remanded. The exercise of personal jurisdiction over PerDiemCo in the Northern District of California is not unreasonable and satisfies due process.
Reasoning: The Court applied Federal Circuit law “because the jurisdictional issue is intimately involved with the substance of the patent laws.” Autogenomics, Inc. v. Oxford Gene Tech. Ltd., 566 F.3d 1012, 1016 (Fed. Cir. 2009). Therefore, because the parties did not dispute the jurisdictional facts, the Court reviewed the question of personal jurisdiction de novo.
The exercise of personal jurisdiction over an out-of-state defendant involves an evaluation as to whether the forum state’s long-arm statute permits service of process and whether the assertion of personal jurisdiction violates due process. California allows service of process to the limits of the Due Process Clauses, and therefore the “two inquiries fold into one”—whether personal jurisdiction over PerDiemCo was consistent with due process.
A Court may exercise personal jurisdiction over a defendant when the defendant has had sufficient minimum contacts with the forum state and when the exercise of personal jurisdiction “does not offend traditional notions of fair play and substantial justice.” Int’l Shoe Co. v. Washington, 326 310, 316-17 (1945).
Minimum contacts are typically established when the defendant intentionally reaches out to the forum state and purposefully avails itself of doing business there. The plaintiff’s claims must arise out of or relate to those contacts. To satisfy fair play and substantial justice, the Court considers the burden on the defendant, the forum state’s interest in adjudicating the dispute, the plaintiff’s interest in convenient and effective relief, the interstate judicial system’s interest in obtaining an efficient resolution, and the shared interest of the states in furthering fundamental substantive social policies.
The Court noted that Supreme Court cases following Red Wing make clear that special patent policies and considerations cannot impact the personal jurisdiction analysis.
The Supreme Court has held that communications sent into a state may give rise to specific personal jurisdiction and that a defendant that repeatedly communicates with the forum state “clearly has fair warning that [its] activity may subject [it] to the jurisdiction of a foreign sovereign.” Quill Corp. v. North Dakota, 504 U.S. 298, 308 (1992). The Federal Circuit has interpreted this to mean that “negotiation efforts, although accomplished through telephone and mail . . . can still be considered as activities purposefully directed at residents of [the forum].” Inamed Corp. v. Kuzmak, 249 F.3d 1356, 1362 (Fed. Cir. 2001) (discussing Quill). The Court noted that it previously held that Red Wing did not create a rule that “patent enforcement letters can never provide the basis for jurisdiction in a declaratory judgement action.” Jack Henry & Associates, Inc. v. Plano Encryption Technologies LLC, 910 F.3d 1199, 1206 (Fed. Cir. 2018).
Other circuits have found that communications from outside a forum state can lead to specific personal jurisdiction in the forum. See, e.g., Yahoo! Inc. v. La Ligue Contre le Racisme et l’Antisemitisme, 433 F.3d 1199, 1208 (9th Cir. 2006) (en banc) (cease-and-desist letter can be basis for personal jurisdiction); Oriental Trading Co. v. Firetti, 236 F.3d 938, 943 (8th Cir. 2001) (directing communications into state gives rise to personal jurisdiction).
Other activities have also led to minimum contacts relevant to declaratory judgment patent cases, such as hiring an attorney or patent agent in the forum state, Elecs. for Imaging, Inc. v. Coyle, 340 F.3d 1344, 1351 (Fed. Cir. 2003); physically entering the state to demonstrate the technology, id., or to discuss infringement allegations with the plaintiff, Xilinx, Inc. v. Papst Licensing GmbH & Co. KG, 848 F.3d 1346, 1357 (Fed. Cir. 2017); the presence of an exclusive licensee in the state, Breckenridge Pharm., Inc. v. Metabolite Labs., Inc., 444 F.3d 1356, 1366-67 (Fed. Cir. 2006); and “extra-judicial patent enforcement” targeting businesses in the state, Campbell Pet Co. v. Miale, 542 F.3d 879, 886 (Fed. Cir. 2008).
Further, the Court evaluated the Supreme Court’s recent decision in Ford Motor Co. v. Mont. Eighth Jud. Dist. Ct., which found that the “link” or “connection” between the defendant’s contact with the state and the plaintiff’s suit requires only that the complaint “arise out of or relate to the defendant’s contacts with the forum.” 141 S.Ct. 1017, 1026 (2021). The Federal Circuit interpreted this to mean that nonexclusive patent licenses in a forum state can support personal jurisdiction over the licensor.
Here, the Court found that PerDiemCo’s contacts with California were extensive, including twenty-two communications with Trimble in California over three months. This is “far beyond solely informing a party who happens to be located in California of suspected infringement.” Therefore, PerDiemCo had sufficient minimum contacts to justify personal jurisdiction in California.
Further, the Court found that the factors of fair play and substantial justice each lean in favor of personal jurisdiction being reasonable. The Federal Circuit reversed the district court’s order finding a lack of personal jurisdiction and remanded for further proceedings.
Hyatt v. Hirshfeld, 998 F.3d 1347 (Fed. Cir. 2021)
Facts: Hyatt bulk filed 381 patent applications in 1995. These applications claimed priority to applications filed in the ‘70s and ‘80s, through Hyatt’s practice of submarine patenting, which allowed an applicant to extend the term of a patent by claiming priority to an earlier filed, and subsequently abandoned, application in the patent family.
Within the bulk filing, the 381 applications ranged from 289 to 576 pages of text and 40-60 pages of figures, much longer than a typical patent application. While Hyatt initially agreed with the USPTO to focus his claims on distinct subject matter, he instead filed amendments over the next several years to increase the number of pending claims to about 300 per application, or 115,000 total. Of these claims, 45,000 were independent claims. Some amendments resulted in entirely new claims. In others, Hyatt reintroduced claims that had previously been lost in interference proceedings.
The USPTO began to examine Hyatt’s filings, but due to the sheer volume and the subsequent amendments, examination was slow. Because each filing claimed priority to several earlier filings, it was difficult for examiners to determine priority dates to identify prior art. The size of the patents also made it difficult to determine whether the applications complied with 35 U.S.C. § 112 written description requirements. Further, examination of Hyatt’s patents was stayed from 2003 to 2012 due to pending litigation. Examination restarted in 2013. The USPTO created an art unit dedicated to examining Hyatt’s filings. It was estimated that to complete examination, it would take a single examiner over 500 years.
The USPTO ultimately rejected the applications. Hyatt appealed to the Board of Patent Appeals and Interferences, which placed only a small subset of his claims in condition for allowance.
Hyatt filed a district court action under 35 U.S.C. § 145 against the USPTO to obtain four patents from his bulk filing, totaling 1592 claims. The PTO asserted an affirmative defense of prosecution laches. The district court held that the USPTO did not meet its burden of proving prosecution laches and that the claims were not invalid. Specifically, the court found that the USPTO had not provided Hyatt with adequate warning of a laches rejection, had not shown prejudice, had not issued laches rejections for the four applications at issue, and had not met its burden of proving “unreasonable and unexplained delay” by a preponderance of the evidence. The USPTO appealed the decision.
Held: Prosecution laches is an affirmative defense available to the USPTO in a 35 U.S.C. § 145 proceeding. The USPTO may assert prosecution laches even if it did not previously issue rejections based on laches. The USPTO met its burden to shift the burden of proof to Hyatt. Delay by the USPTO does not excuse delay by the applicant.
Reasoning: Prosecution laches “render[s] a patent unenforceable when it has issued only after an unreasonable and unexplained delay in prosecution that constitutes and egregious misuse of the statutory patent system under a totality of the circumstances.”
The Court first addressed whether the USPTO may assert prosecution laches in a § 145 proceeding. The Court reasoned that the USPTO can reject applications based on prosecution laches, and 35 U.S.C. § 282 evidences congressional intent to allow the USPTO to assert affirmative defenses, such as prosecution laches, in any patent validity action. Thus, the Court held that prosecution laches was available.
Second, the Court addressed whether the USPTO can raise the issue of prosecution laches in a §145 proceeding even if it had not raised it previously. Because § 145 proceedings permitted the plaintiff to introduce new evidence and arguments, fairness dictated that the USPTO must also be able to assert new meritorious defenses, such as prosecution laches.
Third, the Court considered which facts the district court should have considered when determining whether the delay in prosecution was “unreasonable.” Though the “totality of the circumstances” must be considered, the Court held that the consideration should place more weight on delays caused by the applicant than delays caused by the USPTO.
Fourth, the Court held that the USPTO had presented enough evidence to shift the burden of proof to Hyatt. It found that Hyatt’s actions “all but guaranteed indefinite prosecution delay,” and that, even though he had not literally violated regulations or statutes, he had “clear[ly] abuse[d] the patent system.” Further, the Court found that the USPTO had proven prejudice. In a proceeding between an accused infringer and a patentee, a prosecution of delay of over six years raises a presumption of prejudice. Here, the Court reasoned that Hyatt’s admission that there was a delay of seven years between the claimed priority date and the filing date of the patents at issue triggered this presumption. Alternatively, the Court reasoned that Hyatt’s “clear abuse” of the examination system was also sufficient to raise the presumption.
The Court remanded the case so that Hyatt could present his own evidence against prosecution laches.
Facts: Mylan petitioned for inter partes review (IPR) to challenge the validity of a Janssen patent. Janssen argued that the IPR would be inefficient, since two pending court cases involving that patent would likely reach a final judgment on validity prior to the IPR. One of those cases was also between Janssen and Mylan. The Patent Trial and Appeal Board (Board) agreed with Janssen and denied institution of the IPR. Mylan filed a direct appeal and a request for mandamus to the Federal Circuit.
Held: The Federal Circuit has no jurisdiction to consider a direct appeal of a decision to deny IPR institution. The Federal Circuit does, however, have jurisdiction over a mandamus request to review a failure to institute an IPR.
Reasoning: The Court found that it had no jurisdiction to consider Mylan’s direct appeal. It reasoned that federal courts can only hear “cases and controversies” within the meaning of Article III of the Constitution. Further, lower federal courts may only hear causes of action identified by statute. The Court held that no statute grants jurisdiction over direct appeals for denial of IPR institution. 28 U.S.C. § 1295(a) merely enables federal courts to review final written decisions of an IPR, but 35 U.S.C. § 314(d) prevents appeal of denial of IPR institution.
The Court held that it had jurisdiction to review Mylan’s petition for mandamus. 28 U.S.C. § 1651(a) authorizes federal courts to issue “necessary and appropriate” writs in aid of their jurisdiction. Because 28 U.S.C. § 1295(a)(4) grants federal courts “exclusive jurisdiction” over Board decisions if that decision is appealable (e.g. in the case of a final judgement in an IPR), the Court reasoned that a denial of IPR institution effectively prevents the Federal Circuit from reviewing a final decision, thereby diminishing its jurisdiction. The Court concluded that, to protect its prospective jurisdiction, it must be able to conduct review when presented with a mandamus request.
The Court held that Mylan’s mandamus request failed on the merits, however. Mandamus is reserved for “extraordinary” circumstances, but the Court found that Mylan could not show that it was being denied a legal right and that it had no other method of obtaining relief. The Court reasoned that Mylan, through its ongoing litigation against Janssen, could easily try the validity of Janssen’s patent even after the Board denied IPR institution. Thus, the Federal Circuit rejected Mylan’s mandamus request.
§ II. Copyright Cases
II.a. Supreme Court decisions
Google LLC v. Oracle America, Inc., 141 S. Ct. 1183 (2021)
Facts: This case concerns whether copying the “declaring code” of an Application Programming Interface (“API”) is fair use, and thus avoids copyright infringement, when the copying party has written and implemented its own “implementing code.”
In 2005, Google purchased Android, Inc. to develop a software platform for mobile devices. The Android software platform used Java, a programming language many software programmers were already using. Java is a programing language developed by Oracle’s predecessor Sun Microsystems and Oracle owns the copyright in the software platform Java SE.
Google originally planned to license the Java platform from Oracle for Android, but after negotiations broke down, Google decided to build its own software platform for Android. Google developed the Android platform specifically with mobile devices in mind. The Android platform includes millions of lines of code written by Google engineers. However, the Android platform also includes about 11,500 lines of code copied from the Application Programming Interface (“API”) of the Java SE platform.
An API is a tool for programmers to access prewritten code aimed at performing functions rather than writing the raw code that provides that functionality. The Court broke down the portions of an API at issue into three parts: a “method call,” the “declaring code,” and the “implementing code.” A “method call” is a line of code a programmer will use to ask the program to perform a task. The “implementing code” is the set of instructions that will instruct the processor how to perform that task. The “declaring code” performs the needed link to between the “method call” and the “implementing code” so the desired functionality occurs. As such, while both are essential to the operation of the API, “the implementing code” requires a much greater amount of code than the “declaring code” does.
The 11,500 lines of code that Google copied were of the Java SE API’s “declaring code” so that programmers coding for Android could use the same “method calls” they were accustomed to while coding in the Java programing language.
In 2010, Oracle brought action against Google in the Northern District of California for copyright infringement. The district court ruled at trial that the API’s “declaring code” was not protected under copyright law. On appeal, the Federal Circuit reversed, stating that the “declaring code” was also entitled to copyright and remanded to the district court on the issue of fair use. The Supreme Court, at that time, denied certiorari on the Federal Circuit’s copyrightability determination.
The district court found fair use and the case was once again appealed to the Federal Circuit. The Federal Circuit again reversed, finding that “there is nothing fair about taking a copyrighted work verbatim and using it for the same purpose and function as the original in a competing platform” and remanded on the issue of damages. 141 S. Ct. 1183, 1195 (2021) (internal quotations omitted). The Supreme Court granted certiorari to review the Federal Circuit’s determinations on both the copyrightability and fair use issues.
Held: The Court did not rule on whether the API was entitled to copyright protection and instead reviewed only whether Google’s use of part of that API constituted fair use. The Court ultimately concluded that Google’s use of that portion of the API was fair use and thus did not constitute copyright infringement.
Reasoning: The Court analyzed Google’s use under the four factors of 17 U.S.C. § 107 but noted that “applying copyright law to computer programs is like assembling a jigsaw puzzle whose pieces do not quite fit.” Id. at 1998 (internal quotations omitted). The Court gave specific attention to the following factors of the “fair use” defense to copyright infringement:
Nature of the Copyrighted Work: While Congress has declared computer programs as subject to copyright, “declaring code” differs from other kinds of copyrightable computer code. First, “declaring code” is “inextricably bound” to the general system and the organizing tasks that the Court determined are not copyrightable. Second, “declaring code” is similarly bound to the “method calls” and the “implementing code” that either were not contested or were not the subject of any evidence of copying. Additionally, “declaring code” derives its value from the programmers using it who do not hold the copyright. Therefore, the Court identified that this factor “points in the direction of fair use.” Id. at 1202.
Purpose and Character of the Use: The Court said the analysis of this factor must go further than determining if the copying itself was transformative and should include the purpose and character of the use as dictated by § 107. Here the Court focused on Google’s expanding use toward new products. This “reimplementing” use furthered the development of computer programs. Id. at 1203. Since the purpose and character was transformative, even if the code was copied verbatim, this factor weighed in favor of fair use.
The Amount and Substantiality of the Portion Used: The Court suggested that the better way to view this factor in this context is to view that amount of “declaring code” copied (around 11,500 lines of code) against the much larger amount of “implementing code” (millions of lines of code) that Google wrote. The “declaring code” is inseparably bound to those “task-implementing lines.” Id. at 1205. The Court also disagreed with the Federal Circuit that Google could have only copied the 170 lines of code fundamental to writing in Java, stating that determination construed Google’s “legitimate objectives too narrowly.” Id. Therefore, this objective weighted in favor of fair use.
Market Effects: Google has made significant money from Android in the mobile computing market, a market that Oracle’s predecessor had attempted to enter. However, the Court pointed to Oracle’s predecessor’s failure to compete in that market, the sources of its lost revenue, and the risk of public harm as helping this factor weigh towards fair use. To the Court, Google’s revenue was not supplanting Oracle. Rather, it came because of third party programmer’s investments of time in learning the Java language and Google’s own efforts to developing a platform geared towards high functionality mobile devices.
Therefore, the Supreme Court found Google’s copying of portions of Java SE’s API constituted fair use.
II.b. Circuit Court decisions
Unicolors, Inc. v. H&M Hennes & Mauritz, L.P., 959 F.3d 1194, 1196 (9th Cir. 2020), cert. granted in part, 141 S. Ct. 2698 (2021)
Facts: This case determines the scope of the knowledge inquiry under 17 U.S.C. §411(b), which prevents the filing of a lawsuit for copyright infringement without a valid copyright. This case also determines the meaning of the Copyright Act’s publication standard, deciding the requirements for a single-unit registration.
Unicolors Inc. (“Unicolors) filed suit against H&M Hennes & Mauritz L.P. (“H&M”) claiming that H&M infringed its copyright by selling two clothing items made from Unicolors’ copyrighted fabric design. Unicolors filed its copyright registration (‘400 Registration) as a single-unit registration of thirty-one separate designs. Unicolors registered the date of first publication as the date when it presented the designs collectively to its salespeople. At a later date following the presentation, Unicolors placed nine of the works in its showroom available for public view and purchase.
H&M argued that because Unicolors sold nine of the works in the ‘400 registration separately to customers, the works identified in the ‘400 single-unit registration were not first sold together or at the same time. To register a copyright as a “single unit” the works must have been first sold or offered for sale in some integrated manner. H&M further argued that because Unicolors knew that the works were not sold as a single unit, the intent requirement to invalidate a copyright registration under 17 U.S.C. § 411(b) was met, and the copyright registration was invalid.
The district court upheld the validity of Unicolors’ registration on two grounds. First, H&M failed to show that Unicolors intended to defraud the Copyright Office at the time of filing its application and thus its registration was valid. Second, although Unicolors may have sold the works separately, the collection of works were made available to the public at the same time and thus “published” on the same day. The jury reached a verdict in favor of Unicolors. H&M appealed and argued that the court erred in finding Unicolors’ copyright registration valid.
Held: The Ninth Circuit reversed the district court’s decision and held that a single-unit registration under 37 C.F.R. § 202.3(b)(4) requires that the work is first made available for sale to the public in a singular, bundled collection. The Ninth Circuit also held that a copyright registration can be invalidated through constructive knowledge under 17 U.S.C. § 411(b). Therefore, Unicolors’ knowledge that the works were not first published in a singular bundled collection was enough to invalidate Unicolor’s registration.
Reasoning: The Ninth Circuit applied the principles of statutory interpretation to determine the requirements for a single-unit publication under the Copyright Act. The Ninth Circuit looked to the definition of publication under the Copyright Act as “offering to distribute” the “work to the public by sale or other transfer of ownership” regardless of whether a sale occurred. Because Unicolors did make the designs available for the public’s purchase at the same time, Unicolors did not meet the single-unit registration requirement.
The Ninth Circuit interpreted the knowledge requirement under 17 U.S.C. § 411(b) as not whether Unicolors knew that the registration ran afoul of the single-unit requirement but whether Unicolors knew that certain designs in the registration were published separately to exclusive customers. The court expressly chose to not infer an intent-to-defraud requirement in the statute. This left a split between the Eleventh and Ninth Circuit.
Unicolors filed a petition and the Supreme Court granted certiorari to determine (1) whether the Ninth Circuit misapplied the publication standard when it determined that a single-unit registration requires a collection to be “offered for sale as part of a ‘bundled collection and (2) whether 17 U.S.C. § 411(b) requires a fraud standard to invalidate a copyright.
§ III. Trademark/Trade Dress Cases
Ezaki Glico Kabushiki Kaisha v. Lotte Int’l Am. Corp., 986 F.3d 250 (3d Cir. 2021), as amended (Mar. 10, 2021), cert. denied sub nom. Glico v. Lotte Int’l Am., No. 20-1817, 2021 WL 5043589 (U.S. 2021)
Facts: This case concerns the doctrine of functionality in trade dress protection of product designs.
Ezaki Glico (“Ezaki”) a Japanese confectionary company, sells a product line of thin, stick-shaped cookies. The cookies are partly coated with chocolate or a flavored cream with an uncoated portion to serve as a handle. Ezaki has two incontestable trade dress registrations for the elongated rod partially covered with chocolate, another for almonds on top of the chocolate or cream, and a utility patent for “Stick Shaped Snack and Method for Producing the Same.”
Lotte International American Corporation (“Lotte”) began selling Pepero, a similar-looking stick shaped cookie partly covered in chocolate with an uncoated portion. Ezaki filed suit for trade dress infringement in the district court. The district court granted summary judgment in favor of Lotte holding that the Ezaki’s product configurations were functional, and therefore nonprotectable trade dress.
Ezaki appealed the district court’s order for summary judgment on the grounds that its product design is not essential and therefore not functional.
Held: To be considered functional and thus ineligible for trade dress protection, product designs do not need to be essential, just useful. Because both the stick shape and the uncoated handle were useful for holding the snack, the Third Circuit held that Ezaki’s trade dress was functional and thus nonprotectable, thus affirming the district court’s holding.
Reasoning: The Third Circuit determined that the prohibition on trade dress protection for functional elements is not narrowly limited to essential product configurations. The Supreme Court’s decision in Qualitex Co. v. Jacobson Products Co., 514 U.S. 159 (1995) listed several ways in which a product feature is functional but not hold that a product feature is considered functional “only” if it is essential. Because functionality is intended to keep trade dress protection as a workaround from patent law, the test for functionality should be interpreted similarly to patent law.
In analyzing the functionality of Ezaki’s trade dress, the Third Circuit looked to the usefulness of the uncoated portion of the snack, the shape of the snack itself, and the design as a whole. The Third Circuit also pointed to Ezaki’s promotion of its snack’s utilitarian advantages.
The Third Circuit noted that the availability of alternative designs was unimportant for the functionality determination because even if there are alternatives, a product design can still be functional. The Third Circuit also determined that the district court erroneously considered Ezaki’s utility patent for the making of the snack’s stick shape. Because the features claimed in the trade dress were for the shape itself and the shape was not the “central advance” of the utility patent, the patent shed no light on whether the trade dress was functional.
The Great Recession taught an important lesson: if economic pressures prevent your organization from buying new software, then be on the lookout for an audit of your existing software licenses. Software vendors have seized upon noncompliance issues as leverage in convincing reluctant customers to buy new products.
For the past fifteen years, we have advised clients on how to manage software audits, even litigating when necessary. Over time, we’ve seen audits become consistently more sophisticated—employing well-known consulting firms, elaborate and tricky reporting mechanisms, and vendor-friendly scripts or automated review processes.
In this two-part article series, we will first delve into the steps of a software audit and tips for managing audits. Then, we will explore ways to improve your agreements to limit audits and put you in the best position possible when the auditor comes knocking.
Part One – Steps of the Software Audit and How to Manage It
By John Gary Maynard, III
What should I do upon receipt of an audit demand?
When you receive an audit demand, there are several things you should do immediately.
Ownership. First, determine who will “own” the software audit. Is it your legal department or IT? The worst thing you can do is create ambiguity about who is managing the audit. You should also consider whether outside counsel should be engaged. Outside counsel can provide key advantages, particularly with respect to preserving privilege and avoiding admissions.
Collect Relevant Documents. At its core, a software audit is a contract dispute. Identifying and collecting all governing contracts and related documents is therefore imperative. If in doubt, collect it. Of course, there may be executed contracts between the parties that govern, but note that many vendors use clickwrap agreements. It may be difficult to obtain copies of these agreements, or even to verify through the vendor’s website which version applies to your software. Don’t forget that related documents, including settlements of prior disputes, may be set forth in emails or letters rather than in formal agreements. Vendors sometimes refer to these as “close letters.” These can be crucial. Whether due to the passage of time or sloppiness on the part of the vendor, it is not uncommon for vendors to present noncompliance fees based upon usage that was previously released.
Confirm Basic Terms. Although the terms of software contracts are as varied as the types of software, you should conduct an initial review of the relevant documents to answer the following questions: (a) which legal entities of the company are subject to the audit? (b) what is the geographic scope of the audit? (c) what software products are covered by the audit? and (d) what are the relevant deadlines? On that last point, you don’t want to waive arguments by failing to respond in a timely manner.
Control Communications. Put procedures in place to control communications with, and about, the vendor. Establish a single point of contract, preferably someone with sound judgment and a good understanding of the business issues. We recommend a businessperson for this role rather than a lawyer. Once you’ve identified the single point of contact, notify the vendor and your employees. Guard against employees unwittingly making admissions regarding noncompliance. Relatedly, verify whether the vendor has any on-site personnel. If so, ensure your employees with regular interaction with the on-site vendor personnel do not talk about the audit.
What does the audit process look like?
Each vendor has its own process, but large vendors typically employ outside consultants as auditors. Shortly after issuing the audit demand, the vendor will likely introduce you to the auditor. Don’t be surprised if the vendor does not participate in the audit from that point forward.
Kickoff Meeting. Once the auditor has been identified, you will be asked to participate in a kickoff meeting. There are several issues to consider before participating in this meeting, but, at a minimum, you need to confirm confidentiality of the audit. Your software contract likely contains confidentiality obligations between you and the vendor, but you likely will need a separate agreement with the auditor.
The Rest of the Audit Process. In general, the next steps will include: (a) an explanation of the data collection process, (b) collection of the data, (c) review of the data, (d) confirmation of the data by each party, and (e) monetization of any noncompliance issues. Each step is potentially fraught with peril. Whether you use inside counsel or engage outside counsel, it is imperative that counsel be involved at this point in the process, even though counsel likely will not communicate directly with the auditor.
How do I manage the audit process?
The goal with any audit is to resolve it with the least disruption to the company’s business, and at the lowest price. Treating the audit as a business transaction, not an adversarial proceeding, is the best approach. Most vendors do not want to sue their customers. But this does not mean the audit process is not adversarial. Audits routinely identify alleged noncompliance issues, which vendors then attempt to monetize. The numbers can be extremely large—we’ve seen initial demands in excess of $100 million. Software agreements are simply too complicated for noncompliance issues not to arise. But those complicated agreements also provide opportunities for reasonable disagreement about the scope of noncompliance. It is a tricky process.
Role of Lawyers. Lawyers have important roles to play and should be involved from the very beginning. Obvious roles for lawyers include reviewing and revising confidentiality agreements with auditors, as well as drafting any final settlement agreements or close letters. But the real value of lawyers is preserving privilege issues and avoiding admissions. At the outset, one way for lawyers to do this is to help business personnel establish reasonable parameters for the scope of the audit. Providing auditors with more information than they are entitled to rarely benefits the company. The single point of contact will convey the company’s message in business terms, but that message will be guided by the terms of the relevant agreements that benefit the company.
Similarly, lawyers should help establish the parameters of the data collection process and the subsequent review of such data. This is particularly important for businesses in highly regulated markets. An audit should not unwittingly trigger regulatory breaches. Relatedly, several vendors use automated review procedures with prepopulated language that cannot be modified. These tools may appear to be an innocuous way to confirm usage information, but the prepopulated fields often contain admissions the company should not make. For example, the template might state all information is final and cannot be changed or modified. We’ve even seen some forms that have the company swear under penalty of perjury that the information is accurate and complete.
Finally, at the end of every audit, the business and its lawyers should work together to conduct a post-mortem. It is important to know if any noncompliance issues arose from inadequate internal controls. Any such issues should be addressed. Similarly, the company should consider whether technical problems or practices undermined or interfered with the audit. Finally, the company should also evaluate the vendor: was the vendor a good business partner during the audit? We once assisted a client who generated most of its revenue during a particular quarter. The vendor agreed to move the audit to prevent disruption during the company’s busiest season. It was a simple gesture by the vendor, but it generated a lot of goodwill with the company.
Are there events within the control of the company that trigger an audit?
As previously noted, economic downturns can trigger audits. But other events that are within the control of the company can also trigger audits. For example, corporate restructuring can trigger an audit, because such restructuring may make changes to the identity of the licensed user. Most software agreements not only limit use to specific entities but also prevent an assignment to other legal entities—including affiliates of the original licensee—without the prior written consent of the vendor. Rapid growth can also trigger an audit. Most licensing metrics are tethered to the size of the licensee, such as the number of processors. Rapid growth, therefore, increases the incentive of a vendor to audit a licensee. Finally, nonrenewal of an existing software license can trigger an audit.
Final consideration: Not all licensed software is the same.
Broadly speaking, there are two types of licensed software. First, there is software that facilitates the operation of a business. Here, the business does not incorporate the software into a product that it sells but simply uses the software to make daily operations easier. For example, a doctor’s office may use billing software in this way. Conversely, there is software that a company incorporates into its own product—the code that operates a vehicle’s entertainment system, for example. Not surprisingly, this second type of software is typically unique. Audits regarding business operation software rarely result in formal litigation. It is simply in neither party’s interest to formally litigate. Product-based software, however, can and often does result in litigation.
With respect to business operation software, each vendor generally has its own licensing metric. Understanding that metric can go a long way toward identifying the likely focus of noncompliance issues. One common metric is the number of “users.” This may seem like a relatively benign term, but disputes can arise over terms like “named users,” “concurrent users,” and “access.” For example, with respect to the term “access,” ambiguity in the agreement might allow the vendor to define a user as anyone with the ability to access the software as opposed to anyone who actually accesses the software. This definitional distinction could literally be the difference in millions of noncompliance fees.
With respect to product-based software licenses, it is difficult to generalize, because these are typically not off-the-shelf licenses that follow familiar patterns.
In any event, regardless of the nature of the software, the terms of the agreement will be crucial in determining noncompliance issues. In the next article, we will discuss ways to improve your agreements to avoid or limit an audit.
Historically, the legal industry has lagged behind many other professions in the diversity, equity, and inclusion space. The industry is working to change that today, as DEI-focused recruitment and retention efforts take high priority within the offices of forward-thinking law firms and in-house legal departments.
Executive management and recruiters are embracing every opportunity to build teams that not only fulfill client expectations for diversity but also benefit their own organizations. Research, including yearslong tracking by McKinsey, has repeatedly shown that companies with higher levels of diversity outperform their peers financially, as well as in other areas. When a team includes people of various genders, ages, ethnicities, cultural backgrounds, sexual orientations, etc., it is not only the right thing to do, but it also holds the potential to produce more creative, innovative, and effective results.
Achieving the diversity goals of your firm or department requires attention on two fronts: attracting a diverse group of new talent and working to support and retain attorneys already on your team. Engaging contract attorneys can support achieving both of these objectives.
How Contract Attorneys Can Help You Retain Diverse Talent
Lawyers’ perceptions of their organization’s culture are built on their experiences in a wide range of areas. Work-life balance, collaboration, equitable compensation, the opportunity to work remotely, and the quality of work they are assigned register high on the list of what matters to lawyers as they determine whether to switch jobs or stay put.
Some of these factors can be particularly important to women and people of color. A recent ABA report found, for example, that 68% of women lawyers and 68% of lawyers of color cited better work-life balance as an important factor when deciding to change jobs. Law firms and legal departments looking to retain top talent, especially in underrepresented groups, must understand these priorities, evaluate where their organizations may be falling short, and enact more supportive policies.
How can engaging contract attorneys help? Contract attorneys fill staffing gaps and lessen internal workload, promoting improved work-life balance and preventing burnout among associates. Contract staff can also reduce the burdens associated with routine tasks, such as document review and discovery, to help ensure associates can do the higher-level work that makes them feel more valued and fulfilled. Additionally, having a blended team of associates and contractors can increase team productivity, fueling higher morale and a greater sense of camaraderie.
Bringing contract attorneys into the mix demonstrates empathy for the challenges the lawyers on your team face and communicates your commitment to creating a nurturing culture where they can thrive.
How Your Alternative Legal Service Provider Can Help You Attract Diverse Talent
When you demonstrate your commitment to diversity and present your organization as welcoming to all, you are much more likely to attract diverse candidates. Again, that perception of your firm or department is created when candidates discover that your culture provides work-life balance, equitable compensation, remote work opportunities, and so on.
If you work with contract attorneys, this perception can also be augmented by your choice of alternative legal service provider (ALSP). Working with a woman- or minority-owned firm, or another ALSP that truly understands and supports your DEI goals and initiatives, can give you a leg up in recruiting diverse talent. In general, reputable ALSPs have access to a deep and diverse pool of candidates, for a number of reasons. For example, they are not limited by geography; they can recruit across a much broader expanse of talent and specialization. They can also offer, through contract work, the work-life balance that is especially important to women and attorneys of color, as well as esteemed lawyers in later stages of their careers, who are often looking to share their expertise on their own terms.
As you connect with these candidates and incorporate them into your staff, you can not only bring diversity of thought to your team today but also tee up the potential for bolstering your organization’s diversity in the long term. While contract attorneys are typically brought on for temporary assignments, you may have the option to convert those who prove to be ideal matches for your organization into permanent staff. Your ALSP can help you recruit and onboard those individuals as full-time members of your team.
Talk with your ALSP about your DEI policies and goals. Let them know what you are doing internally to provide an inclusive culture, and discuss ways they can partner with you to achieve your short- and long-term objectives. A good ALSP will have the capability to connect you with exceptional contract attorneys to energize your initiatives and strengthen your team.
Over the past year, SPACs have been through market shifts, regulatory thrashing, economic issues, novel litigation theories, and SEC enforcement actions. I touched on all of these in my previous post for the SPAC Notebook, but for this month’s edition, I turn to some of the most commonly asked but not necessarily answered questions that are top of mind for many SPAC teams right now.
These two questions keep popping up in my inbox:
How can our SPAC team handle the 1% excise tax?
Are there new avenues to get a SPAC deal done?
How to Handle the 1% Excise Tax
The Inflation Reduction Act, which was signed into law on August 16, 2022, establishes a new 1% excise tax on certain stock buybacks by domestic public companies. Many experts, including most attorneys I’ve spoken to, believe the provisions of this new law could be broad enough to possibly pull SPAC redemptions into their sphere.
Option 1: Liquidate Before Year-End
As a result of the new excise tax, most SPAC teams that do not currently have a deal in the works are rushing to liquidate before January 1, when the tax becomes effective. According to SPAC Research, as of December 2, 64 SPACs have liquidated this year, with the frequency of liquidations increasing significantly in the last two quarters. There were 18 liquidations in October.
Source: SPAC Research
Although we have not seen many post-liquidation lawsuits so far, some litigators expect that the increased number of liquidations will prompt the plaintiff’s bar to test some of those liquidation decisions and proceedings in court. Therefore, a careful look at whether an extension of D&O insurance coverage (also known as a tail) for the SPAC’s directors and officers post-liquidation is warranted.
Option 2: Extend and Cover the Tax Bill
Other SPAC teams that believe they will get a deal done before their deadline or have one on the table but are waiting to close in early 2023 may be willing to risk becoming subject to the excise tax. These teams usually are looking to extend their investment period for another three to six months.
But, of course, with such an extension landing the SPAC and any of its redemptions square into 2023, the question is who will pay for the excise tax? Will it be the SPAC sponsor or the shareholders? Will this tax come out of the trust funds, or will the sponsors need to come up with additional sponsor capital to cover what could end up being a multimillion-dollar tax bill?
Some SPACs, like the Data Knights Acquisition team, realizing that this could become a sticking point for shareholders who need to approve their extension, are coming out with promises that they will not touch the trust but will cover the tax out of sponsor capital. Other SPAC teams will likely follow this strategy as well.
Option 3: Extend but Leave the Tax Bill to Shareholders
Other SPAC teams may have a different view. Depending on how the SPAC’s documentation is written, some SPACs may take the position that the excise tax, like franchise and other taxes, will need to come out of the trust funds. This will, of course, endanger the $10-per-share shareholder investment, especially if these same SPACs decide to keep their trust funds in cash to avoid tripping the SEC’s Investment Company Act safe harbor. Will the shareholders of these SPACs go along with this idea, or will they object via a lawsuit? We have yet to find out.
New Avenues for SPAC Dealmaking
Necessity is the mother of invention, and that proverb is proving to be true in SPAC land. Aside from the creative ways SPAC teams are enticing their shareholders to approve extensions, many teams are looking for alternative avenues for getting a deal done.
Having realized that they may not have what it takes to land or close a deal but not wishing to liquidate, some SPAC teams now are considering two options: a team swap or a public company merger.
Team Swap
In a team swap, the old team enters a sharing or hand-over arrangement with a new team, in which they share some of the economics of the deal, but essentially the new team takes the reins on finding a suitable target and/or closing the transaction. The new team invariably brings deal know-how and connections to the table. As for the old team, walking away with a fraction of interest in a potential deal versus 100% of interest in no deal is often a better alternative.
As you can imagine, these swaps are difficult to accomplish. They are also challenging when it comes to insurance coverage. The old team wants to be covered in case they’re pulled into a lawsuit or an enforcement action after the swap. And the new team, of course, wants to be protected as well.
For insurance underwriters who based their terms and premium pricing on the track record of the old team, a new team with a different track record may not be palatable. If the underwriter is not willing to extend the original policy to the new team, the new team may need to go looking for new coverage, which may be unavailable or a lot more expensive than what the old team was able to obtain 18+ months ago.
The costs of this coverage will need to be folded into the swapping arrangement the two teams ultimately agree on. Having this conversation with your SPAC insurance broker before entering into any agreements is key.
Complicating the situation is coverage for the outgoing team after the swap. If the new team obtains a new policy, it is unlikely to cover the old team’s directors and officers, and the old policy is unlikely to continue after the swap. The outgoing team then will need to consider whether it needs to buy tail coverage for its original policy, another cost that it may not have anticipated. The new team may be willing to cover this cost, but again, this discussion needs to happen before completing the swap. That way, the insurance broker will be able to advise the two teams on the best course of action.
Public Company Merger
On the theory that some public companies may be more willing and able than private companies to enter into a merger with a SPAC, some SPAC teams are considering a merger with an already existing public company. An example of such a transaction is the October 31, 2022, closed merger of Coeptis Therapeutics Inc. with the SPAC Bull Horn Holdings Corp. The SPAC sponsor reportedly liked the idea because of greater transparency stemming from the publicly available performance record of the target.
For the public company, a merger with a SPAC provides a cash infusion from the SPAC’s trust account and access to the SPAC team’s expertise. For the SPAC, aside from the undeniable benefit of getting the deal done, the risk is presumably reduced for several reasons. First, there are fewer issues with public company readiness, a problem that has plagued many newly de-SPACed companies. And second, there is the greater transparency of an already publicly filed business. I’ll leave it to the bankers to opine on whether the economics of these kinds of deals will benefit the investors in the SPAC and the target company.
From the insurance perspective, interesting questions come up as far as coverage of the original SPAC and its team prior to the merger. As with other unusual SPAC-related situations, the insurance coverage and costs need to be looked into thoroughly ahead of making any major budgeting decisions.
Mergers with already public companies arguably miss the point of the SPAC vehicle, which was designed as an alternative to a traditional IPO. However, in the current hostile market, I would not be surprised to see other similar transactions in the near future.
Looking Ahead
It is heartening to see the recent uptick in deal activity in the SPAC world. According to November’s Nasdaq SPAC Monitor, although SPAC IPO activity is understandably down this year, October was the hottest month for SPAC merger announcements since December 2021.
Despite the recent wave of liquidations that make it feel like every SPAC is liquidating right now, SPAC Insider reports that only 12.9% of the 2020 SPAC class and 2% of the 2021 SPAC class have liquidated so far. This is a much smaller ratio than for the 2010 through 2016 SPAC vintages. We’ve also seen 26 announced mergers in October 2022. Although the enterprise values of those deals are unsurprisingly down versus last year (average $800 million in 2022 versus $2.3 billion in 2021), the increased pace of deals is a welcome change. Perhaps we’ll see even more deals with novel structures and approaches as the SPAC market continues to evolve and adapt.
An earlier version of this article appeared in the Woodruff Sawyer SPAC Notebook.
This article describes two recent Delaware decisions relevant to the Model Business Corporation Act (the “MBCA”). One of those decisions relates to a board’s determination of the availability of surplus to support distributions to stockholders, and the other upholds, at the motion to dismiss stage, a claim that the directors breached their fiduciary duty by not taking action in response to a stockholder’s demand. In addition, this article describes recent decisions in MBCA states addressing the meaning of “fair value” and the application of director liability shields to exculpate directors from monetary liability.
Determining Surplus to Support Distributions
Corporations often make distributions to stockholders by way of dividends and stock buybacks. For private equity–backed companies, it is not unusual to see leveraged recaps in which the corporation borrows funds to make distributions to the private equity investors. These distributions raise the question for a board of directors of whether the corporation has sufficient funds that are legally available to permit a lawful distribution under the corporate statute. The failure to satisfy the statutory requirement for distributions can result in personal liability for the directors. Determining the funds legally available for distributions can be challenging.
Delaware and MBCA Distribution Laws
Sections 160 and 173 of the Delaware General Corporation Law (the “DGCL”) set the limits on a Delaware corporation’s power to repurchase stock and issue dividends. Section 160 provides that no corporation may purchase or redeem its shares when the capital of the corporation is impaired or would be impaired as a result of such purchase or redemption. A repurchase impairs capital if the funds used for the repurchase exceed the amount of the surplus.[1] Sections 170 through 173 impose similar requirements for the payment of dividends. Section 170 provides that a board of directors may declare and pay dividends on shares of the corporation’s capital stock either (i) out of its surplus (within the meaning of section 154) or (ii) if there is no surplus, out of the corporation’s net profits for the fiscal year in which the dividend is declared or the preceding fiscal year—so-called “nimble dividends.” The term “surplus” generally means the excess of the corporation’s total assets over the sum of the total liabilities and capital of the corporation (usually the aggregate par value of its outstanding shares). If the test for a lawful distribution or dividend is not met, the directors face personal liability under section 174, which is not subject to exculpation by a charter provision permitted by section 102(b)(7). However, a director is “fully protected” under section 172 from personal liability if he or she relied in good faith upon the corporation’s records or upon its officers, employees, board committees, or experts in determining that the corporation had adequate surplus to support the distribution or dividend.
The MBCA follows a similar approach to the DGCL, although with more statutory precision and some notable differences. Under section 6.40(c), distributions, which include dividends in the MBCA’s terminology, may not be made if the corporation would not be able to pay its debts as they become due in the usual course of business (the “equity insolvency test”) or its total assets would be less than the sum of its total liabilities and the amount that would be required to satisfy the preferential rights that the holders of senior classes or series of shares would have upon dissolution (the “balance sheet test”). MBCA section 6.40(d) provides that the board of directors may base its determination either on the corporation’s financial statements prepared using accounting principles reasonable in the circumstances, which would include those prepared in accordance with generally accepted accounting principles (GAAP), or on a fair valuation or other method reasonable in the circumstances. Under section 7.32, a director approving the improper distribution is personally liable to the corporation for the excess amount if it is established that the director did not meet the standards of conduct in section 8.30, which require that a director act in good faith and in a manner that the director reasonably believes to be in the best interests of the corporation (the so-called duties of care and loyalty). Section 8.30(e) offers protection for directors by providing that a director is entitled to rely on information, opinions, reports, or statements, including financial statements, prepared or presented by officers or employees, lawyers, accountants, or other advisers, or a board committee, so long as the director does not know that reliance is unwarranted.
Challenges to Distributions
When a distribution is challenged, it is usually because the board of directors used the present value[2] of the corporation’s assets to determine surplus rather than the amounts reflected on the corporation’s financial statements, which are usually lower. For example, a board might use the current appraised value of real estate even though that real estate is carried on the financial statements at its historic cost less accumulated depreciation. The Delaware Supreme Court has held that a board can use present value in determining surplus as long as it does so in good faith and on a consistent basis.[3] However, what if the board instead relies on the amounts shown on the corporation’s GAAP financial statements?
The Chemours Decision
The Delaware Court of Chancery addressed this question and provided important guidance in the case of In re The Chemours Company Derivative Litigation.[4] The Chemours Company (“Chemours”) was spun-off by the E.I. DuPont de Nemours Company (“DuPont”) in 2015. In the spin-off Chemours assumed certain environmental liabilities of DuPont, which Chemours subsequently claimed to be vastly in excess of the amount that DuPont had stated. This dispute was settled by DuPont’s agreeing to share the environmental liabilities. After the spin-off, Chemours made a series of stock repurchases and dividend payments based upon the board’s determination that Chemours had adequate surplus based upon the amount of the contingent environmental liabilities reflected on its audited financial statements. The plaintiffs, claiming that demand on the board was excused because it would be futile, brought a derivative action challenging these distributions and dividends as exceeding the available surplus, specifically alleging that the board should have used the amount of the contingent environmental liabilities actually expected rather than relying on the amount shown on the audited balance sheet. To support this allegation, the plaintiffs cited Chemours’ own allegations in its dispute with DuPont. Under GAAP, specifically FASB ASC 450–20 (formerly FAS No. 5), only contingent liabilities that are probable and reasonably estimable are accrued and reflected as liabilities on the financial statements.[5] If a material contingent liability is not probable but is reasonably possible, footnote disclosure is required. Footnote disclosure is also required even if a contingent liability is reasonably possible or probable but is not presently estimable.
The Court addressed whether the plaintiffs had met the burden of proving that demand was futile because a majority of the Chemours directors faced a substantial likelihood of liability. In so doing, the Court addressed the substance of the claims and found that the plaintiffs had failed to plead specific facts implying that the directors faced a substantial likelihood of liability because of the distributions, and therefore the plaintiffs were not entitled to bring the derivative action without first making a demand on the board.
The Court began its analysis of the likelihood of liability by observing that boards of directors have broad authority to determine the amount of a corporation’s surplus and, in that connection, the method of determining surplus. Therefore, the Court said that it would defer to the board’s calculation of surplus “so long as [the directors] evaluate assets and liabilities in good faith, on the basis of acceptable data, by methods that they reasonably believe reflect present values, and arrive at a determination of the surplus that is not so far off the mark as to constitute actual or constructive fraud”— i.e., that the values “reasonably reflect present values.” The Court ruled that the board was not required to depart from GAAP in determining the corporation’s reserves for contingent liabilities in the calculation of the corporation’s surplus. Accordingly, the Court found that the directors were not “willful or negligent” as required to subject them to liability under section 174. The Court also found that the directors were “fully protected” under section 172 in relying on the corporation’s financial statements, consulting with management and financial advisors, and receiving presentations on the environmental liabilities. Finally, the Court found that the plaintiffs’ general claim of breach of fiduciary duty, apart from liability for improper distributions, did not result in a substantial likelihood of liability because any such liability was subject to exculpation as permitted by section 102(b)(7), absent bad faith, which the plaintiffs did not plead with particularity.
Applicability to MBCA
The Court’s approach to distributions and dividends in the Chemours opinion is consistent with the approach of the MBCA, as explained in the Official Comment to section 6.40. The Chemours opinion gives directors considerable flexibility, and therefore protection from liability, in making determinations of the corporation’s surplus to support decisions on dividends and other distributions to stockholders. This allows directors to determine present values, such as the current fair market value of the corporation’s assets, and in some cases to use reserves for contingent liabilities reflected in a corporation’s GAAP financial statements. The Official Comment to section 6.40 states that “[t]he determination of a corporation’s assets and liabilities for purposes of the balance sheet test of section 6.40(c)(2) and the choice of the permissible basis on which to do so are left to the judgment of its board of directors.” Similar to Delaware law, the Official Comment to section 6.40 indicates that “[o]rdinarily a corporation should not selectively revalue assets,” but “should consider the value of all its material assets,” and similarly, “all of a corporation’s material obligations should be considered and revalued to the extent appropriate and possible.” Section 6.40 authorizes the use of financial statements prepared on the basis of accounting practices and principles that are reasonable under the circumstances and, consistent with the Chemours decision, also authorizes any other “method of determining the aggregate amount of assets and liabilities that is reasonable in the circumstances.” This means that “a wide variety of methods may be considered reasonable in a particular case even if any such method might not be a ‘fair valuation’ or ‘current value’ method.”
These determinations under both the DGCL and the MBCA need to be made in good faith, and to demonstrate good faith boards of directors should follow a careful and considered process. That process should be recorded as part of the minutes.
Although reliance on financial statements can protect directors from personal liability for improper distributions, directors dealing with contingent liabilities, whether operating under the DGCL or the MBCA, will want to go beyond the amounts shown in the financial statements. In order to comply with their fiduciary duties, they also should consider the broader information included in any footnote disclosures required under the applicable accounting standards, even if liability for a breach of those duties may be covered by an exculpation provision in the charter.
Determining Fair Value in Appraisal Proceedings
The primary issue in an appraisal proceeding is the determination of the fair value of the shares held by shareholders exercising their appraisal rights. Section 13.01 of the MBCA defines “fair value” for purposes of appraisal proceedings based on “[t]he value of the corporation’s shares … using customary and current valuation concepts and techniques generally employed for similar businesses in the context of a transaction requiring appraisal … and without discounting for lack of marketability or minority status….” This definition gives a court considerable discretion to consider various methodologies including, as applicable, the deal price, unaffected share price analysis, comparable precedent transactions, a comparative company analysis, asset valuations, and a discounted cash flow (DCF) analysis. The method or methods that may be used can vary based upon the circumstances of the particular transaction, and the favored methods have changed over time.
Recently, the Supreme Court of North Carolina in Reynolds American Inc. v. Third Motion Equities Master Fund Ltd.[6] had the opportunity for the first time to interpret the provisions of the North Carolina version of the MBCA to determine if the North Carolina Business Court properly determined the fair value of the shares in an appraisal proceeding of the tobacco company, Reynolds American, which was acquired by British American Tobacco. The Business Court determined that the fair value of the shares did not exceed the deal price of $59.64 plus interest that had been paid to the dissenting shareholders and therefore no further payments were required.
In upholding the Business Court decision, the North Carolina Supreme Court, in an extensive and detailed analysis, cites freely to the well-developed body of Delaware decisional appraisal law and significantly defers to the exercise of discretion by the Business Court in determining fair value based on the evidence before it. In particular, the Court held that the Business Court’s primary reliance on the deal price was justified, even though the acquisition of Reynolds American by a large, but non-controlling shareholder was not actively marketed. The Business Court used other factors, including indicia of a robust deal process and various other “customary and current valuation concepts and techniques” to confirm that the deal price was indicative of the fair value.
By extensively citing to the well-developed body of Delaware law on determining fair value in an appraisal proceeding, the North Carolina Supreme Court provides support for using the Delaware decisions as relevant precedent for determining fair value under the MBCA, notwithstanding the differences in the appraisal provisions between the two corporate statutes.
A final issue addressed by the Court was the dissenting shareholders’ claim that they were entitled to additional interest under the North Carolina counterpart of MBCA section 13.30(e). Although acknowledging that the provision is “ambiguous,” the Court held that it would be nonsensical and contrary to the legislative intent to award an interest windfall and encourage “appraisal arbitrage” when no additional payment on the shares was due.
Determining Fair Value for Purchase in Lieu of Dissolution
Section 14.34 of the MBCA permits a corporation in a proceeding for judicial dissolution under section 14.30(a)(2) to elect to purchase the petitioning shareholder’s shares at their “fair value.” If the parties cannot agree on the price and terms of the purchase, the court is required to determine the fair value of the shares and the terms and conditions of the purchase, including whether payments may be made in installments and whether to award any expenses. However, the MBCA does not define “fair value” for purposes of section 14.34 or refer in section 14.34 or in the Official Comment to the definition of “fair value” for appraisal purposes in section 13.01.
In Bohack v. Benes Service Co.[7] the Nebraska Supreme Court addressed the meaning of fair value under the provision of the Nebraska Model Business Corporation Act (“NMBCA”) comparable to section 14.34. The Court began by deciding to look to the appraisal provisions of the NMBCA for guidance as to the meaning of fair value in section 14.34. Section 13.01 requires that the fair value of a corporation’s shares be determined using “customary and current valuation concepts” and “without discounting for lack of marketability or minority status.” Although the Official Comment to section 13.01 states that the “specialized” definitions in section 13.01 apply only to chapter 13, the Court stated that it was not foreclosed from looking to the definition in section 13.01. It noted that the Official Comment was not adopted as part of the NMBCA but went on to observe that in the earlier version of the Official Comment, there was a statement that a court applying section 14.34 might find it useful to consider valuation methods applicable to an appraisal proceeding. That statement is no longer in the Official Comment to section 14.34 in the 2016 Revision of the MBCA. Although the Court noted on this issue and on the discounts issue discussed below that the Nebraska legislature did not adopt the Official Comment, it recognized that the Official Comment is a relevant resource in interpreting the statutory provisions. This reflects the general approach of courts in other states where the Official Comment has not been formally adopted as part of the state’s corporation statute. Some states make it a practice to mention in their legislative history that the Official Comment to the MBCA should be considered in interpreting the statute.
The Court next determined that discounts for lack of marketability and minority status should not apply because they are excluded, with certain exceptions not applicable in this case, from the definition of fair value for appraisal purposes. It noted the distinction between “fair value” and “fair market value” in other Nebraska statutes. The Court declined to consider a statement in the Official Comment to an earlier version of the MBCA that a minority discount may be appropriate under section 14.34, a statement that is also no longer in the Official Comment to the 2016 Revision of the MBCA. The Court noted again that the Official Comment was not adopted as part of the NMBCA but went on to state that the Official Comment to the definition of fair value in Section 13.01 states that discounts for lack of marketability or minority status are inappropriate in most appraisal actions because they give the majority an opportunity to take advantage of the minority that is being forced to accept the transaction triggering the appraisal. The Court analogized an appraisal transaction to a forced buyout under section 14.34. However, the Court did not reference other parts of the extensive discussion in the earlier Official Comment identifying the differences between a proceeding under section 14.34 and an appraisal proceeding under chapter 13 that could affect the Court’s approach to determining fair value. Those differences include the relevance of liquidation value under section 14.34 when there is deadlock, the need for adjustments when the value of the corporation has been diminished by wrongful conduct of controlling shareholders, and the appropriateness in some circumstances of a minority discount. The earlier Official Comment made it clear that the approach to a valuation is very much dependent on the particular facts and circumstances, that a court in a proceeding under section 14.34 has considerable flexibility, and that using valuation methods relevant to judicial appraisal is permissible. The reasons for the Court’s unwillingness to consider portions of the earlier Official Comment that were not included in the Official Comment to the 2016 Revision are not entirely clear. The elimination or revision of a statement in an earlier Official Comment as part of the editorial process of the Corporate Laws Committee does not necessarily mean that the earlier statement was deemed incorrect or no longer relevant by the Committee. The reasons for editorial changes vary based upon the particular comment omitted or revised. In general, the editing of the Official Comment in the 2016 Revision was designed to streamline it and serve solely as a guide to the interpretation of the applicable statutory provisions and not necessarily because they were no longer considered relevant or correct.
The Court determined that a going concern value was appropriate in the circumstances because the corporation would be continuing in business. It then went into the details of the appropriate valuation methodology, which had unique aspects and which do not need to be recounted here.
Director Liability Shield
In Meade v. Christie,[8] which involved a shareholder’s challenge to a going private merger, the Supreme Court of Iowa addressed the relationship of the Iowa counterparts of sections 8.30 and 8.31 of the MBCA and the application of the exculpation provisions authorized by section 2.02(b)(4) of the MBCA (referred to by the Court as the “director shield statute”), and the procedural requirements of those provisions. In its opinion reversing and remanding the trial court’s denial of a motion to dismiss by the director defendants, the Court referenced the Official Comment to the 2016 Revision of the MBCA and analyzed the differences between the exculpation provisions of the Iowa Business Corporation Act (the “IBCA”), which are based on those in the MBCA, and DGCL section 102(b)(7).[9]
The case involved a class action brought by a former shareholder of an Iowa insurance holding company who alleged that the directors breached their “fiduciary duties of care, loyalty, good faith, and candor” by approving the merger in “a flawed process that resulted in too low a price being paid to the minority shareholders.” The issue considered by the Court on appeal was whether the shareholder’s pleadings were sufficient to show that the IBCA’s counterpart of MBCA section 8.31 did not protect the directors from liability. The appeal also involved the issue of whether the claim was a direct or derivative claim but, because of its determination that the directors’ motion to dismiss should be granted, the Court did not have to reach the issue of whether the trial court was correct in finding that the claim was properly brought as a direct claim.
The Court began its analysis by discussing the standards of conduct for directors under section 8.30, describing them generally as a duty of care and a duty of loyalty. It then noted that, although section 8.30 provides the standards of conduct, section 8.31 sets forth the conditions for holding a director liable for money damages. Under section 8.31, a director is not liable unless the complainant establishes that an exculpatory provision in the corporation’s articles of incorporation authorized by section 2.02(b)(4) does not apply. Since the holding company had adopted an exculpatory provision that tracked the statutory authorization, the Court then analyzed whether the shareholder pled facts sufficient to show that one of the exclusions to exculpation, specifically “intentional infliction of harm on the corporation or the shareholders,” applied.
In reaching its conclusion that the shareholder’s allegations were insufficient to establish the “intentional infliction of harm” exclusion, the Court looked at the background of exculpation statutes, referring to the MBCA’s Official Comment, and compared the MBCA and Delaware exculpation provisions.
Citing the explanation of the Corporate Laws Committee for the addition of a director exculpation provision,[10] the Court noted that policymakers in the mid-1980s, concerned about qualified individuals declining to serve on boards of directors, began advocating for enhanced protections for corporate directors. These concerns arose out of court rulings that expanded directors’ personal liability for money damages, notably the Delaware decision in Smith v. Van Gorkom.[11] After Delaware and other states, including Iowa, amended their corporate statutes to permit director exculpation provisions, the MBCA was amended to further increase the protections for directors. Iowa amended its statute in 2003 to adopt the MBCA exculpation provision. The Court observed that the Delaware exculpation provision in section 102(b)(7), which excludes from exculpation “acts or omissions not in good faith or which involve intentional misconduct,” picks up a broader range of fiduciary misconduct than the narrower exclusion of “intentional infliction of harm” standard in the MBCA and the IBCA. Citing the Official Comment to section 2.02(b)(4) stating that the use of “intentional” refers to a specific intent to perform or fail to perform the acts with actual knowledge that it will cause harm, the Court stated that the MBCA standard would not exclude from exculpation claims of reckless conduct, conscious disregard of a duty, or intentional dereliction of a duty, all of which are excluded from exculpation in Delaware. Based on the MBCA’s higher bar for an exclusion from liability and the resulting heightened pleading requirement, the Court held that the shareholder’s allegations were insufficient to establish an “intentional infliction of harm on the corporation or the shareholders” by the directors. The Court observed that this result was consistent with the purpose of exculpation, to provide not only protection from liability but also to avoid the costs and stress of litigation. It also noted that shareholders who believe a merger buyout price is inadequate have the alternative remedy of appraisal rights under section 13.02.
Director Duties in Assessing Demand
Unlike Delaware, which has a demand required/demand excused approach to derivative actions, the MBCA follows a universal demand approach.[12] The fundamental premise for the universal demand requirement in the MBCA is that the board of directors should have an opportunity to assess demands and to act in the best interest of the corporation, subject to judicial oversight of its action. Underlying this premise is the requirement that directors fulfill their fiduciary duties in dealing with a demand.
In Garfield v. Allen,[13] the Delaware Court of Chancery considered a challenge by a stockholder of The ODP Corporation to an equity compensation award to the chief executive officer on the ground that it exceeded the limits of the equity compensation plan approved by the stockholders. The Court held that the complaint stated a claim for relief based on a breach of fiduciary duties by the directors in not correcting the violation after the stockholder sent a demand letter to the board calling attention to the issue.
In upholding the claim, the Court noted that it was based on a “novel theory” that the Court accepted with “admitted trepidation” because it could permit plaintiffs in the future to create claims by sending demands to boards if those demands are not acted upon. Nevertheless, although historically a board’s rejection of a litigation demand has only affected parties who control the derivative claim and has not been held to be grounds for a separate breach of fiduciary duty claim, the Court found the logic of the claim in this case sound because it indicated a possible conscious failure of the directors to act that could equate to a knowing, wrongful action. The Court, however, urged caution in dealing with this as a basis for such claims going forward.[14]
This article originally appeared in the Winter 2022 issue of The Model Business Corporation Act Newsletter, the newsletter of the ABA Business Law Section’s Corporate Laws Committee. Read the full issue and previous issues on theCorporate Laws Committee webpage. Another article by the same author discussing several other recent Delaware decisions relevant to the MBCA appears in the Summer 2021 issue of The Model Business Corporation Act Newsletter. One of those decisions has been reversed by the Delaware Supreme Court, as discussed in an update also appearing in the Winter 2022 issue.
The views expressed in this article are solely those of the author and not Locke Lord LLP or its clients. No legal advice is being given in this article.
See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 153 (Del. 1997). ↑
The Delaware courts use the phrase “present value” in this context to mean the current fair market value of the corporation’s assets, not the “present value” of the corporation’s future cash flows, as used in financial analyses. ↑
See Klang v. Smith’s Food & Drug Centers, Inc., 702 A.2d 150, 155 (Del. 1997); see also Morris v. Standard Gas & Electric, 63 A.2d 577, 582 (Del. Ch. 1949). ↑
The claim in Garfield involved the alleged liability of the directors for a breach of their fiduciary duties under Delaware law. As noted in the discussion of the Meade v. Christie decision under “Director Liability Shield” above, the standards of conduct for directors under MBCA section 8.30 and the conditions for holding directors liable for monetary damages under MBCA section 8.31 are different. ↑
The market for digital assets has exploded in recent years. Digital and virtual currency activities provide great opportunities financially and technologically. However, such currencies can be utilized for illicit activity through exchanges, peer-to-peer exchanges, mixers (a service that mixes different streams of potentially identifiable cryptocurrency), and darknet markets, which increase the risk of money laundering and terrorist financing. Financial institutions and other industry players have both struggled with and embraced digital currencies to varying degrees. With innovation and increased popularity comes risk.
The U.S. government is keen to identify ways to mitigate the risks that digital assets present, while recognizing that opportunities and potential benefits may exist. On March 9, 2022, President Biden issued the Executive Order on Ensuring Responsible Development of Digital Assets (EO). The EO was the first whole-of-government strategy to address not only the risks of digital assets, but also the benefits of their underlying technology. The EO outlined six priorities that factor into addressing a national policy for digital assets and called for interagency coordination to implement the EO.[1]
Most recently, on September 16, 2022, the White House published a fact sheet that combines data from the nine reports submitted to date in response to deadlines included in the EO. The fact sheet articulates the first comprehensive framework that supports the six priorities for responsibly developing digital assets, which includes regulatory considerations and makes clear that misuse will give rise to enforcement.
The United States has already pursued enforcement in the cryptocurrency space, particularly against mixers. Mixers provide anonymity and aid in hiding the origin and movement of funds. Recently, the U.S. Department of the Treasury’s Office of Foreign Assets Controls (OFAC) imposed sanctions on Tornado Cash, a virtual currency mixer, which was utilized to launder more than $7 billion worth of virtual currency since 2019. The figure included more than $455 million stolen by the previously sanctioned Lazarus Group of the Democratic People’s Republic of Korea (DPRK) back in 2019. Additionally, the Treasury’s Financial Crimes Enforcement Network (FinCEN) assessed a $60 million civil money penalty against the owner and operator of a virtual currency mixer for violations of the Bank Secrecy Act (BSA) and its implementing regulations. Enforcement further signals the necessity for financial institutions and those in the virtual currency industry to mitigate the risks presented by virtual currencies.
As part of a company’s Bank Secrecy Act / Anti-Money Laundering (BSA/AML) and sanctions programs, it is critical to prevent sanctioned persons and other illicit actors from exploiting digital currency for illicit and criminal purposes. Even if not formally subject to such regulations, each company in the industry should take a risk-based approach to assess the various risks associated with different virtual currency services, develop and implement measures to mitigate such risks, and address the challenges anonymizing features can present to compliance with BSA/AML and sanctions obligations. Given recent enforcement actions, mixers should generally be considered high risk, and companies should proceed with caution when considering whether to process transactions involving mixers, unless appropriate processes and controls are in place to prevent money laundering or identify illicit or designated actors.
Since we can expect the U.S. government to exercise its authority against malicious cyber actors to expose, disrupt, and hold accountable perpetrators that enable criminals to profit from cybercrime and other illicit activity, it is crucial that financial institutions and businesses engaged in the financial services sector consider these priorities and actions in their efforts to combat illicit use of digital currencies.
A risk-based approach coupled with a comprehensive risk assessment are critical, foundational aspects of both compliance and combatting financial crime. Revisiting risk assessments periodically is also critical—especially considering the current rate of regulatory change and published guidance in the digital currency space.
The priorities are: consumer and investor protection; promoting financial stability; countering illicit finance; U.S. leadership in the global financial system and economic competitiveness; financial inclusion; and responsible innovation. ↑
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