In a recent decision, In Re Clovis Oncology, Inc. Derivative Litigation,[1] the Delaware Court of Chancery held that stockholders of Clovis Oncology, Inc. (Clovis), a developmental biopharmaceutical company, adequately pled facts that supported a pleading stage inference that the Clovis board of directors breached its fiduciary duties by failing to oversee the clinical trial of the company’s most promising drug, and then allowing the company to mislead the market regarding the drug’s efficacy. This decision follows the Delaware Supreme Court’s recent reversal in Marchand v. Barnhill,[2] which involved the dismissal of Caremark claims arising from a listeria outbreak at Blue Bell Creameries USA, Inc., resulting in a number of deaths.
Background
Clovis is a biopharmaceutical company that has no products on the market and generates no sales or revenue. In early 2014, the Clovis board was determined to get U.S. Food and Drug Administration (FDA) approval for the company’s then-most promising, cancer-fighting drug, Roci, before AstraZeneca’s competing drug for lung cancer received FDA approval. After clinical trials began in 2014, the Clovis board received data suggesting that management was inaccurately reporting Roci’s efficacy by including unconfirmed responses to corroborate Roci’s cancer-fighting potency. Although the Clovis board allegedly knew that under the protocols for its clinical trial the FDA could base approval of Roci’s new drug application only on confirmed responses, the Clovis board did nothing to address the fundamental departure from protocol. Clovis continued to publicly report inflated numbers in 2014 and early 2015, and used the inflated numbers to obtain additional funding from investors during that timeframe. By November 2015, the FDA informed Clovis that it could report only confirmed responses, and Clovis issued a press release informing the public of Roci’s actual efficacy, which led to a 70-percent drop in the company’s stock price. In April 2016, the FDA voted to delay action on Roci until Clovis could provide concrete evidence that Roci produced meaningful tumor shrinkage in patients treated with the drug, which led to another 17-percent drop in the company’s stock price, and Clovis withdrew its new drug application for Roci.
Analysis
In this action, plaintiffs alleged that the Clovis directors breached their fiduciary duties under Caremark by either failing to institute an oversight system for the Roci clinical trial, or consciously disregarding a series of red flags that the clinical trial was failing. The defendant directors moved to dismiss plaintiffs’ claims for failure to (1) make a pre-suit demand under Court of Chancery Rule 23.1, and (2) state a claim upon which relief could be granted. The court disagreed and found that: (1) pre-suit demand was excused because plaintiffs pled particularized facts to support a reasonable inference that the Clovis directors faced a substantial likelihood of liability under a Caremark theory of liability that excused plaintiffs’ failure to make a pre-suit demand, and (2) plaintiffs stated a Caremark claim by making well-pled allegations that the Clovis board acted in bad faith by consciously disregarding red flags that arose during the course of Roci’s clinical trial that placed FDA approval of the drug in jeopardy. According to plaintiffs, the Clovis board then allowed the company to deceive regulators and the market regarding the drug’s efficacy.
As the court noted, successful Caremark claims require well-pled allegations of bad faith to survive dismissal, i.e., allegations that the directors knew that they were not discharging their fiduciary obligations. Plaintiffs may meet that burden by showing either that the board completely failed to implement any reporting or information system or controls, or that the company implemented an oversight system but the board failed to monitor it as evidenced by red flags which were known, but ignored, by the board. Here, the court found that plaintiffs successfully pled that the Clovis board ignored red flags that revealed a mission-critical failure to comply with drug protocols and associated FDA regulations. The court noted that a board’s oversight obligations are enhanced with respect to mission-critical products while operating in a heavily regulated industry.
Takeaways
As then-Chancellor Allen stated of a Caremark theory of liability: “The theory here advanced is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment”.[3] In order to meet this enhanced pleading burden, the plaintiffs in Clovis and Marchand brought books and records actions under section 220 of the General Corporation Law of the State of Delaware prior to bringing their Caremark complaints. The books and records actions enabled the plaintiffs to gather crucial facts that highlighted potential gaps in compliance systems and board-level ignorance of red flags. Some practical lessons can be drawn from both cases.
In Clovis, the Court of Chancery emphasized the importance of a board’s oversight function when a company is operating in the midst of a mission-critical regulatory compliance risk, suggesting that a board’s oversight of such impactful business risks may be subject to greater scrutiny than the same board’s oversight of less-critical business risks. In Marchand, the Delaware Supreme Court’s decision emphasized the importance for corporations operating in heavily regulated industries to implement a system that ensures that mission-critical risks and compliance issues are brought to the attention of the board whether through a board-level compliance committee or a direct reporting line between the corporation’s top compliance officer and the board. Both cases underscore the importance of board engagement in regular discussion of critical business risks and compliance issues and the evaluation of the effectiveness of existing monitoring and compliance systems.
Prior decisions of the Delaware courts relating to Delaware corporations with vast global operations have emphasized the importance for such an enterprise to: (1) establish compliance standards and procedures that are designed to prevent violations of the law at all levels of the organization, (2) require participation in training programs, and (3) establish whistleblower systems that enable employees to report potential wrongdoing anonymously and without fear of retaliation.
Acme’s cloud storage provider just got hacked. Private information was exposed. Acme’s customers who lost information in the hack are angry and don’t care that it was a third party that failed to secure the information or that some maleficent hacker from across the globe got into their system. Likewise, their customers don’t care how difficult it is for Acme to migrate data, or how they retain and store their records, or what regulations govern each part of Acme’s business. Acme’s customers care only about their information, their data, and whether Acme performs for them.
This story could be any company’s story. The problems afflicting Acme could be one of a number of information-management issues that confound most businesses. In 2020, you should expect that bad actors will seek to break into your information trove and find and exploit any weakness in your information culture. Expect they will try regularly—they are trying right now, in fact. Expect that customers will become ever more aware of “their” private information, and when (not if) that information is exposed, it may impact your relationship with your customers, vendors, and the public. Expect that confidential information may fly across the ether unprotected, and that sensitive information may fall into the wrong hands. Expect that records may be kept for too long or not long enough, and that discovery for a lawsuit may be inexplicably gone, precipitating a claim for spoliation.
If every worst-case scenario is not only possible, but likely at some point, then now what? Take a deep breath and read on because there is a path forward. As you reflect on how to change the course of, or mitigate the fallout from, some future event, you could find help in building a mindful information culture at your company. Building a more mindful information culture has several distinct and critical elements:
Who Is the Organization’s “Champion”? Every major project or initiative requires a champion possessing a combination of institutional knowledge and political savvy to help make the journey more productive and less painful. It is critical that the face of the journey to build a mindful information culture has the right temperament and skill set. In order to establish and properly incubate this shift, your champion must demonstrate three essential qualities: the ability to clearly communicate, a balance of business and technology acumen, and knowledge of the organization. Properly selecting the right champion will enable the new culture to grow and flourish, whereas failing to select the right champion will likely doom it to failure.
Relying on the Right Support to Do the Heavy Hauling and Deliver Guidance. Every programmatic trek also needs the right supporting cast that represents the essential parts of your organization. Without the right supporting team members to haul each segment of the organization forward, the initiative will likely experience headwinds and hurdles (which might happen anyway). For every information project, there must at a minimum be business, IT, and legal executive involvement, and do not minimize the need for excellent project-management skills, too. Getting the right executive’s imprimaturs will be essential in getting the employees’ behind the initiative.
Assessing Where You Are in the Fog. The only way you know where you are is by looking. The only way you know what needs fixing is by assessing “the good, the bad, and the ugly.” Knowing what is “good enough” and what needs fixing is an essential part of the project, and it should happen early in the process. Additionally, when you have several issues that must be addressed, each issue must be evaluated based on risk to the organization. In other words, the issues that create the greatest risk, and the issues that can be addressed fairly easily, should be tackled first. Until you assess, you cannot address, but only after identifying your organization’s problems can you begin to change your information culture.
Building a Plan to Get to Information Nirvana. Having the right remediation path and taking the right action steps to triage and fix any information problem requires a plan. Ensuring your organization provides long-term solutions to address company and employee needs for information similarly requires a plan, and likely new technology to ensure information accessibility.
So, what should your organization’s plan look like? You have done your triage and know that immediate litigation response requirements likely take precedence over longer-term records retention fixes. Likewise, managing private information that is sitting unprotected on a server likely takes precedence over training on information classification. However, the plan must be more than just triaging emergencies. The tyranny of the immediate cannot derail you from your long-term goals. Your organization can implement tactical fixes at the same time that it fleshes out the strategic initiatives. You simply must manage resources to maximize effectiveness and not overwhelm a particular business unit or individual.
Part of the path forward also requires that your plan consider your organization’s existing information culture. What is your work force’s openness to change? Are they technologically sophisticated? Centralized? Are business units autonomous? Does your company vet and buy applications for the entire company? How big is the problem? Who is required to fund and fix it? Are employees going to balk if you change e-mail retention, for example? The bottom line is to be ambitious but take the time to build a plan that includes the needed expertise from across the organization, and be realistic about what can get done given the company information culture, resource constraints, and other projects impacting employee availability.
Messaging as the Information Mantra. Moving your team, department, or organization to change is not easy. It will be effective only if the key leaders properly message the change. Mid-level management typically does not steer the ship; redirection is done by the people at the top.
For example, when moving to a new collaboration environment or migrating to O365, your workforce’s needs and concerns should be anticipated and managed, otherwise the project will likely get derailed. Providing the necessary information to the proper people and giving them the opportunity to ease into change and readjust their way of operating will be necessary for your plan to succeed.
People default to what is simple and what they know. Therefore, the messaging surrounding building an information culture is critical. It must be clear, consistent, and anchored to a “why” that resonates with your employees and makes their life better (not just simpler, but better). This will allow them to move past the “but this is how we have always done it” response toward becoming mindful stewards of your organization’s information. Mindful employees are essential to building a great information culture.
Achieving a Mindful Information Culture Requires Processes and Repetition. Achieving any organizational goal, let alone building a mindful information culture, requires the right processes and directives that can become muscle memory—implementable, repeatable, and followed over time. Diligence must become your organization’s state of being. Persistence must be how the champion and executive team manages any information-related initiative and program. A mature information culture is a state of being, like a never-ending marathon. Culture is not a “sometimes thing,” it is an “all the time thing.” If your company is able to wrangle its information security risks, it is because information security mindfulness was made part of the fabric of your organization. If your organization right-sizes its information footprint annually, it is because minimizing cost and mitigating the risk of keeping unneeded data has also been woven into the fabric of your company. It takes a person doing something correctly 14 times in a row to make it a habit, and achieving information nirvana is no different. Building a mindful information culture can be achieved only by implementing a consistent, persistent, evolving cycle to assess, plan, implement, communicate, monitor, resolve, and repeat. This is the way to truly effectuate cultural change.
Information Mindfulness. All organizations care about profits and costs, yours included. Harvesting and harnessing information can promote both. To be a truly information-mindful organization, your company must use information as a differentiator. Information can promote employee satisfaction and provide a more valuable workplace. Information can advance your customers’ needs and create a deeper customer experience, which translates into a deeper customer connection, which translates into greater sales. Information mindfulness is about using information as the currency that makes business better and the glue that connects people in various ways with your company.
Finding Easy Places to Focus. Your organization should focus its efforts on the most critical gaps first while finding some low-hanging fruit to bolster the credibility of project champion. Once you solve a few of the less complex issues impeding your organization, you can move on to the tougher issues, having acquired wins under your belt and hopefully having banked goodwill and support from management. When employees see the changes to your information culture helping their work day, they will almost certainly climb aboard.
Conclusion
A leader’s obligation is to be constant in principle but flexible in approach—to change just before change is necessary. Specifically, once the pillars are poured, you and your champions must find a new way to look at and think about the enterprise’s information culture, whether a new angle or new focus, a new way forward, or simply to decide to do what you are already doing, just more efficiently. The bad actors never rest and are always reinventing themselves. Without that same dedication to diligence as a way of corporate life, your information culture will stagnate, issues will appear, and you will likely feel the pain that is exacted on the nonvigilant.
In the July issue of BLT I described briefly the consequences of the application of RULLCA’s default rule to members of a limited liability company (LLC) who fail to provide for member death. Readers suggested a follow-up piece that would provide suggestions to avoid those consequences.
The issue arises because, unlike the shares of a corporate shareholder all of whose rights, unless otherwise provided in a shareholders agreement, pass to his or her estate, when an LLC member dies, unless something is provided to the contrary, his or her interest divides, with only economic rights passing to the estate.[1] The management rights devolve upon the remaining members. In a multi-member LLC (MMLLC), where the pick-your-partner principle of partnership law applies, this result is clearly appropriate. In a single member LLC (SMLLC) pick-your-partner protection is oxymoronic.
The consequences for the decedent’s heirs are different in the MMLLC from those in the SMLLC. In the former, the estate is treated as an assignee or transferee of the economic rights.[2] The now former member, dissociated at death, has provided his or her heirs with little or no authority to enforce their inherited economic rights. They are at the mercy of the remaining LLC members who may choose not to make distributions. They have no right to participate in the direction, whether wise or foolhardy, in which the surviving members may take the LLC. [3] Recovery of the decedent’s capital account will not be realized until the LLC dissolves if that event should ever occur. The estate has no right to compel the LLC’s dissolution[4] or even, perhaps, to acquire information as to the LLC’s ability to make distributions.[5]
In the SMLLC, where the economic rights also pass to the estate, the problem is that if the estate does not act within a short statutory period to name a successor member who accepts the role, the memberless LLC dissolves with whatever unintended consequences flow from that event.[6]
Knowledgeable business lawyers will protect against these consequences. When a multi-member LLC is formed, and all the members are on the same side of the table and don’t know who will be the first to die, the lawyers will offer suggestions as to how the members may wish to provide for death in their operating agreement. If admission to membership of one or more successors to a deceased member is not desired, perhaps a buy-out on death can be negotiated, or provision made for the heirs to have certain rights short of participation in management.
In the SMLLC provision should also be made in the operating agreement for the one future event that is certain to occur. Here are a few suggestions.
1. Treat the member’s interest similar to that of a sole shareholder in a corporation. The operating agreement might provide that:
Upon the death of the member (or last surviving member in a multi-member LLC), the member’s estate is admitted to membership in the LLC on the member’s date of death with both economic rights and full management authority.
The time gap between the date of death and the appointment of an executor or administrator for the estate, during which business operations may not be able to be directed, might be addressed by naming an interim manager.
2. The operating agreement might name a successor member admitted to membership immediately upon the death of the member.[7]
3. If the governing statute permits, name a special member who has no capital account or percentage interest in the LLC and thus should not impair its disregarded status for income tax purposes.[8]
4. If the governing statute permits, the concept of a springing member might be utilized.
5. Instead of placing the membership interest in the individual, it may be placed in a revocable trust for the client (a) if a trust may be an LLC member and (b) if the client is willing to incur the complexity and cost of a trust agreement in addition to an operating agreement.
My attention has been called to The Uniform TOD Securities Registration Act, part of the Uniform Non-Probate Transfers on Death Act, promulgated in 1989 when LLCs were in their infancy. Its design is to provide the owner of securities an alternative to the process of probate. Although the statute’s definition of security is broad enough to encompass an interest in an LLC, the statute does not address the dichotomy between economic and management rights. It is doubtful that, in a multi-member LLC, authorization for non-probate transfer overrides the pick-your-partner principle. The statute’s usefulness to a SMLLC, limited by the definition of Registering Entity, may present practical difficulties.
[1]Ott v. Monroe, 2011 WL 5325470 (Va. 2011): An LLC interest, like a partnership interest, is comprised of two separate components. The first is the management right to control or participate in administration. The second is the economic or financial right to participate in the sharing of profits and losses and receipt of distributions. The only interest alienable is the economic interest
[2]Faienza v. T-N-B Marble-N-Granite, LLC, 2018 WL 1882586 (Conn. Sup. Ct. 2018): The deceased member’s estate has only the rights of a transferee, not a member, and cannot sue for dissolution. To the same effect: Estate of Calderwood v. ACE Grp., Int’l, LLC, 61 N.Y.S. 3d 589 (App. Div. 2017); SDC University Circle Developer, L.L.C. v. Estate of Patrick Whitlow, M.D., 2019 WL 92791 (Ct. App. Ohio 2019).
[3] See, Gebroe-Hammer v. West Green Gables, LLC, 2019 WL 3428499 (App. Div. N.J. 2019). Act of sole surviving member bound, LLC.
[5]Succession of McCalmont, 261 So.3d 903 (La. App. 2018): As a mere assignee the deceased member’s estate as could not access the LLC’s books and records to determine if it was getting its fair share of distributions.
[7]Blechman v. Estate of Blechman, 160 So. 3d 152 (Fla. App. 2015): Where supported by adequate consideration, contracts transferring a property interest upon death are neither testamentary nor subject to the Statute of Wills, but are instead evaluated under contract law. See also, in the corporate context, Jimenez v. Carr, 764 S.E.2d 115 (Va. 2014)
[8] Support for this proposition is Historic Boardwalk Hall, LLC v. C.I.R., 694 F.3d 425 (3rd Cir. 2012), where the entity involved was not recognized as a partnership for tax purposes because the purported partner had no meaningful stake in its success or failure.
A key distinction in international transactions has been whether a contract is governed by the law of a civil-law jurisdiction or the law of a common-law jurisdiction. For purposes of contracts, the structural distinctions between civil law and common law have diminished in significance, but use of common-law terminology in contracts governed by the law of a civil-law jurisdiction remains a source of confusion. After considering the historical difference between civil-law and common-law contracting, this article suggests how to avoid that confusion.
Civil Law and Common Law
Civil law is primarily derived from Roman law. In civil-law jurisdictions, codified principles serve as the primary source of law. By contrast, common law is based on medieval English law. In common-law jurisdictions, judicial decisions serve as the primary source of law.
The primary English-speaking jurisdictions—the United States, the United Kingdom, the English-speaking parts of Canada, and Australia—are common-law jurisdictions. Civil-law jurisdictions can be divided into the Romanistic (including Italy, France, and Spain), the Germanic (including Germany, Austria, Switzerland, and Taiwan), and the Nordic (Denmark, Finland, Norway, and Sweden).
Shorter or Longer Contracts
The conventional wisdom is that contracts drafted in common-law jurisdictions are longer than those drafted in civil-law jurisdictions because civil-law drafters are able to rely on codified default rules.
For example, section 121, paragraph 1 of the German civil code defines the word unverzüglich to mean “without culpable delay.” When that word occurs in contracts, it is generally understood to express its statutory meaning, subject to caselaw relating to how it is to be interpreted—it need not be defined in a contract.
And although common-law contracts often spell out what constitutes an event of default for purposes of the transaction and what the resulting consequences are, that’s addressed in the German civil code. Generally, the parties to a contract may deviate from such default rules in their contract.
But this distinction between common-law and civil-law contracts is blurring—English-language drafters used to common-law drafting apply a more exhaustive approach even for purposes of contracts governed by the law of a civil-law jurisdiction. And civil-law drafters exposed to common-law drafting are prone to replicating it. Nevertheless, it would always be prudent to make clear how contract provisions relate to the codified default rules. For example, if the words “without culpable delay” are used in the contract, an explicit reference to section 121, paragraph 1 of the German Commercial Code should be included to indicate that these words are used to convey that meaning.
Whether Interpretation Is Limited to the Wording of the Contract
It’s also the conventional wisdom that common-law judges, in reliance on the parol evidence rule, are likely to interpret a contract based solely on the contract text, whereas civil-law judges also take into account subjective considerations like the parties’ presumed intent, even if that requires departing from the wording of the contract.
For example, in a famous German court case from 1916, the parties intended to conclude a sale contract for whale meat. But their contract referred to håkjerringkjøtt, the Norwegian word for the much cheaper meat of the Greenland shark. The court had no difficulty finding that the contract was for whale meat.
But this distinction is less clear-cut than it seems. For example, courts and commentators in the United States have swung back and forth between an approach that relies exclusively on the text and one that takes context into account. And the parol evidence rule is subject to exceptions.
Law and Equity
Traditionally, common law distinguished between law and equity. Even though in the United States the distinction has been eliminated in federal and most state courts, courts retain many of the differences between legal and equitable principles. In particular, courts have continued—with exceptions—to grant specific performance only when money damages are inadequate. By contrast, the distinction between law and equity doesn’t exist under civil law. The statutory default remedy for breach of contract under civil law is to have the defaulting party perform. For example, if a seller delivers nonconforming goods, by law the buyer’s initial remedy is delivery of conforming goods.
So in a civil-law contract it would still be unnecessary to refer to equitable remedies. In fact, it might be counterproductive: because the word equity, in translation, can be equated with fairness, a judge might take use of the word equity as an invitation to instead apply general considerations of fairness.
Common-Law Terminology
Contracts for international transactions are usually drafted in English even if no party to the transaction is based in a jurisdiction where English is an official language. And the overwhelming majority of standard contracts promulgated by trade groups for international transactions (for example, the FIDIC standard forms) are in English.
Because the primary English-speaking jurisdictions are also common-law jurisdictions, it’s commonplace for English-language contracts governed by the law of a civil-law jurisdiction to incorporate, by a process of cross-contamination, common-law terminology. Some of that terminology is confusing for those with a civil-law background. That risks causing greater annoyance and uncertainty than the broader differences between civil law and common law.
The standard advice is not to use problematic common-law terminology. That’s our advice, too, but with a difference—the problematic common-law terminology is problematic for common-law drafting as well, so you should eliminate it from all your drafting.
We consider below some examples of this problematic terminology.
Referring to Consideration
The Common-Law Feature: The traditional recital of consideration, which appears to say that there is consideration for the transaction. It usually consists of grotesquely archaic language of this sort:
NOW, THEREFORE, in consideration of the premises and the mutual covenants set forth herein and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto covenant and agree as follows.
The Problem:Consideration is defined as something bargained for and received in exchange for a contract promise. In common-law jurisdictions, consideration is required for a contract to be enforceable. Consideration is not required in civil-law jurisdictions.
The Fix: Eliminate the traditional recital of consideration, and not just for contracts governed by the law of a civil-law jurisdiction: in common-law jurisdictions, you cannot create consideration where there was none just by saying you have consideration. Say instead, The parties therefore agree as follows.
The Common-Law Feature: Use of the phrase represents and warrants in contracts to introduce statements of fact, and use of the phrase representations and warranties to refer to those statements of fact.
The Problem: Drafters in civil-law jurisdictions might assume that use of the word represents somehow refers to an action for misrepresentation (a tort claim) and that use of the word warrants somehow refers to an action for breach of warranty (a claim under the contract). Unsurprisingly, they are puzzled as to how common-law remedies are meant to be relevant for purposes of a contract governed by the law of a civil-law jurisdiction.
The Fix: The phrase represents and warrants is pointless and confusing. Attempts by commentators (and, in England, by a couple of courts) to justify use of the phrase in common-law contracts fail utterly. It follows that no one should have any reservations about deleting it from civil-law contracts. For any contracts, whether civil-law or common-law, if you have sufficient negotiating leverage and are not working in a hidebound practice area like mergers-and-acquisitions, consider using states instead. If you continue to use represents and warrants, don’t use it to list not only statements of fact but also obligations—that just makes things worse.
The Common-Law Feature: Use of the verb warrants and the noun warranty in contracts for the sale of goods.
The Problem: Under common law, an express warranty is a seller’s affirmation of fact to the buyer, as an inducement to sale, regarding the quality or quantity of goods. When the verb warrants and the noun warranty appear in civil-law contracts, drafters in civil-law jurisdictions are understandably puzzled as to how common-law concepts are meant to be relevant for purposes of a contract governed by the law of a civil-law jurisdiction.
The Fix: It’s a simple matter to avoid using this terminology. To introduce a statement of fact, use states, as described above. Instead of using warrants to introduce a statement of future fact, use a conditional clause followed by the remedy. For example, don’t say this:
The Vendor warrants that during the six months after the date of this agreement, the Equipment will conform to the Specifications. In the event of breach of the foregoing warranty, the Vendor shall modify or replace the Equipment.
Instead, say this:
If during the six months after the date of this agreement the Equipment fails to conform to the Specifications, the Vendor shall modify or replace the Equipment.
Even common-law drafters should be willing to make these changes: under the Uniform Commercial Code, enacted in U.S. jurisdictions, a statement does not need to be called a warranty to be a warranty. But because in common-law jurisdictions the notion of a warranty for goods is widely recognized, it might be convenient to use the word warranties as a heading in a common-law contract.
Resource: Kenneth A. Adams, A Manual of Style for Contract Drafting 437–39 (4th ed. 2017).
Using a Variety of Efforts Provisions
The Common-Law Feature: Use of the phrases reasonable efforts, best efforts, good-faith efforts, and other efforts variants.
The Problem: In common-law jurisdictions, many who work with contracts accept the idea of a hierarchy of efforts standards, with, for example, an obligation to use best efforts being more onerous than an obligation to use reasonable efforts. And courts in England and Canada have accepted this notion. Drafters in civil-law jurisdictions wonder whether the gloss given to these phrases in common-law jurisdictions is relevant for purposes of civil-law contracts.
The Fix: A hierarchy of efforts provisions is unworkable for three reasons. First, imposing an obligation to act more than reasonably is unreasonable. Second, requiring that a contract party act more than reasonably creates too much uncertainty as to what level of effort is required. And third, legalistic meanings attributed to efforts standards conflict with colloquial English. Furthermore, rationales offered to validate the idea of a hierarchy of efforts standards fall short. Drafters, whether in civil-law or common-law jurisdictions, should use only reasonable efforts and should structure efforts provisions to minimize the vagueness.
Although anyone involved in international transactions should be aware of the historical distinctions between civil-law contracting and common-law contracting, those distinctions have become less significant. But a cause of annoyance remains: the tendency for drafters to insert irrelevant common-law concepts into contracts governed by the law of a civil-law jurisdiction. Because the primary examples of such terminology are also suboptimal for purposes of common-law drafting, the simplest fix is to express the intended meaning more clearly, without relying on obscurantist terms of art.
As discussed in part one of this two-part article, there is a general premise in bankruptcy law that waiving or contracting away the right to file for relief under the Bankruptcy Code[2] is contrary to public policy. Thus, contractual waivers of such rights are generally deemed invalid. Nevertheless, as the case law has developed over the years, a number of courts have held that operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable. In recent years, lenders have become more creative in seeking to reduce or eliminate their bankruptcy risk. In this regard, a common approach is to create a bankruptcy-remote limited liability company by obtaining, either directly or through a nominee, a so-called golden share in their borrower. Contemporaneously, the lender insists that its borrower incorporate various blocking provisions into their operating agreement such that it can utilize a bankruptcy approval requirement to effectively preclude a bankruptcy filing. When a bankruptcy is filed notwithstanding the inclusion of such provisions, challenging issues are raised. Part two of this article will discuss how courts have dealt with such issues.
Blocking Provisions in Favor of Creditors Are Unenforceable on Public Policy Grounds
Although the law in this area remains in the early stages of development, the cases discussed below suggest that a blocking provision contained in a limited liability company operating agreement in favor of a lender who also holds an equity interest will likely be deemed invalid as contrary to federal public policy.
In re Bay Club Partners-472, LLC. In In re Bay Club Partners-472,[3] the debtor was formed to renovate and operate an apartment complex in Arizona and borrowed $24 million from the lender to finance such efforts. Years later, after multiple defaults by the debtor, the debtor commenced a chapter 11 bankruptcy case. The petition was signed by the debtor’s manager and was accompanied by a written consent prepared to document authorization of the chapter 11 filing that was signed by three of the debtor’s four members, representing 80 percent of the debtor’s equity. The fourth member opposed the bankruptcy filing.
The operating agreement contained a bankruptcy waiver provision that provided that the debtor “intends to borrow money with which to acquire the Property, and to pledge the Property and related assets as security therefor.”[4] The operating agreement went on to provide that the debtor “shall not institute proceedings to be adjudicated bankrupt or insolvent” until “the indebtedness secured by that pledge is paid in full.”[5] The operating agreement was executed by all of the debtor’s members at the time of the original loan.
The lender and the dissenting member filed motions to dismiss the bankruptcy case. The court began its analysis by acknowledging that much of the parties’ arguments focused on state law. However, the court concluded, disposition of the motions to dismiss was governed by federal law. The court noted: “The Ninth Circuit has been very clear that a debtor’s prepetition waiver of the right to file a bankruptcy case is unenforceable because it is a violation of public policy.”
Acknowledging that the lender had not requested any bankruptcy waiver language in the loan documents, the court observed that: “What the evidence established in this case is more cleverly insidious.”[7] The court found that the lender had requested that the bankruptcy waiver be included with its requests for other restrictive covenants in the operating agreement, and that such provision was included in the operating agreement without any discussion among the members. The court deemed the provision unenforceable, reasoning:
The purpose of the bankruptcy waiver provision to prevent a bankruptcy filing while any amount was owed on the Loan debt is clear from the provision of . . . the Operating Agreement that the restrictive covenants of Article XI would only be effective “[u]ntil such time as the [Loan] indebtedness secured by that pledge is paid in full.” That the members of Bay Club signed the Operating Agreement among themselves rather than acquiescing in the bankruptcy waiver provision in a Loan agreement with [lender] is a distinction without a meaningful difference. The bankruptcy waiver in . . . the Operating Agreement is no less the maneuver of an “astute creditor” to preclude [the debtor] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy.[8]
The court held that the bankruptcy waiver provisions were unenforceable and allowed the case to proceed.
Lake Michigan Beach Pottawattamie Resort, LLC. In In re Lake Michigan Beach Pottawattamie Resort,[9] a lender financed the purchase of a vacation resort. Six months later, the debtor defaulted on the loan. After the lender commenced a mortgage foreclosure action, the parties entered into a forbearance agreement under which the debtor’s operating agreement was modified to make the lender a “special member” with the right to approve or disapprove any “material” action, including the right to file for bankruptcy relief. Notwithstanding its “special member” status, the lender had no rights in profits or losses, distributions, or tax consequences, and expressly would not owe any fiduciary duties to the debtor or the other members.
Thereafter, the debtor filed a chapter 11 petition without the lender’s consent. The lender moved to dismiss the bankruptcy case, arguing among other points, that the bankruptcy was filed without the requisite corporate authority. The Bankruptcy Court for the Northern District of Illinois rejected this argument. The court observed that, in general, absolute prohibitions against filing for bankruptcy are void against public policy,[10] but suggested that restrictions in corporate control documents may be treated differently from those in contracts. Nevertheless, the court determined:
common wisdom dictates that the corporate control documents should not include an absolute prohibition against bankruptcy filing. Even though the blocking director structure described above impairs or in operation denies a bankruptcy right, it adheres to that wisdom. It has built into it a saving grace: the blocking director must always adhere to his or her general fiduciary duties to the debtor in fulfilling the role. That means that, at least theoretically, there will be situations where the blocking director will vote in favor of a bankruptcy filing, even if in so doing he or she acts contrary to purpose of the secured creditor for whom he or she serves.[11]
The court found that the amendment to the operating agreement was void under Michigan law because the special member expressly owed no fiduciary duties and was not required to consider the debtor’s interests.[12] The court colorfully summarized its view of the law as follows:
The essential playbook for a successful blocking director structure is this: the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditors that they were shoes be. [The lender’s] playbook was, unfortunately, missing this page.[13]
Turning to Michigan law, the court found that as a member of a Michigan limited liability company, the special member was required to consider the interests of the debtor.[14] The court found that the blocking provision was void because it allowed the special member to consider only its own interests, in violation of Michigan law. “By excluding the Debtor’s interests from consideration” by the lender when acting as the special member of the debtor, the operating agreement “expressly eliminates the only redeeming factor that permits the blocking director/member construct.”[15] Thus, the court found, the provision was unenforceable both as a matter of Michigan corporate governance law and bankruptcy law.
In re Intervention Energy Holdings. In In re Intervention Energy Holdings, LLC,[16] the debtor was an oil and gas exploration and production company mainly doing business in North Dakota. The debtor, a Delaware limited liability company, entered into an agreement through which the lender agreed to loan up to $200 million. The debtor defaulted on the loan, and the parties entered into a forbearance agreement. In exchange for the lender waiving all defaults, the debtor agreed to give the lender one share in order to make the lender a common member of the limited liability company. The debtor also amended its operating agreement to require unanimous consent of all common members in order to file bankruptcy.
The debtor and certain affiliates ultimately sought chapter 11 protection with the consent of all members except the lender in the Bankruptcy Court for the District of Delaware. The lender filed a motion to dismiss, arguing that the debtor lacked authority to file bankruptcy because it had not consented to the filing. Noting that Delaware state law authorizes members of a limited liability company to eliminate fiduciary duties, the lender argued that a limited liability company that has done so may contract away its rights to file bankruptcy at will.[17] The lender also cited to cases in which courts have upheld consent provisions among members.[18] It warned that if the bankruptcy court declared the agreement void, it would cause confusion concerning the breadth of a limited liability company’s right to contract.[19]
Conversely, the debtor relied upon Lake Michigan Beach to argue that the blocking member could not abrogate its fiduciary duties and “must retain a duty to vote in the best interest of the potential debtor to comport with federal bankruptcy policy.”[20] The debtor also argued that if the provision were enforced, debtor/creditor relationships would dramatically change, and future lenders would demand similar provisions in future transactions.
Declining to address the parties’ state law arguments, the court decided the case on federal public-policy grounds. The court found that the amendment was an absolute waiver of the limited liability company’s right to file for bankruptcy, which was unenforceable as a matter of federal law. The court explained:
It has been said many times and many ways. “[P]repetition agreements purporting to interfere with a debtor’s rights under the Bankruptcy Code are not enforceable.” “If any terms in the Consent Agreement . . . exist that restrict the right of the debtor parties to file bankruptcy, such terms are not enforceable.” “[A]ny attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor’s future bankruptcy filing is generally unenforceable. The Bankruptcy Code pre-empts the private right to contract around its essential provisions.” “[I]t would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.” “It is a well settled principal that an advance agreement to waive the benefits conferred by the bankruptcy laws is wholly void as against public policy.”[21]
This rule is not new, the court noted while citing various cases that date back to the early 1900s.[22] Nevertheless, “[t]oday’s resourceful attorneys have continued th[e] tradition” of trying to contract around bankruptcy.[23]
The court acknowledged that other courts have upheld provisions in limited liability company agreements requiring unanimous consent or supermajority approval to file for bankruptcy. However, such cases were distinguishable because the Intervention Energy operating agreement was amended pursuant to a forbearance agreement with a lender, as opposed to included by the members when the limited liability company was organized. The court concluded by explaining:
The federal public policy to be guarded here is to assure access to the right of a person, including a business entity, to seek federal bankruptcy relief as authorized by the Constitution and enacted by Congress. It is beyond cavil that a state cannot deny to an individual such a right. I agree with those courts that hold the same applies to a “corporate” or business entity, in this case an LLC.
A provision in a limited liability company governing document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor—not equity holder—and which owes no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.[24]
In a footnote, the court distinguished the lender from the lender in Global Ship Systems (discussed in part one of this two-part article). The court noted that the creditor in Global Ship Systems had a 20-percent equity interest, whereas the creditor in Intervention Energy had only one share that was provided as part of a forbearance agreement.[25] The court also referenced, and expressly disagreed with, the conclusion of the DB Capital Holdings’ courtthat contractual waivers of the right to file a bankruptcy case may be enforceable absent coercion by a lender.
In re Lexington Hospitality Group, LLC. In In re Lexington Hospitality Group, LLC,[26] the debtor was a Kentucky limited liability company and owned and operated a hotel. The lender had provided the financing to purchase the hotel. Contemporaneously with the execution of the loan documents, an amended operating agreement was executed admitting 5332 Athens, an entity wholly owned by the lender, as a member of the debtor with a 30-percent membership interest. The amended operating agreement also included several provisions that limited the debtor’s ability to file bankruptcy and required a 75-percent vote of the members. The debtor defaulted on the loan and filed a bankruptcy petition. The lender filed a motion to dismiss the bankruptcy case, arguing that the debtor did not have the corporate authority to file the bankruptcy petition.
The court acknowledged that the authority to file for bankruptcy is governed by state law, but that the validity of the restriction on filing bankruptcy is controlled by federal law. Relying on the cases discussed above, the court held that a contract term imposed by a creditor that prohibits a bankruptcy filing is void as contrary to federal public policy. The same was true where, as here, the so-called independent director was really a nominee of the lender. The court determined:
A requirement that an independent person consent to bankruptcy relief, properly drafted, is not necessarily a concept that offends federal public policy. The appointment of an independent person to help decide the need for a bankruptcy filing may suggest fairness on all sides. The input of a truly independent decision maker avoids the fear and risk that a member of manager will act in its own self-interest. But [the operating agreement] shows that the Independent Manager is not a truly independent decision maker.[27]
The court found that the lender’s complete control over 5532 Athens gave it total control to block any bankruptcy filing. “Unlike a member or manager, [5532 Athens] has no restrictions and no fiduciary duties to [the debtor] that might limit self-interested decisions that ignore the best interests of the [debtor].”[28] In any event, the grant to the lender’s nominee of 30 percent of the equity in the debtor itself gave the lender the ability to block a bankruptcy filing. “Such provisions, alone or working in tandem, serve only one purpose: to frustrate [the debtor’s] ability to file bankruptcy.”[29] As a result, the court found, they were unenforceable. Consequently, the court denied the lender’s motion to dismiss the case.
In re Franchise Services of North America. In In re Franchise Services of North America,[30] the Fifth Circuit Court of Appeals became the first appellate court to weigh in on these issues, holding that federal law does not prevent a bona fide shareholder from exercising its right in the company’s governing documents to prevent the filing of a bankruptcy petition by the company merely because it is also a creditor. The court was careful to limit the scope of its holding to the facts before it, and avoided ruling broadly on the validity of “golden share” or blocking provisions.
An investment bank made an investment of $15 million in the debtor pre-petition. In exchange, the bank received 100 percent of the debtor’s preferred stock. At the same time, the debtor reincorporated in Delaware and amended its certificate of incorporation. As a prerequisite to filing a voluntary bankruptcy petition, the amended certificate required the consent of a majority of each class of the debtor’s common and preferred shareholders.
Following some ill-fated business decisions, the debtor filed for bankruptcy. Fearing that its shareholders might nix the filing, the debtor never put the matter to a vote. The preferred shareholder filed a motion to dismiss the bankruptcy petition as unauthorized. The debtor argued that the shareholder, who was also a sizable creditor, had no right to prevent the filing, relying on the aforementioned cases. The bankruptcy court sided with the shareholder and dismissed the petition.
Given the frequency with which this issue has arisen in chapter 11 cases in recent years, direct appeal to the Fifth Circuit was authorized. Three questions, which broadly asked the appellate court to address the legality of “blocking provisions” or “golden shares,” were certified. Instead of addressing the certified questions, which the Fifth Circuit found would have required it to give an advisory opinion, the court narrowed the issue to the specific facts before it: “when a debtor’s certificate of incorporation requires the consent of a majority of the holders of each class of stock, does the sole preferred shareholder lose its right to vote against (and therefore avert) a voluntary bankruptcy petition if it is also a creditor of the corporation?”[31]
The Fifth Circuit began its analysis by noting that state law determines who has the authority to file a voluntary bankruptcy petition for a company. Where, as here, the petitioners lack authorization under state law, the court noted, the bankruptcy court “has no alternative but to dismiss the petition.” Acknowledging that numerous bankruptcy courts have invalidated, on federal public-policy grounds, agreements whereby a lender extracts an amendment to the organization’s governing documents granting the lender a right to veto a bankruptcy filing, the court held that simply being a creditor does not prevent a bona fide equity holder from exercising its right under a charter to block a bankruptcy filing. Under the facts of the case before it, the court found that the shareholder was a bona fide equity holder. There was no evidence to show that the shareholder’s equity interest was “merely a ruse” to ensure that it would be paid on its claims against the debtor.[33]
Finally, the court rejected the debtor’s argument that the shareholder’s fiduciary obligations as a controlling shareholder prevented it from blocking the debtor from filing for bankruptcy. The court found that the record did not establish that the shareholder was, in fact, a controlling shareholder exercising actual control over the debtor, such that it would owe fiduciary duties under Delaware law. Even if the shareholder were a controlling shareholder, the court concluded, “[t]he proper remedy for a breach of fiduciary duty claim is not to allow a corporation to disregard its charter and declare bankruptcy without shareholder consent.”[34] Rather, the debtor’s remedy was under state law. Accordingly, dismissal of the debtor’s bankruptcy case was affirmed.
Conclusion
All of the cases discussed herein and in part one of this article begin with the general premise that waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy. Although the law in this area remains in the early stages of development, the cases suggest that a blocking provision contained in a limited liability company operating agreement in favor of a lender (as opposed to a bona fide shareholder) will likewise be deemed invalid. This is particularly true if: (1) the provision was added at the lender’s behest and during a period of financial distress, (2) the provision eliminates any fiduciary duties to the debtor, (3) the “golden share” was acquired for little or no consideration, and/or (4) the “golden share” is a de minimis percentage of the equity of the debtor.
Regarding the fiduciary duty part of the analysis, applicable state law may also be influential because some states (including Delaware) expressly permit members and managers of limited liability companies to eliminate fiduciary duties in their operating agreement.[35] If a debtor is permitted to, and in fact does, expressly eliminate fiduciary duties, then it is harder to argue that a blocking provision in favor of a lender is contrary to public policy. Conversely, no such authorization exists in many states, including Michigan, the law of which governed in Lake Michigan Beach. Thus, lenders seeking to render their borrowers bankruptcy-remote should ensure that the borrowers are formed as a Delaware limited liability company (or another state that permits waiver) and should eliminate fiduciary duties.[36]
[2] The Bankruptcy Code is set forth in 11 U.S.C. § 101 et seq. Specific sections of the Bankruptcy Code are identified as “section __.” Similarly, specific sections of the Federal Rules of Bankruptcy Procedure are identified as “Bankruptcy Rule __.”
[3]In re Bay Club Partners-472 LLC, 2014 WL 1796688 (Bankr. D. Ore. May 6, 2014).
[6]Id. at *4 (citing In re Cole, 226 B.R. at 651–54; In re Huang, 275 F.3d at 1177; In re Thorpe Insulation Co., 671 F.3d at 1026; Wank v. Gordon (In re Wank), 505 B.R. 878, 887–88 (9th Cir. BAP 2014)).
[9]In re Lake Mich. Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).
[10]Id. at 912 (citing Klingman v. Levinson, 831 F.2d at 1296; In re Shady Grove Tech Ctr. Ltd. P’ship, 216 B.R. 386, 390 (Bankr. D. Md. 1998)).
[11]Id. (citing In re Trans World Airlines, Inc., 261 B.R. at 114 (“Bankruptcy courts are loathe to enforce any waiver of rights granted under the Bankruptcy Code because such a waiver ‘violates public policy in that it purports to bind the debtor-in-possession to a course of action without regard to the impact on the bankruptcy estate, other parties with a legitimate interest in the process or the debtor-in-possession’s fiduciary duty to the estate.’”)).
[12]Id. at 912–13 (citing In re Gen Growth Props., 409 B.R. at 64; In re Kingston Square Assocs., 214 B.R. 713, 736 (Bankr. S.D.N.Y. 1997); In re Spanish Cay Co. Ltd., 161 B.R. 715, 723 (Bankr. S.D. Fla. 1993)).
[14]Id. at 914 (citing MCL § 450.4404(1) which requires a “manager” to discharge managerial duties “in good faith . . . and in a manner the manager reasonably believes to be in the best interest of the limited liability company.”).
[22]Id. (citing In re Weitzen, 3 F.Supp. at 698–99; Nat’l Bank of Newport v. Nat’l Herkimer Cnty. Bank, 225 U.S. 178, 184 (1912)).
[23]Id. (citing NHL v. Moyes, 2015 WL 7008213 at *8 (D. Ariz. Nov. 12, 2015) (“If a contractual term denying the debtor parties the right to file bankruptcy is unenforceable, then a contractual term prohibiting the non-debtor party that controls the debtors from causing the debtors to file bankruptcy is equally unenforceable. Parties cannot accomplish through ‘circuity of arrangement’ that which would otherwise violate the Bankruptcy Code.”).
[36] Perhaps the most surefire way to preclude a borrower from filing bankruptcy is to require that the members of the borrower personally guarantee the borrower’s indebtedness upon a default or bankruptcy filing by the borrower, through a so-called bad boy guarantee. Such guarantees are usually enforced and, for obvious reasons, dramatically decrease the likelihood that a borrower’s members and managers will elect bankruptcy as a remedy. See, e.g., F.D.I.C. v. Prince George Corp., 58 F.3d 1041, 1046 (4th Cir. 1995).
Innovation in internet and related communication technology has spawned new ways for firms to tap into the marketplace. Business models built on digital platforms can generate significant income from remote markets through network connections without a significant physical presence in the form of facilities or personnel. The sharing economy, cloud computing, streaming services, electronic marketplaces, advertising, and software services provide examples of activities that can target remote markets from operational bases that could be anywhere. Moreover, these activities are now common components in many business models.
The permanent establishment (PE) concept, which is based on physical presence within the taxing jurisdiction, is no longer considered an effective tool for allocating taxing authority by some countries. As the value chain for providing goods and services continues to expand across jurisdictional boundaries, governments have struggled to address their ability to capture taxes on an appropriate share of economic income from firms tapping their markets without a PE within their borders.
Legal techniques designed to shift income from high-tax to low-tax jurisdictions have also presented tax administration challenges. Anti-avoidance rules designed to prevent shifting profits through contracts and legal relationships have long been part of the international tax regime. Transfer pricing rules based on arm’s-length principles have emerged as effective tools to address income allocation for transactions involving traditional goods and services. However, as technological change has shifted more value into intangibles and information, some claim those rules have been strained to appropriately measure and assess value creation and the locus of economic benefits.
Government Responses: Sovereignty Versus Coordination
The Organization for Economic Cooperation and Development (OECD) has become the leading international organization devoting efforts toward study and policy development for a coordinated response to the changing tax environment. Although sovereign states maintain their own power to impose taxes, coordinated approaches offer advantages, including more efficient compliance and the avoidance of double-taxing or double-nontaxing income.
Beginning with a 2013 report on base erosion and profit shifting (BEPS), the OECD identified the jurisdiction to tax digital goods and services as one part of a multipronged action plan to address the changing tax environment. However, the complexities of the digital landscape and differences in policy commitments among state participants have contributed to disagreements based on sovereign interests of member states. For example, if rules change to allow market states to tax more of the income generated by the digital economy, states that previously taxed that income—including those where intellectual property, capital, and management skills are located—stand to lose portions of their current tax base.
The OECD continues to work on a coordinated solution, targeting early 2020 as the date for achieving high-level political agreement. In the meantime, sovereign governments are working independently on solutions that will address their own desires for revenue. The EU launched a coordinated digital tax proposal of its own in 2015, which targeted large businesses utilizing digital platforms. However, EU countries have also failed to reach an agreement on a coordinated approach for member nations. Some EU countries (and in some cases, states within those countries) have resolved to forge ahead with digital tax proposals of their own, including the United Kingdom, Spain, France, and Italy. Outside the EU, other countries are modifying their tax laws to address their conception of the value proposition inherent in the digital environment, including the role of their consumers in generating income. Tax claims based on providing support for markets, rather than support for firms based on physical presence, are expanding.
So far, these country-specific approaches have taken four primary forms: (1) changing the PE threshold; (2) withholding taxes involving payments for digital goods and services; (3) so-called turnover taxes on gross receipts from firms offering digital goods and services; and (4) specific taxes targeting large multinational enterprises with digital activities.
The OECD will be taking these approaches into account in its quest to find a coordinated approach, with a targeted completion date scheduled for mid-2020. OECD leadership has professed a goal of developing a neutral system that does not significantly change the current allocation of taxes, but one wonders how that goal can be reconciled to the desire of sovereign states to assert their independent interests.
Implications for Business Advisors
Modifying the PE concept will likely have the most far-reaching effects on (even small) firms conducting business abroad. If the PE concept is modified to permit a significant digital or online presence, income tax possibilities become magnified. India, the Slovak Republic, and Israel have all started down this path. Still unresolved is the manner of solving competing claims for allocating income among different states.
Most firms engaged in cross-border businesses have experience with withholding taxes; however, if the withholding tax base is potentially expanded beyond traditional categories of interest, dividends, and royalties to include certain kinds of digital and technical services, there will not only be new compliance challenges, but also changes to the economics of delivering those services. Although business customers in a market state may bear some of the compliance burdens, firms dealing directly with consumers may face special compliance challenges as rules emerge to shift the locus of collection and payment responsibilities.
When tax obligations are based on reaching minimum thresholds (such as gross receipts or the number of transactions within a jurisdiction), business planners and tax policymakers must both carefully think through the significance of legal structures for delivering products and services to foreign markets. Can the tax be mitigated by changing the locus for providing goods or services? Does that structural change make good business sense? How will those tax implications affect pricing policies?
Concerns about double taxation in this regime are well-founded, particularly when states use different approaches. These tax changes are likely to enhance the possibilities of conflict with taxing authorities of multiple states. Such problems are akin to those experienced on a subnational level in the United States, where U.S. states adopt different income allocation approaches. Bilateral tax treaties and the foreign tax credit regime both are designed to address the double-taxation concern. Treaty protections will require new scrutiny, and some of these taxes will also present U.S. taxpayers with challenges in obtaining a foreign tax credit to offset taxes imposed elsewhere. A creditable tax must have a predominant character as an income tax in the United States; gross receipts taxes may not be able to satisfy these requirements.
Finally, IT departments must become more involved with their counterparts in the tax department. These new tax regimes will require information that current accounting and information systems may not be designed to produce. Geolocation technologies may prove increasingly important in determining how and where digital goods and services are delivered. Moreover, the collection and retention of this information for tax compliance will also implicate cross-border responsibilities involving privacy and security, which present their own legal and economic challenges.
In short, business lawyers must pay attention to developments in this area if they are to effectively identify and manage the risks that accompany participation in international markets.
The energy industry is exploring a variety of technological innovations that will make energy cheaper, greener, and more reliable.* For instance, distributed energy resources, microgrids, and battery storage have the potential to fundamentally reshape energy markets. Blockchain is another such innovation that has garnered attention from utilities, energy electricity suppliers, prosumers, FinTechs, and other industry participants. Some of the buzz relates to blockchain’s potential to enable high-volume, peer-to-peer electricity transactions across the distribution grid. Industry participants also recognize blockchain’s advantages within traditional energy market structures, such as the potential efficiency gains from improving data traceability, integrity, and security and automating functions.
Advising clients on the costs and benefits of implementing blockchain solutions and their attendant regulatory challenges requires a basic understanding of the technology. To that end, this article provides a high-level overview of blockchain’s core technical components: cryptography, decentralization and consensus protocols, and distributed ledger.[1]
Baseline Concepts
Three baseline concepts will be helpful to keep in mind. First, blockchain is digital ledger technology. One definition of blockchain is distributed computing architecture through which every network node (or computer) executes and records the same transactions, and new transactions are grouped into blocks that reference prior blocks of transactions. In other words, blockchain is a computing code that groups information into blocks and records the information onto a digitized record in near real time that is accessible by multiple parties.
Second, there is no singular blockchain or application. Rather, blockchains can be developed for a variety of purposes and customized to record various data.
Third, blockchain and cryptocurrencies are not synonymous. Cryptocurrencies are a type of encrypted digital token that are used for payments.[2] Although transactions involving cryptocurrencies are recorded on a blockchain, a blockchain does not necessarily need a cryptocurrency to serve a useful function.
Cryptography: Public and Private Keys
Public key cryptography is a fundamental component of every blockchain. Every user of a particular blockchain has a “private key,” meaning a unique digital signature, and a “public key,” or a digital account identification number. These keys are a unique pair generated by an algorithm. As their names indicate, the public key is publicly disclosed (like a street address) but the private key is not (like a house key). Users verify the transactions they want to initiate over a blockchain by “signing” their transactions with their private key (meaning they combine their private and public keys, but the private key itself is not disclosed). A transaction is valid only if the private key that signs the transaction matches that user’s public key. Once a transaction is signed, the transaction will be broadcast to the blockchain’s decentralized network of nodes, or computer systems, to be verified via the network’s consensus protocol.
Decentralization (Peer-to-Peer) and Consensus Protocols
Blockchains generally are referred to as “decentralized,” or peer-to-peer, because no central entity acts as a trusted intermediary through which information flows and who is responsible for verifying transactions. Rather, a network of unassociated computers confirm transactions according to an agreed-upon verification standard.[3] Given that verification relies on a preset protocol, none of the people who operate a computer in the network need to trust or even know each other; they simply must trust the blockchain consensus mechanism. Once a transaction is initiated, the transaction is broadcast to the network and bundled into “blocks” with other transactions broadcast around the same time. Once a block is full, the block is converted into a unique set of letters known as a hash. Picture a piece of lined paper; each individual transaction takes up one line. Once all the lines are full, the piece of paper is deemed a unique unit, and that unit is given a short name.
One computer that is part of the network will be chosen randomly to apply the rules of the network’s preset verification standard, known as a consensus protocol, to determine whether each transaction has the correct combination of private and public keys. That computer will then relay its work to the network for verification. If the network agrees on which transactions contain appropriately matched key pairings, the blocks containing those transactions are approved. Upon approval, those blocks will be recorded on the blockchain, making them a part of the transaction history of that blockchain. Blockchains are referred to as immutable because all new information must be consistent with all previously confirmed information, which makes manipulating the record by changing past data points a laborious, expensive, and nearly impossible (under most circumstances) proposition.[4]
Entities that operate computers in the network are compensated for their work with either transaction fees paid by the entities initiating the transaction, or by receiving a unit of a digital asset generated by the underlying blockchain’s algorithm. The process of confirming transactions has a different name based on the nature of the consensus protocol. For instance, nodes on the Bitcoin blockchain are called “miners” because they receive newly released Bitcoins in exchange for confirming transactions. The consensus protocol used is called “Proof-of-Work” because each computer must conduct difficult computations to verify blocks. Although there are varieties of consensus protocols and reward structures, the key point is that many computers operated by people who do not need to know or trust each other are able to verify transactions among two or more parties by checking transactions against a preset verification standard.
Distributed Ledger
Finally, blockchains are distributed ledgers. Every computer that is part of a blockchain’s network has access to the entire record of that blockchain.[5] Thus, the blockchain is distributed rather than controlled by a select recordkeeper or group of recordkeepers. Not every computer must have the same level of access to the data, however. For example, settings can be put in place so that certain industry participants, such as purchasers and sellers of electricity, could add information by initiating transactions, whereas others, such as regulators, could review only the information that has already been verified. Given that the same data is shared with multiple unrelated entities, it is difficult for any single entity or group of entities to alter the data without the other participants noticing. By combining these features, blockchains create a shared, immutable record of transactions that is updated and maintained without reliance on any particular third party.
Other Important Concepts: Public Versus Permissioned Blockchains, and Smart Contracts
Two other important concepts to keep in mind are the distinction between public and permissioned blockchains, and smart contracts. Blockchains are decentralized and distributed, but they do not necessarily need to be public records. A public blockchain is a blockchain that allows anyone to join the network and to access its data. The Bitcoin blockchain is the most famous example of a public blockchain. Anyone can download the blockchain and, by doing so, access the full history of its data and help confirm transactions.
On the other hand, many other blockchains, particularly enterprise blockchains, are permissioned. Only entities that are granted access to a permissioned blockchain can access its data and confirm transactions. Permissions can be customized to restrict what data a user can access or whether that user can add data. Data privacy is also handled differently between these types of blockchains. In public blockchains, the parties’ identities are anonymous or pseudonymous, but the details of a transaction are often public. Permissioned blockchains generally adopt the opposite privacy features, with known parties transacting on a private ledger.
Smart contracts are programmable computer code that modify information on a blockchain automatically once specific conditions are met. In essence, they are if-then statements that can be programmed to update a blockchain based on events. For instance, two parties could write a smart contract that would transfer automatically a certain sum of money from one party to another on a certain day or once a claim is settled, and that information would be recorded to the blockchain. Smart contracts can be written with technical code or natural language, depending on their purpose and the underlying blockchain system.
Conclusion
The energy industry has been and will continue to explore various use cases for blockchain, experimenting with different parameters and consensus protocols to capture efficiency gains and adapt to the shifting marketplace. Understanding the fundamentals of the technology will enable lawyers to counsel to clients effectively as they consider whether to integrate blockchain into their day-to-day operations.
* Daniel Cohen is an associate with K&L Gates, LLP, in Washington, D.C. His practice focuses on regulatory compliance counseling and government affairs representation for blockchain-based platforms, payment companies, and financial institutions. He thanks Buck Endemann and Ben Tejblum for their comments and insight.
[1] For an in-depth discussion of blockchain’s technical aspects and its existing and potential use cases, see Buck Endemann, Ben Tejblum, Daniel S. Cohen, et al., Energizing the Future with Blockchain, 39 Energy L. J. 197 (2018). This article will not delve into more advance concepts, such as hashing, or the various types of consensus protocols, among others.
[2] They are also referred to as virtual currencies. Encrypted digital tokens can serve other functions; for instance, they can represent a security, commodity, or act as a prepaid instrument such as a gift certificate. In the energy industry, some companies have created digital tokens to represent available electricity for sale. Regardless of their function, the digital tokens are recorded onto a blockchain.
[3] However, in practice, individuals and companies often join together, forming “pools” in order to share the rewards for confirming transactions. Fundamentally, blockchains are not operated by a centrally controlled entity, unlike bank accounts, for instance.
[4] A public blockchain known as Ethereum Classic was hacked in January 2019 by an attack from entities that controlled a majority of the computing power of the network. Ethereum Classic used the proof-of-work protocol, which requires significant computing power to confirm transactions. To date, significantly larger networks that use proof-of-work, such as Bitcoin, and large blockchains that use other consensus protocols have not been hacked directly.
[5] For some blockchains, nodes have access to only a select portion of the transaction history in order to reduce the amount of data processing required. This feature of a blockchain can be customized to meet the users’ needs.
When one thinks about the dynamics of a trust created by agreement (at its most basic level) and the normal progression of its creation and administration, there typically are several parties that are thought to be integral to the entire structure. Most notably, these are the grantor (or settlor), the trustee, and the beneficiaries. Once the trust is created and funded by the grantor, the trustee is charged with managing the assets of the trust in accordance with the express provisions of the trust agreement for the benefit of the beneficiaries. If the trustee mismanages the trust assets or takes some action that is not in the interests of the beneficiaries, those beneficiaries (or someone acting on their behalves) may bring an action against the trustee to enforce the terms of the trust and seek a remedy. Under this traditional trust framework, a trust without a beneficiary would not be enforceable. As a consequence, courts historically refused to permit such arrangements unless the trustee was willing to carry out the purpose of the trust, thus honoring a trust-like relationship that otherwise would have failed as a traditional trust (this trust-like relationship commonly is referred to as an “honorary trust”).[2]
Given that honorary trusts do not have an identifiable beneficiary, they exist merely to further the purpose for which they were created. Accordingly, honorary trusts are closely related to a traditional charitable purpose trust, which generally is a trust created for the support of religious, educational, scientific, artistic, and similar endeavors. Charitable purpose trusts can be formed for a general charitable purpose or to support a specific beneficiary, which beneficiary could at times be subject to change so long as the charitable purpose of such trust is left intact.[3] Traditionally, the honorary trust and the charitable purpose trust were the only two avenues by which a grantor could advance a cause other than the support of an identifiable beneficiary.
Although the honorary trust doctrine was occasionally applied in England[4] and eventually in the United States,[5] honorary trusts were far less common historically than charitable purpose trusts. Typically, an honorary trust was created for the care of burial plots, the care and maintenance of animals, and the saying of masses.[6] Slowly, as honorary trusts for the pursuit of certain noncharitable purposes became more routine, various jurisdictions around the country, including Delaware, began to pass statutes to specifically allow for their creation as noncharitable purpose trusts.[7] However, it was not until the release by the Uniform Law Commission of the Uniform Trust Code (UTC) in 2000 (and its subsequent adoption in one form or another by 35 states) that a wider array of noncharitable purpose trusts became permissible as a matter of statutory law.
II. The Delaware Purpose Trust Statute
The two fundamental guideposts in Delaware’s law governing the creation and administration of common law trusts (Delaware Trust Law)[8] is that maximum deference will be afforded to the intent of the settlor, and that the settlor has contractual freedom to reflect this intent in the governing documents of the trust. Section 3303(a) of Title 12 of the Delaware Code provides that “[i]t is the policy of this section to give maximum effect to the principle of freedom of disposition and to the enforceability of governing instruments.” Similarly, that section also provides that “a governing instrument may expand, restrict, eliminate, or otherwise vary any laws of general application to fiduciaries, trusts, and trust administration.”
Governed by these two concepts, Delaware has a long history of providing settlors with the tools necessary to create the trusts that suit their needs. To this end, Delaware has adopted a robust noncharitable purpose trust statute. Delaware’s statute, 12 Del. C. § 3556 (the Delaware Purpose Trust Statute), gives greater freedom for settlors to customize their noncharitable purpose trusts. Unlike the more restrictive provisions of the UTC adopted by many states, the Delaware Purpose Trust Statute does not contain a limitation on the duration of noncharitable purpose trusts, and provides that such trusts are valid so long as they contain a declared purpose that is “not impossible of attainment.” By contrast, the noncharitable purpose trust provisions under section 409 of the UTC provide that such trusts are valid only for a period of 21 years. Furthermore, the official comment to section 404 of the UTC, discussing permissible purposes for all types of trusts, provides that a noncharitable purpose trust must have a purpose that is not frivolous or capricious. The Restatement (Third) of Trusts, referenced in the official comment to section 404 of the UTC, implies that a trust may be considered capricious if it does not satisfy “a desire that many (even if not most) people have with respect to the disposition of their property[,]” or if an “unreasonably large” amount of the property is devoted to the trust’ purpose.[9] According to this language, for example, a perfectly reasonable purpose could be invalidated simply for being over funded, or a reasonably funded trust could be invalidated because a purpose important to the settlor could be deemed frivolous by others.
However, given that the focus of Delaware Trust Law is on the subjective intent of the individual settlor with regard to the disposal of his or her property—not the objective standards of “many (even if not most) people”—the Delaware legislature saw these restrictions in the UTC as unnecessarily limiting. The intent behind the Delaware Purpose Trust Statute was to put all purpose trusts, charitable and noncharitable, on equal footing. Settlors of charitable purpose trusts have long enjoyed deference to their stated purposes and unrestricted timeframes in which to apply the assets of their trusts, and the Delaware Purpose Trust Statute affords settlors of noncharitable purpose trusts with these same benefits. An individual has an infinite number of creative ways to dispose of or apply his or her individually owned property, whether for charitable purposes or otherwise, and a settlor’s right to do so is a basic premise of Delaware Trust Law.
In addition, fiduciary responsibilities may be altered under Delaware Trust Law (and in some cases eliminated)[10] if necessary to promote the declared purpose in the trust agreement. The opportunity to divide roles and responsibilities among trustees provides flexibility to allow the trustees to handle the trust assets and carry out the stated purpose of the trust as intended by the settlor. This facet of trust administration, along with many others, can be uniquely tailored to fit the requirements of each situation.
The flexibility of the Delaware Purpose Trust Statute, coupled with the foundation of freedom of contract underlying Delaware Trust Law, provides a powerful platform for settlors to create trusts that may successfully carry out their unique, noncharitable purposes.
III. Facebook Is Utilizing Delaware Law to Support Its Unique Goals
Facebook, Inc. (Facebook), from its inception on the campus of Harvard and throughout its growth into a social media leader, has consistently striven to uphold the values of free speech and freedom of expression. However, Facebook also understands that “there are times when speech can be at odds with authenticity, safety, privacy and dignity.”[11] Realizing the need to balance the rights of all of its users, including users of Instagram, and in an effort to address these competing concerns head on, Facebook is using the Delaware Purpose Trust Statute (in conjunction with the Delaware Limited Liability Company Act (the Delaware LLC Act[12]) to create and operate a social media content review “Oversight Board.” Generally, it is Facebook’s intent that members of the Oversight Board will review appeals regarding user content decisions by Facebook. The decisions of the Oversight Board with respect to such appeals will be binding on Facebook and its users. In addition to conducting this content review, the Oversight Board will also issue policy advisory opinions regarding Facebook’s policies governing content on Facebook and Instagram.[13]
Although Facebook could easily create and operate the Oversight Board within its existing corporate framework, this approach likely would not provide the level of independence necessary to balance the interests of each party involved in a content dispute, including Facebook itself. As a result, Facebook sought an alternative approach that would allow the company to create a truly independent body to “ensure fair decision-making based on standards and values.”[14] Enter the Delaware Purpose Trust Statute.
Specifically, utilizing the Delaware Purpose Trust Statute, Facebook has created and funded a trust, known as the Oversight Board Trust (the Trust), with the following stated purpose:
to facilitate the creation, funding, management, and oversight of a structure that will permit and protect the operation of an Oversight Board for Content Decisions (the “Oversight Board” or “Board”), whose purpose is to protect free expression by making principled, independent decisions about important pieces of content and by issuing policy advisory opinions on Facebook’s content policies.[15]
Facebook’s intent is to create a lasting benefit for those in the worldwide community who engage with one another through Facebook’s platforms. Although there is a broad range of individuals and entities that will be impacted by and benefit from the stated purpose of the Trust, it would be impossible to consider all Facebook users as beneficiaries of the Trust, and a traditional trust structure would therefore not be appropriate. Although Facebook’s overarching goal is to improve social interaction for the collective good of all its users, providing independent review of appealed content for an entity such as Facebook would not be labeled as a traditional “charitable” purpose (i.e., a religious, educational, scientific, artistic, or similar purpose). As a result, a noncharitable purpose trust under the Delaware Purpose Trust Statute is the perfect tool to realize Facebook’s vision.
Before delving more deeply into the details of the creation and operation of the Oversight Board and the Trust, it is important to examine the basic overall structure employed by Facebook. The Trust is a Delaware purpose trust created and funded by Facebook pursuant to the Delaware Purpose Trust Statute, and the Trust will serve as the main source of funds needed to facilitate the operations of the Oversight Board. The Trust is irrevocable and is treated as a grantor trust for federal income tax purposes. Pursuant to the Delaware LLC Act, the trustees of the Trust (the Trustees) have formed and, collectively, on behalf of the Trust, will be the member of a single-member Delaware limited liability company (the LLC) that will be managed by a corporate manager (the Corporate Manager) and one or more individual managers (the Individual Managers, and together with the Corporate Manager, the Managers).
The LLC will enter into a service agreement to provide the above-discussed content review services to Facebook. These services ultimately will be performed by the Oversight Board pursuant to contracts between the LLC and the members of the Oversight Board. The Oversight Board will consist of a diverse set of members with a broad range of knowledge, competencies, diversity, and expertise.[16] In addition, the members of the Oversight Board must not have any actual or perceived conflicts of interest (such as being affiliated with Facebook or any of the Trustees) and should be familiar with “matters relating to digital content and governance, including free expression, civic discourse, safety, privacy and technology.”[17]
With respect to the funding and operation of the LLC, and ultimately the Oversight Board, the Individual Managers will serve as distribution direction advisers of the Trust pursuant to 12 Del C. § 3313 (and Facebook will additionally serve as an adviser pursuant to section 3313 by exercising consent rights in connection with certain actions of the Trustees, including regarding the investment of the Trust’s assets). The Individual Managers are also involved with the retention of the members of the Oversight Board and the facilitation of the Oversight Board’s content review process. As described in greater detail below, the Individual Managers will directly monitor and, when appropriate, replace the Oversight Board members, helping to ensure separation between Facebook and the Oversight Board and promote the independence of the Oversight Board’s decisions.
Currently, the Trustees are composed of a corporate Trustee (the Corporate Trustee) and one initial individual Trustee (the Individual Trustee). Facebook has the ability to appoint additional Individual Trustees, and once there are at least three serving, the number of Individual Trustees shall always be at least three and no more than 11. The Corporate Trustee may serve indefinitely, and each Individual Trustee will generally serve for a five-year term that will automatically be extended for an additional five years if such Trustee does not resign or is not removed. There is no limit to the number of terms an Individual Trustee may serve. The Individual Trustees have the ability to remove the Corporate Trustee by super-majority vote (greater than 66 percent), and the Corporate Trustee has the authority to remove any one or more of the Individual Trustees, provided that the other Individual Trustees consent to such removal by majority vote.
Although the Trustees generally have full authority to administer the Trust and carry out its stated purpose, as mentioned above, the Trust also takes advantage of section 3313 of the Delaware Trust Law, which permits the use of direction and consent advisors in connection with the administration of a Delaware trust.[18] For example, the Corporate Trustee has the responsibility under the Trust to invest the Trust’s assets in a manner that best facilitates the purpose of the Trust, but does so jointly with an investment committee (the Investment Committee) established under the Trust. The Investment Committee is composed of at least three Individual Trustees who are appointed by a majority vote of all of the Individual Trustees. In addition, distributions from the Trust shall be made only upon the direction of certain Managers of the LLC. Distributions that are necessary for the general administration of the LLC (such as to cover insurance premiums, attorney’s fees, accountant’s fees, investment counsel fees, tax payments, service provider fees, etc.) shall be made by the Corporate Trustee as directed by the Corporate Manager of the LLC. Distributions needed to cover expenses directly related to the operations of the Oversight Board, including compensation of Oversight Board members, reimbursement of Oversight Board member expenses, employment of staff to support the Oversight Board, and rent and other office-related expenses, shall be made by the Corporate Trustee as directed by the Individual Managers of the LLC.
In an effort to provide further clarity as to the roles and responsibilities that are allocated among the Trustees, the Trust incorporates the concept of an excluded trustee as permitted under 12 Del. C. § 3313A. Where the settlor of a trust wants to grant certain powers exclusively to only one of multiple co-trustees, the associated fiduciary responsibility rests solely on the trustee who has been exclusively granted the power in question. The nonauthorized excluded trustees are not liable for any loss or other claim stemming from the exercise of such power. Under the terms of the Trust, the Corporate Trustee shall also act as Individual Trustee for a limited period of four months from the effective date of the Trust. However, following the expiration of the four-month period, the Corporate Trustee will be an excluded trustee under 12 Del. C. § 3313A(a)(2) with respect to all matters requiring the action of the Individual Trustees, Investment Committee, Facebook as settlor, or other fiduciaries.
This division of investment and distribution powers among various advisors and fiduciaries is common in modern Delaware trusts for the benefit of individual beneficiaries. However, the unique approach described above utilizes the Managers of the LLC (who are tasked with the role of furthering the purpose of the Trust and are in the best position to determine the capital needs to fund such purpose on a daily basis) to direct contributions from the Trust in a manner similar to a capital call. In order to ensure the availability of assets for continued operations of the LLC, Facebook has included an initial conservative investment mandate regarding the Trust assets. The investments may be changed by the Corporate Trustee and Investment Committee provided that Facebook gives consent. Although a prudent investor rule normally applies to investment decisions by trustees, which may prompt a less conservative approach under other circumstances, this standard is waived under the Trust.[19] The ability to craft these unique provisions derives, in part, from the freedom of contract principle that is integral to both Delaware Trust Law and the Delaware LLC Act.[20]
As mentioned, the LLC (formally known as Oversight Board LLC) is managed by one Corporate Manager and one or more Individual Managers. Each Individual Trustee shall serve as an Individual Manager of the LLC. The Corporate Manager may be the Corporate Trustee but also may be another individual or corporate entity as selected by the Corporate Trustee. In addition, the Corporate Manager may appoint a “Director of LLC Administration” to assist in carrying out its duties. Other positions may be created and filled by the Managers to effectuate the purpose of the LLC as the Managers deem fit.
The Corporate Manager and the Director of LLC Administration shall undertake the following tasks:
Management of Finances. The Corporate Manager shall manage all finances of the LLC.
Payment of Service Providers. The Corporate Manager, or the Director of LLC Administration if one is appointed, may engage the services of accountants, payroll providers, investment counsel, travel service providers, insurance providers, and other professional advisors as necessary to facilitate the ongoing operations of the LLC. Each Manager is also authorized to hire agents, advisors, attorneys, or other counsel to assist the Manager in carrying out the business of the Company or the duties of the Manager, and such costs shall be paid by the LLC as directed by the Corporate Manager.
As discussed above, the main responsibility of the LLC is to support the Oversight Board in furtherance of the purpose of the Trust. The “Director of the Oversight Board” is appointed by the Individual Managers and may be removed, with or without cause, by majority vote of the Individual Managers. This is a required position and must be filled at all times. The Director of the Oversight Board shall have authority to take action on behalf of the Individual Managers as such authority is delegated from the Individual Managers. With respect to the operations of the Oversight Board, the Individual Managers and the Director of the Oversight Board shall undertake the following tasks:
Enter into Oversight Board Member Contracts. After the selection of the individual Oversight Board members, the Director of Oversight Board may enter into a contract with each such individual to provide services as an Oversight Board member according to terms that are suggested by the Individual Managers and the Oversight Board. However, the ultimate contract provisions must be approved by the Director of Oversight Board (subject to the consent of Facebook solely with respect to provisions dealing with Facebook data). These Oversight Board member contracts shall be for a three-year term, with two potential renewals for a maximum term of nine years.
Enter into Service Agreements with Facebook. The Individual Managers may authorize the LLC to enter into agreements with Facebook to provide content review and moderation services, which shall be negotiated and executed by the Director of Oversight Board based on recommendations from the Individual Managers and the Oversight Board.
Annually Certify Oversight Board Member Activities. The Individual Managers shall annually certify to the Corporate Manager that each Oversight Board member has satisfactorily performed the obligations under his or her contract, or proceed with removal if warranted.
Remove Oversight Board Members. The Individual Managers, with the consent of the Individual Trustees, may terminate any contract of an Oversight Board member, or decide not to retain such member, if it is determined that he or she has not satisfactorily performed his or her obligations.
Direct Compensation and Other Payments for Oversight Board Members. As discussed previously, the Individual Managers may direct the Corporate Trustee to make contributions to the LLC for the purpose of compensating the Oversight Board members or reimbursing Oversight Board members for expenses under the terms of their contracts.
Provide for Miscellaneous LLC and Oversight Board Member Expenses. The Individual Managers and the Director of Oversight Board have the authority to direct the Corporate Manager to pay on behalf of the LLC other miscellaneous LLC and Oversight Board member expenses not otherwise covered under a service contract.
Employ Staff. The Director of Oversight Board may employ staff to provide general support to the Oversight Board. The Individual Managers shall direct the Corporate Manager to make payments on behalf of the LLC to cover the costs associated with such employees.
Provide for an Office and Office Expenses. The Director of Oversight Board may secure reasonable office space and acquire office supplies and equipment to facilitate the ongoing operations of the LLC and the Oversight Board. The Individual Managers shall direct the Corporate Manager to make payments on behalf of the LLC to cover rent and other office-related expenses.
Provide for Research or Related Services. The Director of Oversight Board may engage research and other related services to support the functions of the Oversight Board. The Individual Managers shall direct the Corporate Manager to make payments on behalf of the LLC to cover the costs of such services.
In an effort to create and fund an independent body to weigh the sometimes competing interests inherent in public discourse, Facebook has capitalized on Delaware’s policy of freedom of contract to craft the creative structure described above. The flexibility of Delaware Trust Law and the Delaware LLC Act has allowed Facebook to carry out its purpose to provide additional transparency and clarity to its users with respect to content decisions and policies.
[1] Vincent C. Thomas is a partner, and Justin P. Duda and Travis G. Maurer are associates, with the law firm of Young Conaway Stargatt & Taylor, LLP, in Wilmington, Delaware. The authors are grateful for the insights of Glenn G. Fox, Esq. and Rodney W. Read, Esq., both of the law firm of Baker & McKenzie LLP, as well as Elizabeth King, Aileen C. Denne-Bolton, and Edward Devine of Brown Brothers Harriman & Co.
[2] George G. Bogert et al., The Law of Trusts and Trustees § 166 (3d ed. Supp. 2019).
[3] A change of charitable beneficiary is accomplished through the doctrine of cy pres. For a further discussion of court modification of charitable beneficiaries under the doctrine of cy pres to achieve the settlor’s intent, see Restatement (Third) of Trusts § 67 cmt. e (Am. Law Inst. 2003).
[4] Bogert et al., supra note 2, § 166 (citing In re Dean, 1889, 41 Ch. D. 552 (care of animals); Mussett v. Bingle, W.N. (1876) 170 (building of monuments); Reichenbach v. Quinn, 21 L.R.Ir. 138 (for the saying of religious masses); In re Thompson, (1934) 1 Ch. 342 (to support fox hunting)).
[5]In re Searight’s Estate, 95 N.E.2d 779, 782 (Ohio Ct. App. 1950).
[6] Restatement (First) of Trusts § 124 (Am. Law Inst. 1935).
[7] For example, some states to adopt statutes allowing noncharitable purpose trusts include Wisconsin (Wis. Stat. § 701.11; honorary trusts, enacted in 1969 and repealed in 2014 with passage of UTC provisions), Montana (Mont. Code Ann. § 72-2-1017; honorary trusts and trusts for animals, enacted in 1993), Colorado (Colo. Rev. Stat. § 15-11-901; honorary trusts and trusts for animals, enacted in 1995), New York (N.Y. Est. Powers & Trusts Law § 7-8.1 (formerly § 7-6.1); trusts for pets, enacted in 1996) and Alaska (Ala. Stat. § 13.12.907; honorary trusts and trusts for pets, enacted in 1996).
[8] Generally, this refers to chapters 33 and 35 of title 12 of the Delaware Code and Delaware’s common law regarding the creation and administration of Delaware trusts.
[9] Restatement (Third) of Trusts § 47 cmt. e (Am. Law Inst. 2003).
[10] Although this is particularly helpful in the context of a purpose trust, Delaware Trust Law allows for altered fiduciary responsibilities in all trust instruments. It is possible to completely exclude a trustee from taking certain actions (and from the liability associated with those actions) under 12 Del. C. § 3313A.
[19] Altering the prudent investor rule is specifically authorized under 12 Del. C. § 3302(e).
[20]See 6 Del. C. § 18-1101. The Delaware LLC Act allows the Managers’ duties to be expanded, restricted, or altered as necessary under the LLC’s operating agreement, provided, however, that the covenant of good faith and fair dealing shall not be eliminated.
The Bankruptcy Code[2] contains a number of so-called ipso facto provisions that invalidate contractual provisions triggered by the bankruptcy filing or insolvency of the debtor.[3] Moreover, even where one of the ipso facto provisions is not applicable, courts have long held that it is contrary to federal public policy for a debtor to waive its right to seek relief under, or the protections set forth in, the Bankruptcy Code. Indeed, provisions prohibiting debtors from availing themselves of the bankruptcy laws—laws so seminally important that they were specifically authorized under the Constitution—are almost always deemed unenforceable.[4]
Bankruptcy law is equally clear, however, that state corporate law and corporate formalities govern the process for determining whether a bankruptcy filing was duly authorized. Given that limited liability companies are “primarily creatures of contract,” state law strongly favors enforcement of provisions in operating agreements and other governing documents.[5] As such, and as demonstrated by the cases discussed in this article, provisions contained in limited liability company governing documents that set limitations on the company’s ability to file a bankruptcy case raise challenging issues for judges and practitioners alike.
Seizing on this, lenders in recent years have become more creative in seeking to reduce or eliminate their bankruptcy risk. A common approach is to create what effectively becomes a bankruptcy-remote limited liability company by obtaining, either directly or through a nominee, a so-called golden share or membership interest in their borrower. Contemporaneously, the lender insists that its borrower incorporate various blocking provisions into their operating agreement such that it can utilize a bankruptcy approval requirement to effectively preclude a bankruptcy filing. As described by one bankruptcy court, this strategy was recently “created by the credit community in an attempt to work around the prohibition against an entity contracting away the right to file bankruptcy.”[6]
This is an article in two parts. Part one will discuss the applicable law regarding eligibility to file generally, case law prohibiting advance bankruptcy waivers, and case law where courts have nevertheless held that operating agreement provisions setting limits on the authority of members or managers to file a bankruptcy case are generally enforced. Part two will discuss the recent string of cases dealing with so-called golden share provisions and how courts have dealt with the difficult issue of blocking provisions in favor of creditors set forth in limited liability company operating agreements.
Eligibility to File Generally
Section 109(a) permits any “person” to file a bankruptcy petition,[7] and the statute defines “person” to include individuals, partnerships, and corporations.[8] The term “corporation” is defined in the Bankruptcy Code to include a “partnership association organized under a law that makes only the capital subscribed responsible for the debts of such association” and an “unincorporated company or association.”[9] It is now generally acknowledged that a limited liability company is a “corporation” for bankruptcy eligibility purposes and therefore is a “person” eligible for relief under the Bankruptcy Code.[10]
Advance Bankruptcy Waivers Are Unenforceable as a Matter of Federal Public Policy
Courts almost universally agree that the right to file a petition in bankruptcy is fundamental and cannot be waived. This antiwaiver principle is not found anywhere in the Bankruptcy Code. Rather, it has long been the law that agreements promising not to file for bankruptcy or prospectively waiving substantive bankruptcy rights are unenforceable because of the strong public policy favoring access to bankruptcy relief.
In one early case, In re Weitzen,[11] the District Court for the Southern District of New York held that a contractual agreement to waive the benefit of bankruptcy is unenforceable. “To sustain a contractual obligation of this character,” the court explained, “would frustrate the object of the Bankruptcy Act. . . .” In Fallick v. Kehr,[12] the Second Circuit Court of Appeals noted in dictum that advance agreements to waive the benefits of bankruptcy are void. Similarly, in In re Gulf Beach Dev. Corp.,[13] the Bankruptcy Court for the Middle District of Florida held “the Debtor cannot be precluded from exercising its right to file Bankruptcy and any contractual provision to the contrary is unenforceable as a matter of law.”
Given that the Bankruptcy Code does not have any provisions directly on point, courts frequently rely on public-policy grounds for denying bankruptcy waivers. For example, in In re Huang,[14] the Ninth Circuit Court of Appeals noted: “It is against public policy for a debtor to waive the . . . protection[s] of the Bankruptcy Code.” Similarly, in In re Tru Block Concrete Prods., Inc.,[15] the Bankruptcy Court for the Southern District of California noted: “It is a well settled principal that an advance agreement to waive the benefits conferred by the bankruptcy laws is wholly void as against public policy.” In addition, in In re Madison,[16] the Bankruptcy Court for the Eastern District of Pennsylvania held that a prepetition agreement to waive a debtor’s right to file further bankruptcies within 180 days from the filing of the debtor’s last bankruptcy petition was unenforceable because it violated public policy.
Courts frequently have a similarly harsh reaction to prebankruptcy agreements that waive specific benefits of bankruptcy, such as the automatic stay or the right to a discharge. In In re Shady Grove Tech Ctr. Assocs. L.P.,[17] the Bankruptcy Court for the District of Maryland held: “self-executing clauses in pre-petition agreements purporting to provide that no automatic stay arises in a bankruptcy case are contrary to law and hence unenforceable, and . . . self-executing clauses in prepetition agreements . . . to vacate the automatic stay are likewise unenforceable.” Similarly, in In re Pease,[18] the Bankruptcy Court for the District of Nebraska held: “I conclude that any attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor’s future bankruptcy filing is generally unenforceable. The Bankruptcy Code pre-empts the private right to contract around its essential provisions, such [as] those found in 11 U.S.C. § 362.” Finally, in In re Cole,[19] the Bankruptcy Appellate Panel for the Ninth Circuit held: “a state court stipulated judgment where the debtor waives his right to discharge is unenforceable as against public policy.”
Underlying all of these holdings is the concept that business bankruptcy reorganization laws further the economic policy of preserving viable operating entities not only for the benefit of their owners, but also for their customers, suppliers, employees, and society as a whole. If advance bankruptcy waivers were enforceable, the logical result would be that such waivers would become commonplace in all loan agreements.[20] The effect would be to effectively close the doors of the bankruptcy courts to all parties who do business with sophisticated lenders. The negative consequences of such a result to the national economy and local communities could be substantial.
Operating Agreement Provisions Setting Limits on the Authority of Members or Managers to File a Bankruptcy Case Are Generally Enforced
Notwithstanding the foregoing, operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are generally enforced. Courts enforcing such provisions make a distinction between waivers of the right to file bankruptcy, and members voluntarily agreeing among themselves that authority to file a bankruptcy shall not exist absent satisfaction of certain conditions precedent.
State law determines who has the legal right to sign and file a bankruptcy petition on behalf of an entity. In fact, the U.S. Supreme Court has determined that “[t]he authority to file a bankruptcy petition must be found in the corporation’s instruments and in applicable state law.”[21] As such, courts have held that a bankruptcy case filed on behalf of an entity by one without requisite authority under state law is improper and must be dismissed for, among other reasons, lack of jurisdiction.[22]
State limited liability company statutes generally do not expressly prescribe whether members or managers have the power to file a bankruptcy petition. As such, the authority determination almost always requires an analysis of the terms of the limited liability company’s operating agreement.[23] Limited liability companies are “primarily creatures of contract.”[24] Therefore, great deference is given to provisions contained in operating agreements and other governing documents agreed upon by the members.
Given this great deference, it has been determined that “the long-standing policy against contracting away bankruptcy benefits is not necessarily controlling when what defeats the rights in question is a corporate control document.”[25] Provisions in limited liability company operating agreements that require certain approvals or unanimous consent by managers or members before filing a bankruptcy petition are frequently enforced. For example, in In re Avalon Hotel Partners, LLC,[26] the limited liability company operating agreement required 75-percent member approval for certain “major decisions.” Although bankruptcy was not specifically listed as an event triggering the “major decision” clause, the bankruptcy court easily reached the conclusion that a bankruptcy filing fell within the scope of that provision and, thus, imposed the 75-percent requirement.[27]
When the contractual provision at issue gives lenders an explicit voice in the filing of a bankruptcy petition, the analysis becomes far more complex. Nevertheless, as highlighted by the two cases discussed below, where a lender is acting in its capacity as a member, as opposed to a creditor, such provisions may well be enforced.
In re Global Ship Systems, LLC. In In re Global Ship Systems,[28] the debtor’s operating agreement established a lender as a “Class B Shareholder.” The Class B Shareholder interest consisted of approximately 20 percent of the equity of the company. The debtor’s operating agreement provided that the filing of a voluntary bankruptcy by the limited liability company required the consent of the Class B Shareholder. The lender would not consent to a filing. Therefore, in order to avoid the consent requirement under the operating agreement, the debtor solicited the filing of an involuntary bankruptcy case that it then failed to contest.
The court concluded that the end-run around the lender’s contractual rights as a member was inappropriate and dismissed the case. The court noted: “The fact is that the petitioning creditors’ participation in this case was solicited by the Debtor which was prohibited by the Operating Agreement from filing a voluntary case without [lender’s] consent.”[29] Further noting that the lender was both a creditor and an equity holder, the court found that the lender:
Was granted certain protections in the governance of the LLC. [The debtor] could not sell substantially all of its assets, merge with another company, or file a voluntary bankruptcy case without the consent of [lender]. An absolute waiver of the right to file bankruptcy is violative of public policy if asserted by a lender. However, since [the lender] wears two hats in this case, as a Class B shareholder, it has the unquestioned right to prevent, by withholding consent, a voluntary bankruptcy case.”[30]
Citing various provisions of the Georgia limited liability company statute, the court found that state law permits “to the maximum extent possible, parties to exercise freedom of contract in the structuring of LLCs.”[31] To accord state law’s legislative determination that limited liability companies “should be granted extremely broad discretion in the organization and management of their affairs,” the court concluded that the lender retained a separate, enforceable right, as an equity holder, to refuse to consent to the filing of a voluntary bankruptcy case.[32] Given that the involuntary case was commenced in violation of such right, and in light of other facts unfavorable to the debtor, the case was dismissed as being filed in bad faith.
In reDB Capital Holdings, LLC.In In re DB Capital Holdings,[33] the debtor was a manager-managed limited liability company that was created to develop and sell a luxury condominium project in Aspen, Colorado. The debtor had two members, Aspen and DB Development. The manager had no ownership interest in the debtor but was an affiliate of DB Development.
Under the operating agreement, the rights and powers given to the manager pertained only to managing the affairs of the debtor in the ordinary course of business. The members of the debtor subsequently attempted to strip the company of its ability to file a bankruptcy petition by amending its operating agreement to include a provision that the company: “will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy.”[34]
A few years later, the manager of the debtor filed a voluntary bankruptcy petition on the debtor’s behalf for purposes of defeating a state court receivership commenced by the debtor’s mortgage lender.[35] Aspen did not consent to the filing and sought to dismiss it as unauthorized based on the provision in the debtor’s operating agreement. The manager argued that such a provision should be invalidated on public-policy grounds because the provision was included at the lender’s behest. The bankruptcy court disagreed and dismissed the case.
The Tenth Circuit affirmed on appeal, concluding that the express terms of the operating agreement could prohibit the limited liability from seeking bankruptcy relief. The court rejected the manager’s argument that the antibankruptcy provisions in the operating agreement were void as a matter of public policy, noting that he had not cited any support for the proposition that members of a limited liability company cannot agree among themselves not to file bankruptcy.[36] The court declined to address the manager’s argument that the provision was a product of coercion by the debtor’s secured creditor, and therefore unenforceable, because the evidentiary record did not support such an allegation.
Finally, the court concluded that even if it had disregarded the express prohibition against a bankruptcy filing, such a filing on behalf of the limited liability company was outside the scope of the manager’s authorized duties as set forth in the operating agreement. Under the operating agreement, the manager was only authorized to operate the debtor in the ordinary course of business. The filing of a chapter 11 proceeding, the court found, “represents a radical departure from how any entity carries on its business outside of bankruptcy.”[37] Accordingly, because the members were entitled to, and in fact did, agree among themselves to preclude the manager from filing bankruptcy, and because there was no evidence that such provision was inserted at the insistence of the lender, the appellate panel held that the filing was unauthorized, and therefore affirmed the bankruptcy court’s decision to dismiss the case.
Conclusion
All of the cases discussed above begin with the general premise that waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy. Nevertheless, as the case law has developed over the years, a number of courts have held that operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable. The secured lending community has taken note of this, and creative lenders in recent years have structured or characterized their loan transactions to include an equity component, which arguably would give them the power to control its borrower’s fate with respect to its ability to commence a bankruptcy case. Part two of this article will address how courts have dealt with these extremely difficult cases.
[2] The Bankruptcy Code is set forth in 11 U.S.C. § 101 et seq. Specific sections of the Bankruptcy Code are identified as “section __.” Similarly, specific sections of the Federal Rules of Bankruptcy Procedure are identified as “Bankruptcy Rule __.”
[3]See e.g., 11 U.S.C. § 365(b)(2)(B) (“Paragraph (1) of this subsection [dealing with contract defaults] does not apply to a default that is a breach of a provision relating to . . . the commencement of a case under this title. . . .”); 11 U.S.C. § 365(e)(1)(B) (“Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified . . . at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on . . . the commencement of a case under this title.”); 11 U.S.C. § 541(c) (“An interest of the debtor in property becomes property of the estate . . . notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law . . . that is conditioned on the insolvency or financial condition of the debtor, [or] on the commencement of a case under this title. . . .”).
[4]See In re Gen. Growth Props., Inc., 409 B.R. 43, 49 (Bankr. S.D.N.Y. 2009).
[5] Stanziale v. Versa Capital Management (In re Simplexity, LLC), 2017 WL 2385404 (Bankr. D. Del. June 1, 2017) (citing TravelCenters of Am., LLC v. Brog, 2008 WL 1746987, at *1 (Del. Ch. Apr. 3, 2008) (finding that under Delaware law, “limited liability companies are creatures of contract” and, thus, drafters enjoy broad freedom in creating bylaws); In re Grupo Dos Chiles, LLC, 2006 WL 668443, at *2 (Del. Ch. Mar. 10, 2006) (“Limited liability companies are designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved”).
[6]In re Franchise Services of N. Am., 2018 WL 485959 (Bankr. S.D. Miss. Jan. 17, 2018).
[7] 11 U.S.C. § 109(a) (“Notwithstanding any other provision of this section, only a person that resides or has a domicile, a place of business, or property in the United States, or a municipality, may be a debtor under this title.”).
[17]In re Shady Grove Tech Ctr. Assocs. L.P., 216 B.R. 386, 390 (Bankr. D. Md.1998).
[18]In re Pease, 195 B.R. 431, 435 (Bankr. D. Neb. 1996).
[19] Hayhoe v. Cole (In re Cole), 226 B.R. 647, 651–52 n.7 (9th Cir. B.A.P. 1998).
[20]See, e.g., Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011, 1026 (9th Cir. 2012) (“This prohibition of prepetition waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive.”).
[22]See, e.g., Hager v. Gibson (In re Hager), 108 F.3d 35, 38–39 (4th Cir. 1997) (holding that the bankruptcy court does not acquire jurisdiction over a petitioning corporation if those purporting to act for the corporation lack authority under local law).
[23]See e.g., In re Real Homes, LLC, 352 B.R. 221, 225 (Bankr. D. Idaho 2005); In re Farner, Boring & Tunneling, Inc., 26 B.R. 29, 31 (Bankr. D. Tenn. 1982).
[24] Stanziale v. Versa Capital Management (In re Simplexity, LLC), 2017 WL 2385404 (Bankr. D. Del. June 1, 2017) (citing TravelCenters of Am., LLC v. Brog, 2008 WL 1746987, at *1 (Del. Ch. Apr. 3, 2008) (finding that under Delaware law, “limited liability companies are creatures of contract” and, thus, drafters enjoy broad freedom in creating bylaws)); In re Grupo Dos Chiles, LLC, 2006 WL 668443, at *2 (Del. Ch. Mar. 10, 2006) (“Limited liability companies are designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved”).
[26]In re Avalon Hotel Partners, LLC, 302 B.R. 377 (Bankr. D. Or. 2003).
[27]See also In re Orchard at Hansen Park, LLC, 347 B.R. 822 (Bankr. N.D. Tex. 2006) (enforcing operating agreement that required unanimous member consent for the filing of a voluntary bankruptcy case); In re 210 West Liberty Holdings, LLC, 2009 WL 1522047 (Bankr. N.D. W.Va. May 29, 2009) (provision that “all decisions” be made by majority vote was sufficient to allow bankruptcy filing over member objection because the objecting member’s approval was not necessary to constitute a majority); In re Ice Oasis, LLC, 2008 WL 5753355 (Bankr. N.D. Cal. Nov. 7, 2008) (in two-member LLC with 50/50 ownership, both members were required to approve the bankruptcy filing because the operating agreement provided for “all decisions” to be approved by a majority).
[28]In re Global Ship Systems, LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007).
