This article is based on the chapter entitled “Customer Health and Safety, Marketing and Labeling, and Customer Privacy” written by the authors in the forthcoming ABA Deskbook on CSR. Authors of a companion chapter in the book have written on CSR and cybersecurity.
Product responsibility and customer care are core issues when discussing corporate social responsibility. Good corporate citizens must acknowledge, understand, and incorporate appropriate compliance on issues related to a company’s main business purpose: to sell goods or services to customers. That means that for companies that sell products, those products must be safe and must inform and sometimes warn customers of any potential issues with such products. Additionally, marketing and advertising for goods and services should also reflect the overall CSR policies of a corporate entity, including truthfulness and fairness of such materials. Finally, companies should also plan for and acknowledge potential or possible privacy issues when it comes to their customers’ data.
Corporate social responsibility is, at least in name, a relatively new phenomenon, although for lawyers it has always been a “thing.” Traditionally, members of the bar were expected to support their associations and their communities by contributing pro bono time and services. This can involve providing representation to indigent clients accused of crimes; assisting persons at or near the poverty line with no-cost legal assistance pertaining to credit, housing, or employment matters; or serving on, or advising, the boards of nonprofit organizations established to support need-based, educational, religious, or other assistance to the communities they have been established to serve. Viewed through this lens, corporate social responsibility has been, in a real sense, a long-standing component of law practice in the United States.[1]
The history of corporate social responsibility is generally seen as a product of the later 20th century,[2] but actions taken by corporations as early as the mid-19th century already demonstrated a desire by some companies to address criticisms of the new British factory system by supporting employee-oriented concerns.[3] Questions of motivations (whether employers were truly concerned with employee welfare, or had in mind business considerations such as enhanced employee productivity) and even legality aside (whether a corporation could properly discharge its duties to shareholders by expending sums for the benefit of employees), the arguments of reformers and the responses of some business owners at that time mark even those early dates as an arguable beginning for a kind of corporate social responsibility.
If an early vision of such a corporate social responsibility encompassing employee welfare became evident in the mid-19th century, it took longer before there was widespread recognition that customers at large should have some expectation of health and safety with regard to products now mass-produced by industrialized businesses. The development of product liability law in a modern sense can be traced to MacPherson v. Buick Motor Co.,[4] in which Benjamin Cardozo, then Chief Judge of the New York Court of Appeals, wrote a decision that dispensed with the doctrine of privity in negligence cases. Previously, the requirement that there be contractual privity between an injured party and the party which it sued had forced those injured by faulty products to sue parties which were usually distributors but not the manufacturers or parties ultimately responsible for the defect. Cardozo’s decision made it possible for a plaintiff to pursue the manufacturer because, with the requirement for privity removed, the harm from a defective item was now the responsibility of the manufacturer.[5]
Still, although McPherson eliminated one hurdle, others remained in place, including the ongoing difficulties of proving a close causal connection between the manufacturer and the injured party, the prevalence of a narrow view of the concept of product defects, and a somewhat welcoming view of defenses based on plaintiff misconduct or assumption of risk.[6]
It was not until later, during the 1960s, that a broader conception of products liability was realized. Many commentators[7] point to two prominent cases, Henningsen v. Bloomfield Motors, Inc.[8] and Greenman v. Yuba Power Products, Inc.,[9] and the final approval of Restatement (Second) of Torts § 402A,[10] as marking the arrival of a “modern” era in strict products liability law.
In Henningsen, the New Jersey Supreme Court struck down the notion put forward by the defendant manufacturer that it should benefit from private limitations on warranties. In Henningsen, the conclusion reached was that these sorts of limitations were not in the public interest; thus, manufacturers should not be shielded by such limitations from the harms caused by the products they had sold into the marketplace.[11]
In Greenman, the California Supreme Court embraced the theory that recovery for products liability, without regard for fault, should be grounded in tort law, not contract law.[12]
With the formal approval of section 402(A) of the Restatement in 1964 by the American Law Institute, there came into existence a set of fundamental rules to address the issue of strict products liability in tort.[13]
Although we now take these developments for granted, it has been only a little more than 50 years since these developments redefined issues of product safety and liability for corporations engaged in manufacturing goods.
Today, it is likely that notions of product liability or responsibility can be found as one of the component pieces of a large company’s statement of policy or commitment to “product responsibility,”[14] “extended producer responsibility,”[15] or “product stewardship.”[16] What originally began as a fundamental but relatively straightforward treatment of risk allocation and responsibility questions with regard to manufactured products is now evolved to a more nuanced and comprehensive approach to reducing health, safety, and environmental risks associated with consumer products. CSR can even be found in the impulse of some companies to take a lifecycle approach to these problems, which focuses not only on sustainable end-of-life management, but also incorporates waste management solutions that are the result of product design innovations and negotiations among multiple stakeholders.[17]
With regard to voluntary efforts at CSR, nonprofit organizations are at the forefront of some of the initiatives in this area and work closely with member corporations and governments to develop not only voluntary initiatives, but also recommendations about legislative solutions to issues related to product or producer responsibility.[18]
In the area of compulsory extended producer responsibility (EPR), the lead generally has been taken up by U.S. states, given that Congress has not been particularly active in this area.[19] Certainly, lawyers for corporate clients, regardless of whether working in-house or for external law firms, will already be aware of the growth of these initiatives and the need to be prepared to provide detailed feedback on existing legal requirements[20] as well as creative inputs when assisting their clients with the design and implementation of voluntary EPR programs.
Given that CSR can also be extremely contextual, lawyers have to understand the specific legal and regulatory environments which impact their clients’ businesses. For example, a lawyer representing an oil and gas company may have a different kind of marketing and labeling focus than a lawyer representing a food company, even while both are working to understand laws and regulations which are oriented around a focus on safety. In the same way, it is also possible that a lawyer working for or representing a company in one industry may be faced with a host of CSR-related questions and issues that are quite different from those coming across the desk of a colleague who works for or represents a corporate client in a different industry. Using the same examples noted above, a lawyer for an energy company may find that her client will benefit that company’s CSR programs account for and respond to current environmental concerns, whereas a retail food company lawyer might be more focused on issues relating to the safe sourcing or production of food in its stores, or on community-based initiatives related to the neighborhoods where its stores are located.
Another issue for lawyers to consider is that notions of what is voluntary or required are constantly evolving. In the case of food labels, the U.S. government has stipulated certain minimum requirements familiar to anyone checking a label for fat, sugar, or protein content, or parents looking to see which is the proper dosage of a children’s cough medicine, and these mandatory (regulatory) requirements are part of the cost of doing business in that particular industry. Separately, however, some companies have been able to differentiate themselves by going beyond what is required and using the platform of a label as a chance to essentially advertise the extra “goodness” of their product, either because of the quality or source of ingredients or other variables. However, consumers may also have something to say about whether a type of labeling should be mandatory. In this context, consider the example of the rejection by voters of Proposition 37 in California, which would have required, among other things, the labeling on raw or processed food offered for sale to consumers if the food was made from plants or animals whose specific genetic material had been altered in specific ways, and which would have prohibited the labeling of any such items as “natural.”[21]
With regard to voluntary actions, lawyers of a certain age will remember the Tylenol poisoning murders in the Chicago area in 1982, which resulted from drug and package tampering. All of the victims thought they were taking Tylenol, but actually died from ingesting tablets laced with potassium cyanide. Johnson & Johnson mobilized a comprehensive response that included introducing tamper-proof packaging to help restore customer confidence in the product. However, this was a classic case of a reactive solution to a problem that (at least in hindsight) was foreseeable. In the wake of the revelations following the Cambridge Analytica and 2016 election scandal that have enveloped Facebook, it is worth considering that a proactive approach may still benefit corporations focused on CSR and consumer safety and customer privacy. The fact that laws and regulations, such as product labeling requirements, become necessary in certain cases where voluntary self-regulation or self-assessment is absent or has failed, seems a cautionary tale. Corporations willing to embrace a CSR outlook and to view proactive efforts to enhance customer safety and privacy as opportunities for market differentiation and innovation may find that they are able to benefit from investing to prevent problems rather than waiting to find out the cost of solving or settling problems later if customer safety and privacy issues are not prioritized.
[1] Indeed, the history of the development of professional standards for lawyers in the United States can be traced back to at least 1836, when David Hoffman developed “50 Resolutions in Regard to Professional Deportment” and published them in a book entitled A Course of Legal Study.
[2] Archie B. Carroll, “A History of Corporate Social Responsibility: Concepts and Practices” in Andrew Crane, Abigail McWilliams, Dirk Matten, Jeremy Moon & Donald Siegel, eds., The Oxford Handbook of Corporate Social Responsibility 19–46 (Oxford University Press 2008).
[12] Graham, supra note 7, at 556; Greenman, 59 Cal. 2d at 61, 377 P.2d at 901, 27 Cal. Rptr. at 701.
[13] Restatement (Second) of Torts § 402A (1965) (although approved in 1964, section 402A was not formally published until 1965); Graham, supra note 7, at 556.
The rise of powerful digital platforms like Google, Facebook, and Amazon in the new global economy has sparked an increasingly public debate worldwide. Politicians across the political spectrum have for the first time brought calls for enforcement and regulation of digital platforms into regular discourse in popular politics. Although some continue to caution against interference that could chill innovation, there is an increasing sentiment consistent with broader enforcement trends that more must be done from an antitrust perspective to address the ability of these established platforms to reduce competition. Despite a history of enforcement around innovative technologies, some have questioned whether the unique features of digital platform markets require a corresponding revolution in the established antitrust enforcement framework.
Within a broader global trend toward more proactive antitrust enforcement, antitrust authorities around the world have begun to focus particularly on the potential for these platforms to entrench their positions by effectively excluding or buying up potential new competitors to the detriment of consumers. The European Commission and member states in Europe have arguably taken the lead in heightened antitrust enforcement, but other regions are following suit with the recent ramp up of enforcement in North America. These developments are also being closely watched across Asia-Pacific, including signs of enforcement in China, where the authorities have traditionally supported the development of strong domestic platform providers.
Policy Initiatives
To date, most of the efforts invested in targeting digital platforms have been at the policy level to understand the key features of digital platforms and the existing enforcement framework. Several antitrust enforcers have actively conducted policy studies on these issues, including holding hearings and issuing policy reports with their findings. In the United States, antitrust enforcers at the Federal Trade Commission (FTC) and Department of Justice (DOJ) have hosted a series of workshops to give a range of stakeholders an opportunity to be heard. The Congressional committees tasked with oversight of antitrust enforcement have also held hearings and taken testimony from the providers. Australia has recently completed a broad market study on the direction of the government on digital platforms, focusing on media, journalism, and advertising services. Several European member states have also conducted similar initiatives, including the Digital Markets Strategy by the UK Competition & Markets Authority (CMA) and a two-year inquiry into online advertising by the French Competition Authority. Authorities in other jurisdictions have hired third-party thought leaders from major universities to prepare reports on digital platform markets, including, for example, the European Commission and the UK Parliament. Competition authorities in Asia, particularly Japan and Korea, have also clearly taken notice and announced their own policy initiatives.
Although each of these policy initiatives has a distinct focus and market context, there are several key themes that have arisen which the authorities are working through:
How should market power be assessed for dynamic platform markets where services are usually offered for free to many user groups?
How does a platform’s collection, use, and storage of user data impact competition? When does a platform’s stockpile of data create a barrier to entry of new platforms?
When is a platform’s leveraging of its own service offerings and exclusion of potential competitors sufficient to sustain an antitrust challenge?
Does traditional merger analysis underestimate the competitive significance of startups and technology innovators acquired by more established competitors?
How should antitrust enforcement standards balance potential risks of over- versus under-enforcement? What are the relative harms for competition and innovation?
Although a recurring theme is that traditional antitrust principles are sufficient to address the unique features of the digital platform markets, these initiatives have given the authorities an opportunity to develop more detailed frameworks for assessing issues that will be tested in enforcement. These efforts have also given rise to recommendations on regulatory or legislative changes that could help promote competition and facilitate more effective enforcement going forward.
Enforcement Initiatives
Following these initiatives, there is an inevitable pressure on competition authorities to put their learning to work. The European authorities have been most active in their enforcement measures so far, in part due to enforcement standards perceived to be more favorable than their counterparts in the United States. The European Commission, for example, has imposed a series of high-profile fines on Google over the past three years for abuse of dominance based on exclusionary practices involving its Android operating system, comparison shopping services, and online search advertising intermediation platform AdSense. The European Commission has recently opened up a high-profile formal investigation into Amazon’s use of sales data to compete with third parties. The European member states have also been active in expanding their enforcement role in these markets, including the German competition authority’s high-profile challenge to Facebook’s data privacy terms, which continues to tests the bounds of traditional antitrust law on appeal after being overturned by an initial appellate decision in Germany. In the United States, enforcement efforts are just beginning to show signs of ramping up. In February, the FTC announced a Technology Task Force to focus on special enforcement efforts targeted at technology markets. More recently, the DOJ has announced a wide-ranging investigation into market-leading online platforms for search, social media, and some retail services online. Both still appear to be in the relatively early fact-gathering stages of their investigations and are actively working with market participants to better assess potential theories of harm under U.S. laws.
Merger enforcement is likely to be an initial enforcement focus, particularly in the United States. Although there have been no significant challenges to date, statements by the authorities have considered the issues identified in the policy initiatives in extended reviews of several high-profile transactions. Investigations going forward will likely place a greater focus the importance of different types of data, the assessment of nonprice competition on innovation and privacy terms, and the competitive position of nascent competitors. The authorities are also expected to revisit consummated transactions that may have previously avoided scrutiny, including deals such as Facebook/Instagram and Google/Waze identified in the UK Digital Markets Strategy. To circumvent the traditional evidentiary challenges of proving competitive harm, the DOJ has outlined a new approach to challenging patterns of prior acquisitions of small potential competitors that may have been used to create or strengthen a platform provider’s monopoly.
Another area of continued enforcement focus globally will be on different forms of exclusionary conduct by dominant or monopolistic platforms. Explicit exclusivity arrangements, loyalty discounts, and other de facto exclusionary vertical arrangements aimed at blocking competitors from the market are likely to come into particular focus in the United States. Global enforcers are also likely to delve into other forms of self-preferencing or leveraging conduct similar to the conduct underpinning the investigations into Google, Amazon, and Apple in Europe, particularly conduct intended to expand market power into related markets or defend existing positions. Given that many platform providers are funded primarily with advertising revenues, digital advertising is becoming an increasing priority. For example, concerns have been raised about how platforms preference their own advertising services above those of rivals (e.g., on search results or social media feeds), exclude rival advertisers from other products or access to data, or introduce technical specifications that favor their own advertising services to the detriment of competitors. Jurisdictions in Europe may also be receptive to more novel remedies to the challenged harm, including, for example, mandating nondiscriminatory access to certain forms of data.
Regulation and Legislation
In addition to these enforcement initiatives, a range of regulatory and legislative measures may be implemented to address the challenges identified. Proposals span a range of issues with varying degrees of intervention, from transparency measures supporting enforcement to direct regulation. Proposals offered by politicians and regulators worldwide include, for example:
requiring new reporting obligations for certain acquisitions by digital platform providers;
shifting burdens in favor of competition authorities to allow for more effective enforcement where legal or evidentiary standards have posed challenges for enforcement;
requiring providers to allow access to competing platforms, in some cases with data portability between different platforms to reduce barriers to customers switching; and
mandating break-up of the existing large platform providers and direct regulation of certain functions as a public utility, similar to historical regulation of the telecom sector.
Although the more transformative proposals would have been unlikely to get traction historically, support appears to be growing across the political spectrum.
Conclusion
A true revolution in competition enforcement involving digital platforms is unlikely, but a further evolution of antitrust enforcement to meet the challenges of the digital economy is virtually assured. Even though much of the enforcement rhetoric is focused on a small number of platform providers, the impact will clearly be felt more broadly in the business community. Businesses should at a minimum be mindful of the potential for heightened scrutiny by authorities anytime transactions or investments implicate digital platforms or other sensitive technology markets, recognizing the unique issues that may arise and the importance of internal documents in assessing competitive effects. Businesses impacted by the conduct of large digital platform providers should also be conscious of the opportunity to be heard in ongoing investigations and market studies into these markets, where the authorities are proactively seeking the input of all stakeholders. Finally, there is a common thread of assessment of these global markets across jurisdictions that must be managed carefully where issues do arise.
The first thing we do, let’s kill all the lawyers.
-Dick the Butcher in Shakespeare’s Henry the VI
(Dick the Butcher was a follower of the rebel Jack Cade who thought that if he disturbed law and order he could become king.)
Introduction
The independence and role of the legal department within regulated banking organizations has come under pressure in recent years. This pressure has been exacerbated by a clash of professional silos among legal, risk, and compliance with a thumb on the scale inserted into the mix by the banking supervisors’ mistrust of lawyers and the in-house legal function. It is far beyond the business-as-usual, healthy tension over legal costs. The result is a push by some to contain in-house lawyers and the legal function away from a trusted advisor role into a smaller role and to exclude them from supervisory meetings and management committees. The main drivers of this push have been bank examiners, senior supervisory staff, and economists at the banking agencies, as well as risk-management professionals consisting largely of former examiners, supervisory staff, and economists from banking agencies.[1] By sharp contrast, the trend outside of the banking sector is exactly the opposite—that is, an increased trusted advisory and strategic role for the general counsel and the legal department in large, complex organizations.[2] Given the extraordinarily important role that the general counsel and in-house lawyers play as trusted advisors to senior management and in managing the legal risk of the banking organization, as well as their beneficial impact on corporate culture and reputational risk, this push is dangerous and should be halted. The appropriate role for the general counsel and in-house legal department in the banking organization should be reaffirmed by boards, senior management, and banking supervisors.
Part of the trouble stems from a misunderstanding among the professional silos of the bar, the examination staff at the banking agencies, risk-management professionals, and compliance professionals. A peace treaty, including each professional silo gaining a greater understanding of the professional roles and ethical codes of the other, needs to be struck as soon as possible.
It is critical to fix this situation now, before the transformative changes in the digital age, because if we continue down the current path, there is a danger that the tools of the digital age will not be appropriately programmed or trained with the legal framework embedded within them or take into account the professional ethics applicable to lawyering. We risk coding the mistakes and bias of the present into the more digital future.
Part I of this article explains how the federal banking supervisors have, by focusing on risk management and separating compliance from the legal department, both accidentally and deliberately contributed to the diminishment of the in-house legal function at banking organizations.[3] Since the financial crisis, an unfortunate culture of strong mistrust of lawyers by the supervisory staff has taken hold. At the same time, the concept of the three lines of defense, the inclusion of legal risk into the operational risk component of capital, and the banking regulators’ unusual attitude toward attorney-client privilege have also contributed, as has the traditional senior management view of in-house legal departments as more about managing the costs of legal services as opposed to managing legal risk.
Part II of this article argues that this situation has become dangerous for banking organizations and the rule of law. The strains on the budget and resources of the in-house legal department, tolerating multiple poles of legal interpretation and judgement within the banking organizations, a narrow view of the role of lawyers, and a misunderstanding of the attorney-client privilege in permitting candid internal conversations are all elements that should be reconsidered.
Part III of this article offers some suggestions to improve the situation. Boards of directors, senior managers, general counsels, in-house lawyers, and banking supervisors all have a role to play. It is time for a peace treaty. Working across professional silos and better training in the basics of other professional silos is key to a better path forward to overcome the misunderstandings of the recent past.
Part I: How We Got Here
The Three Lines of Defense
The aftermath of the financial crisis created a paradigm shift in the legal framework that applies to the banking sector.[4] Moreover, it was widely acknowledged that corporate governance in the banking sector had somehow failed. Both board level and internal corporate governance norms were changed as a result of changes in the legal framework or under discreet supervisory pressure.[5] Regulations and guidance were revised to require an independent CRO, making it explicit that this senior manager must report to a board committee as well as to the CEO.[6] In addition, banking organizations have been strongly encouraged to have independent CCOs, both by supervisory guidance and examination staff, as well as by the DOJ’s compliance standards.[7] The supervisory approach also underwent a paradigm shift deeply influenced by the concept of the three lines of defense: first line business, second line risk management, and third line internal audit.[8] A fatal flaw in the original three lines of defense was that it forgot about the legal department and the role of lawyers.
When originally developed in the United Kingdom, the three lines of defense concept was completely unknown in the U.S. legal and regulatory framework for the banking sector until the OCC, under the Obama administration, proposed to place it into its risk-management guidelines. These guidelines are the only place that the concept is used in the U.S. legal and regulatory framework. The Federal Reserve, in its later proposed governance guidelines for board effectiveness and risk management, refused to employ the concept.[9] To the shock of many in the bar, in 2014 the OCC proposed guidelines placed the legal department in the first line of defense, treating it as the equivalent to a revenue-producing line of business.[10] The view, apparently, was that the legal department created risk. Not surprisingly, the American Bankers Association as well as many other lawyers commented on the proposed guidelines, and this characterization was withdrawn.[11] The final OCC guidelines acknowledged that the legal department is not, with rare exceptions, part of the first line of defense.
Where Does the Legal Department Fit In?
Given its creation by the auditing profession, it is unsurprising that legal departments and general counsels, which have existed at most banking organizations since the New Deal, do not fit neatly into the new, post-financial crisis concept of the three lines of defense.[12] Within the bar, there is a well-developed understanding of the need for the independence of the general counsel and the legal department, as well as the fact that the general counsel reports to the board as well as the CEO.[13] It is also unsurprising that, in the immediate aftermath of the financial crisis, the federal banking supervisors would not feel the need to directly comment on or regulate the organizational or reporting line relationship of the general counsel in the same way they would the CRO or the CCO. Unlike CROs and CCOs, in-house lawyers are already regulated by their state bar associations. They are licensed members of a bar association with requirements to pass exams, follow binding ethics rules, and complete continuing education requirements. The ethics rules are not voluntary guidance, as is the case with risk and compliance professionals, but are binding requirements, supervised by an independent force; in the United States, in-house lawyers can be disbarred or sanctioned by their state bars. The regulatory structure around lawyers is ancient and largely applies at the state level. Federal agencies have largely stayed out of the business of regulating the legal profession.[14]
By sharp contrast, the professional roles of the CRO and CCO are relatively new. There are no licensing standards for entry into the profession, and there is not a long history of independence or reporting to the board.[15] Ethics rules are voluntary and come after taking an online course. The fact that the banking supervisors did not assign the general counsel a board committee or did not state that the legal department is an independent function does not take away the pre-existing nature of the general counsel’s relationship with the CEO and the board and the legal department’s role within the enterprise, which are driven by the ethics rules and the nature of the practice of law.[16] In essence, the best way to think about it is that the banking supervisors were bringing risk management up to the independence of the legal department.
The adoption of the three lines of defense within banking organizations, along with the enhanced intensity of supervision and the spate of large fines and enforcement orders, some of them criminal, on banking organizations, has quite appropriately led to a sharp increase in risk management and compliance professionals at banking organizations.[17] By comparison, there has been a limited increase in the number of in-house lawyers. Quality public figures for the personnel of the banking agencies are hard to come by, but it is apparent that there has been a larger increase in supervisory staff at the banking agencies, while the banking agency legal departments have grown only slightly. At the same time, the banking supervisors have pushed for compliance to be moved out of the legal department at banking organizations and into the newly expanded risk-management departments. This pressure has happened behind closed doors, without any public notice and comment, with little to no active oversight by agency principals and without any meaningful transparency or public accountability, which is essential to the proper functioning of any democratic system of government.[18] Today, almost all of the large banking organizations have placed compliance within risk, while most of the smaller banking organizations keep it within legal.
Professional Silos and Cultural Mistrust
There is a cultural problem of professional silos that has led to mistrust and misunderstandings as one silo looks askance at the work of the other silo. The mistrust begins within the supervisory staff at the banking agencies. The Federal Reserve and the OCC have long been understood to be economist-dominated organizations with relatively small legal staffs of their own. In sharp contrast, the DOJ and the SEC have long been understood to be lawyer-dominated organizations.[19] At some of the banking agencies, there has long been a view by the supervisory staff that their own legal departments should not be involved in policy decisions. Some have taken the view that the agency legal department works for the supervisory staff. There has also been a practice at some of the banking agencies, until recently, that guidance and supervisory letters are published without the agency lawyers commenting on them before publication. This scarcity of lawyers within the banking agencies, and the relative lack of authority and independence of some of the legal departments, is an attitude that former supervisory staff take with them to the private sector when they take jobs in risk, compliance, and audit, as well as in consulting.
Outside counsel have long been scorned by the supervisory staff and deliberately excluded from calls and meetings except in the limited arenas of enforcement.[20] A relatively new trend is agency supervisory staff insisting upon the exclusion of in-house lawyers from supervisory meetings. Another new trend is for compliance or regulatory affairs (when it does not report into the general counsel) to negotiate memoranda of understanding or enforcement orders without bringing in the in-house legal function or the agency legal staff until late in the process.[21]
Since the financial crisis, there has been a growth in the mutual mistrust across professional silos. The supervisory staff view lawyers as withholding of facts, engaging in unsupported defense of the organization’s conduct without regard to the overall situation, overusing attorney-client privilege, careless about conflicts, and weak on pushing back on the business.[22] The bar views the supervisory staff as having forgotten that we live in a constitutional democracy with the rule of law and limited powers of agency staff. There is a deep concern in the bar about the overuse of confidential supervisory information and supervisory discretion. It is not uncommon to hear in-house lawyers speak of Kafka,[23] the Star Chamber,[24] or living under a dictatorship. The cross-cultural mistrust is not healthy.
Part II: The Dangers of the Current Path
The current path is a dangerous one for the ability of banking organizations to be effectively counseled and advised on the law at a time of increasing complexity in the legal framework. The path is also unwise for the banking agencies themselves, where the balance between safety and soundness and prudential regulation on the one hand, and the rule of law on the other, has gone askew. A generation of the supervisory staff has been wrongly trained to believe that safety and soundness transcends the legal framework and that they have the ability to act under their “inherent power,” without limits on their individual discretion. Sometimes, senior supervisory staff told examination staff that they “own” any business problems. Lawyers know that no agency of the federal government has any power that is not given to it by an enabling statute; indeed, safety and soundness itself derives from a statute and is part of the law, not outside of it. In our constitutional separation of powers, there is no such thing as a federal agency with “inherent powers.” The fault here lies not with the examiners but with an almost negligent lack of training of the examiners by agency principals and senior supervisory and legal staff. One first place to begin is to provide training on the rule of law, which is not about imposing court-like hearings on every supervisory decision. It is about regaining the understanding that we are governed by a public set of rules that apply equally to all in a process that is fully transparent and therefore accountable to the public, not by ad hoc standards that can be determined by individual discretion behind closed doors without any meaningful transparency or accountability to the public.
As Shakespeare’s advice teaches us, and as experience has shown time and again, killing the lawyers is the crucial first step of any dictator. In today’s environment, an authoritarian can rule a fiefdom within the corporate structure or within the agency. The relatively bloodless modern corporate and supervisory variant on killing all the lawyers is to exclude or diminish the role of lawyers and the rule of law, both within the banking agencies and within the banking organization itself. In good times, business leaders, risk-management professionals, and supervisory staff may wish to do without the lawyers who, in their view, get in the way of swift decisions and who have a troublesome tendency to remind both their corporate bosses and supervisory staff when they are operating outside the bounds of the law or too near the fuzzy boundaries of the complex legal framework. In bad times, however, those same people suddenly realize that they need a strong legal team and the rule of law.[25] In fact, the path to safety and soundness is best achieved by strengthening the legal department within the agencies and within the banking organizations—not by containing the legal function into a smaller space.
At the moment, there are four main methods by which the independence and stature of legal departments is threatened with diminishment: (1) limiting the budget and resources available to the legal department, (2) narrowing the view of the role of lawyers, including regional banking supervisors pushing to exclude in-house lawyers from supervisory meetings or examination responses, (3) tolerating multiple poles of legal interpretation and judgement within the banking organizations, and (4) profoundly misunderstanding the role of the attorney-client privilege in permitting candid conversations.
Limits on Budget and Resources
Restraints on the budget and resources of the legal department, beyond that which is imposed on other enterprise functions, is one way to limit the role of in-house lawyers. Lawyers are visibly expensive in-house talent, and the outdated view of the legal department as largely serving to cut costs incurred by outside law firms has made it easy to limit the budget and resources of the legal department. At the same time, the recent cycle has seen a major increase in the budget and resources of the risk-management and compliance functions.[26] Imagine three nearly identical houses in a small-town neighborhood. Two of the houses, risk and compliance, have benefited from a regulatory command to increase their budgets, resources, and independence. The houses have had major additions, they have been updated for technology, the kitchens have been modernized, and there is a shiny new car in the driveway. In contrast, the legal department house has been lived in by an elderly couple on a fixed income who have been forced by their lack of resources to do only the minimum of upkeep. The underinvestment in technology for in-house legal departments is the most fundamentally striking aspect, especially in light of the massive amounts spent on digital transformation elsewhere in the organization.[27]
There is also a misunderstanding by some of what costs should be genuinely attributed to legal departments. If, as a result of actions in a business line, a reserve must be taken or a large fine or settlement paid, that is not a cost of the legal department. It is a cost created by the business line. Many in-house budgets make this distinction, but its nuance is lost in the media and in the minds of many not familiar with the management of legal risk. Another element that is lost is the use of consultants by risk and compliance as a substitute for legal advice. Many times these services are, in fact, the unauthorized practice of law without the guardrails imposed by legal ethics or the knowledge of how to interpret the hierarchy of the legal framework. As I have written elsewhere, I am not a purist in the unauthorized practice of law.[28] Substituted legal advice by consultants, however, which is neither tracked as part of the legal spend since the hiring is done by risk and compliance nor, more importantly, supervised by any internal lawyers, distorts both the legal spend and the quality tracking of legal advice that is implemented throughout the organization by policy or otherwise. Oftentimes, this substituted legal advice is marketed as “regulatory advice.” Regulations and guidance are not distinguishable from law; they are part of the law. As I have acknowledged elsewhere, there is a clear benefit to having regulatory readers, but the near complete lack of supervision by any lawyers risks compliance violations within the banking organizations. These compliance violations exist both due to the misreading of the legal framework, and due to the banking organizations and the banking agencies permitting the unauthorized practice of law by nonlawyer supervisors and consultants.
Tolerate Multiple Poles of Legal Interpretation and Judgment within the Organization
Most banking organizations have a clear policy that lawyers and the legal department should own the ultimate legal judgment and interpretation for the banking organization, but in practice, multiple competing poles of legal interpretation and judgment have been permitted to flourish within the organization in recent times. The separation of legal and compliance has led to confusion by many within the organization about the interpretations of the legal framework. For many, the former lawyers or nonlawyers in compliance are a source of legal judgement, and any tension or distance between legal and compliance creates an arbitrage opportunity for forum shopping for a more business-friendly answer (if sought by the business) or a less business-friendly answer (if sought by risk or audit).[29] There has also been an unfortunate tendency of some in the newly formed compliance profession to increase their own professional standing by advocating for oddly limited roles for lawyers.
The increase in the complexity of the legal framework has also led to an increase in sophisticated regulatory readers: those within the organization such as in Treasury, regulatory relations, and the risk function who must read the legal framework as a core part of their job. The fundamental tension between the bar and the regulatory readers is that lawyers read the legal framework from the top down, beginning with the statute, moving to the regulation, then guidance, with analysis infused by important principles of legal interpretation. Regulatory readers, by contrast, read the legal framework from the bottom up, beginning with guidance, moving to regulations, and then looking at the statute and using the practical tools of normal reading, even though they are often inapplicable in the legal framework. Combined with the tendency to look up answers by unreliable googling, these different ways of reading encourage multiple competing interpretations within the banking organization. Legal interpretation is not like ordinary reading, and regulatory readers need basic training on the difference.[30] I have written in detail about this cultural mismatch elsewhere.[31] Finally, the growth of the consultant-industrial complex and the large budgets that have been given to the risk function and the compliance function over the last 10 years has led to a situation where many consultants are, in effect, giving untrained legal advice under the guise of “regulatory advice.” That advice impacts risk decisions and technology without any oversight by the legal department or any trained lawyers.
Narrow View of the Role of Lawyers
Another dangerous tendency is to take a narrow view of the role of lawyers and exclude them from meetings or decision making. Part of this may be driven by the shortage of trained and experienced in-house lawyers in the financial regulatory space, but this narrow view is also driven by other root causes, some of which are barely appropriate in a constitutional democracy. There has been a recent push by some regional banking supervisors across a range of sizes of banking organizations to deliberately and loudly exclude in-house lawyers from supervisory meetings and to narrow the role of the in-house legal department to one of pure advocacy. The view of in-house lawyers as solely about advocacy is fundamentally mistaken. The result is to diminish the stature and independence of the legal department vis-à-vis the risk-management function, the compliance function, and regulatory relations (to the extent it does not report to legal). There is a lot of jostling at the top for the role of trusted advisor, and many within a large organization have their own institutional or self-interested reasons for excluding the lawyers from the room.
Suspicious View of Attorney-Client Privilege and Constraints on Candid Conversations
Another way to narrow the scope of legal representation is to narrow the scope of attorney-client privilege or to otherwise limit candid conversations within the banking organization. In the banking sector, the agencies, with the agreement of their general counsels, have long taken the view that attorney-client privilege does not apply in the supervisory context. In this view, they are at odds with other agencies such as the DOJ and the SEC. As a memo from multiple law firms has argued, the statutory basis for this claim is shaky at best. In reality, the legal departments of most banking organizations appropriately waive attorney-client privilege in the supervisory context for good and valid reasons.[32] In response to that memorandum, the OCC revised its examination handbook to make it easier for examiners to overcome attorney-client privilege.[33] The cultural mismatch and mistrust is real. There has, however, grown to be a critical cultural point. Regulatory readers and banking supervisors have been under-briefed on the role of the attorney-client privilege in a constitutional democracy. As a result, in these days of competing poles of legal interpretations within banking organizations, some outside of the legal department may have been misusing the concept of attorney-client privilege because of their confusion about its role and nature. It is important to reset these misunderstandings. A major reason for the confidentiality of the supervisory relationship is to encourage candid conversations. The attorney-client privilege serves the same goal.
There are other constraints developing on candid conversations within the banking organization. It has long been understood that all e-mails are subject to being read by the banking supervisors. What is not so widely understood is a push to keep change logs of drafts of materials created within the banking organizations. In a world of track changes and multiple comments by rushed people who are multitasking, it may come as a surprise that comments on drafts are being kept just in case the banking supervisors might want to view them. This is happening both in consent order remediation and otherwise, and both in an attorney-client privileged environment and otherwise. It seems to be happening without much forethought.
Part III: A Path to a More Stable Solution
The current path of mistrust and misunderstanding is a poor way to manage legal risks in the banking sector, and it could become much worse with the digital transformation. There should be a rethink within the banking agencies and banking organizations about the role of the legal department and lawyers. There also must be a truce between banking supervisors and risk-management professionals on the one hand, and the legal profession on the other, which will require openness to understanding each other’s professional silos on both sides. In this section of the article, I set forth some recommendations for a more stable equilibrium and a better path to the digital transformation. I will suggest best practices and actions within the banking organizations and by banking supervisors as well as some ways to foster better working relationships among the professional silos. We should also be conscious that there are no innocents here. The organized bar and lawyers have been both too self-protective and asleep at the switch. Risk-management and compliance professionals have been aggressively engaging in the unauthorized practice of law. Supervisory staff have been poorly trained about our constitutional form of government and the rule of law and are happy to exclude those who might challenge their position of “inherent authority.” Risk and compliance professionals have their own institutional or self-interested incentives to limit the role of in-house lawyers both at meetings and in legal interpretation. Agency principals have not, until recently, been paying enough attention to the links among transparency, public accountability, democracy, and the role of lawyers for many years. It is not enough for agency principals to assert that they have really smart people working for them, which is certainly true, and therefore these really smart people will know to do the right thing, which history tells us is very much not true.
Within the Banking Organization
1. Independent Legal Department and General Counsel Reporting Lines
There should be a recommitment to an independent and well-resourced legal department, with an explicit general counsel reporting line to the board as well as the CEO. There should be a clear tone from the top that the general counsel and the legal department have the appropriate stature, budget, and resources. It has long been accepted as a best practice, at least in theory, that the general counsel reports directly to the CEO and to the board, and that the legal department is an independent control function. In the United States, in-house lawyers are full members of the bar, have passed at least one bar exam, are regulated and licensed by the appropriate state bar, and subject to ethics obligations. In practice, however, it is easy to fall into a path of passively undermining the independence of the legal department and the general counsel by viewing it primarily as a cost center and not as the manager of legal risk, and by limiting its technological resources and budget. Moreover, the stature of the legal department is passively undermined when it is not made clear that the general counsel has a dotted reporting line to the board and that she and her delegates are solely responsible for the reporting on legal risks to the board. It is not appropriate, for example, for other functions to report on legal risk to the board. It is an unintended consequence of the federal banking regulators’ focus on the independence, stature, and budget of the risk function and the separate compliance function that legal departments, by comparison, have been diminished. It would be better if boards made this clear as part of their oversight of risk governance.
2. Tighter Coordination Among Risk, Legal, and Compliance
There should also be a renewed commitment to tighter coordination among legal, risk, and compliance functions, with a clear view that although there may be many regulatory readers, only the legal department and the general counsel can make the ultimate legal judgements.[34] This tighter coordination should also involve more legal oversight and supervision of outside consultants and technology vendors hired by risk and compliance, who are providing advice that is mischaracterized as “regulatory advice” but which actually involves legal interpretation and judgment not supervised by lawyers. A new equilibrium should be established that acknowledges the existence of multiple regulatory readers but that also makes clear that there are not coequal, multiple poles of legal interpreters within the organization. The right answer for complex legal risk and legally infused reputational risks is not that any person who can read and Google can assess legal risk. Another path to a solution is tighter coordination among legal, risk, and compliance both on the alignment of interpretive views as well as the hiring of outside vendors and consultants who are regulatory readers. There should be a reaffirmation of the important principle that although there quite appropriately may be many regulatory readers, only the legal department and the GC can make the ultimate legal judgments. This tighter coordination also should involve more legal department input, and sometimes supervision of, the “regulatory advice” that is infused with legal interpretations and provided by outside consultants and vendors to risk and compliance, and greater coordination of the budgets so that outside consultants and vendors are not duplicating work by internal legal and outside lawyers.
Within the Banking Supervisors
The supervisory staff at the banking agencies have grown to mistrust and dislike lawyers and the in-house legal function, whether at a banking organization or within their own agency. With the increase in the complexity and intensity of the legal framework, the move to compliance with law examinations, and the coming wave of digital transformation, a reset is necessary. Many of the banking supervisors’ concerns are mitigated by strengthening, not weakening, the banking organization and agency in-house legal department.
1. Tone at the Top
The principals of the banking agencies should communicate a clearer tone from the top about the rule of law, due process, and data-driven evidence. Many of the current principals are both lawyers and banking supervisors and are in an excellent position to help bridge the professional and cultural silos that have developed.
2. Strengthen the Agency Legal Divisions
The critical shortage of lawyers within the banking agencies as well as the relative lack of budget and resources for the agency legal departments has exacerbated the problem of mistrusting lawyers. Wherever the happy medium between the lawyer-driven and economist-driven agencies should be, there is no doubt that the banking agencies suffer from a shortage of legal services. A side effect of this internal shortage of legal staff is that the supervisory staff has no choice but to publish guidance and take decisions about compliance with law examinations or matters requiring attention without sufficient access to their own legal advice.[35]
Better Communication and Training
Another side effect is the lack of training for supervisory staff on the legal framework. Training on the legal framework has been nonexistent or devolved to the regions.[36] As set forth below, cross-professional silo training is a key to finding a solution. I have previously written about how the hierarchy of the legal framework can be misunderstood by the many regulatory readers and even some digital native lawyers.[37] There should be a commitment to appropriately train all nonlawyer personnel, vendors, and consultants who are regulatory readers.[38] Basic training should be implemented to help regulatory readers understand the hierarchy of authority within the legal framework, the basic legal interpretive principles, the risks associated with free internet legal sources, including material available on agency websites, and when to consult an experienced lawyer. It does not take three years of law school to get the basics.[39] The medical profession has long accepted the need for nurses and other assistants. The key difference is that when the nurse gives us an injection, we know that he has been trained to do so. In the clash of the silos among risk, compliance, supervisory, consultants, and legal professionals, however, that lesson has been lost. Legal interpretation is not like normal reading, and knowing how to read is not enough to interpret the law. A clear understanding of the hierarchy of the legal framework and the basics of legal interpretive canons is needed. There is no reason not to widely share this knowledge. The rise of risk management and compliance has even led to college majors in this area. Strikingly, descriptions of college majors in compliance mention accounting, economics, and statistics but nothing about the law. Popular trade association certifications for risk and compliance professionals contain little or minimal training on the law.[40]
The legal profession has not helped itself by its lack of focus on basic legal training for nonlawyers. Just as lawyers who enter the corporate world need basic training in accounting without becoming CFAs, those who work in risk and compliance need a better understanding of the legal framework. More cross-silo training is urgent for the digital transformation. Many nonlawyers believe that if only the legal rules were clearly known, all will be well in transforming them into augmented intelligence. That will be true for those legal rules that are clear, but for the many legal norms that are deliberately ambiguous and which balance social and economic trade-offs, natural language and augmented intelligence will not be the advance that so many believe.
By the Legal Profession
Recalling the SEC’s appearing and practicing rules, and even worse, the OTS’s early 1990s aggressive foray against Kaye Scholer, many lawyers take the view that it is better that the federal banking regulators do not, as they do with risk and compliance, attempt any direct regulation of legal departments.[41] It is also the case that lawyers, at least in the United States, are directly regulated by state bar requirements with binding professional ethics obligations and do not need an additional federal regulatory overlay. There is a naivety in this belief, and lawyers, including the organized bar, must be aware that continuing to ignore the growing regulatory trends is hurting them rather than helping them.[42] If in-house lawyers do not define themselves, they will be defined by others in the organization who have every incentive to push the contradictory lines that “lawyers are not special” or that lawyers are limited to advocacy. In reality, the exercise of legal judgement is special, and lawyers are not limited to advocacy. That said, the argument that lawyers are “special” can be taken too far.
Conclusion: Toward a Peace Treaty
The current situation of mutual mistrust, diminishment of the in-house legal function, silence by the organized bar, and lack of training in the legal framework for supervisory staff as well as lack of understanding of the basic principles in risk management by lawyers must stop. It is time for a peace treaty. That means more cross-training, more conversations to understand the other professional silos, and more working together within the organization, not less. The time to do so is now because the next step is augmenting basic legal interpretation by algorithms. If we are not doing it properly in human brains, how will the algorithms know, and who will train them? We need to fix the situation now.
* Margaret E. Tahyar is a partner in Davis Polk’s Financial Institutions Group. The author wishes to thank all of her many colleagues who have commented on this article, most especially the in-house lawyers and agency and supervisory staff, in particular Tyler X. Senackerib, who helped with the research for this piece. This article reflects the views of the author and does not necessarily reflect the views of Davis Polk & Wardwell LLP. All errors and any sentences that cause any person to take offense are solely the fault of the author.
[1]See Thomas C. Baxter, Jr., The Rise of Risk Management in Financial Institutions and a Potential Unintended Consequence—The Diminution of the Legal Function, Bus. L. Today, Apr. 2, 2019.
[2] Emma Cueto, ‘Age of the CLO’ Sees Counsel’s Influence Expand: Report, Law360, Jan. 30, 2019.
[3] Tom Baxter has also made this point. See Baxter, supra note 1.
[4] Michael Barr, Howell Jackson, & Margaret Tahyar, Financial Regulation: Law and Policy Ch. 1, 8 (2d ed. 2018).
[5] Office of the Comptroller of the Currency, Comptroller’s Handbook: Corporate and Risk Governance (July 2016); Proposed Guidance on Supervisory Expectation for Boards of Directors, 82 Fed. Reg. 37,219 (Aug. 9, 2017).
[7]See, e.g., U.S. Department of Justice, Criminal Division, Evaluation of Corporate Compliance Programs (Apr. 2019); Office of the Comptroller of the Currency, Comptroller’s Handbook: Consumer Compliance (June 2018); Consumer Compliance Examinations—Compliance Management System, FDIC Consumer Compliance Examination Manual (June 2019).
[8] The three lines of defense was created by the U.K. auditing profession and designed to bolster the role and independence of internal auditors. Soon after the financial crisis, it was adopted by the U.K. supervisors and enthusiastically embraced by internal auditors, risk management, and others outside of the legal profession who were, quite understandably, trying to enhance the reputation and professionalism of their skillsets.
[9] Proposed Guidance on Supervisory Expectation for Boards of Directors, 82 Fed. Reg. 37,219 (Aug. 9, 2017).
[10] OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches; Integration and Regulations, 79 Fed. Reg. 4,282, 4285 (Jan. 27, 2014).
[11]Comment Letter in Response to OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches; Integration and Regulations, American Bankers Association, Financial Services Roundtable, SIFMA and the Institute of International Bankers (Mar. 24, 2014).
[12] Indeed, some have begun to question the utility of the lines of defense, and there is now a greater reliance on the senior management regime. IIA Launches Global Review of ‘Three Lines of Defense,’ The Institute of Internal Auditors (Dec. 5, 2018). The Federal Reserve’s more recent proposed management effectiveness guidelines, which do not use the three lines of defense, illustrate this trend. Proposed Guidance on Supervisory Expectation for Boards of Directors, 82 Fed. Reg. 37,219 (Aug. 9, 2017).
[13] The literature is vast. Two of the very best are: Ben Heineman, The Inside Counsel Revolution: Resolving the Partner-guardian Tension (2016); Thomas C. Baxter, Jr. & Won B. Chai, Enterprise Risk Management Where Is Legal and Compliance?, The Banking L. J. (Jan. 2016).
[14] Lawyers are by and large still a self-regulated profession, although there are some federal agencies that regulate lawyers in limited ways. For example, the SEC implemented regulations governing the professional conduct of attorneys who appear and practice before the agency. 17 C.F.R. § 205 et seq. In contrast, accountants are regulated in many ways by the SEC through its oversight of the Financial Standards Accounting Board, which promulgates U.S. generally accepted accounting principles, and the Public Company Accounting Oversight Board, which oversees the audits of public companies.
[15] A hodgepodge of certifications are available for compliance and risk professionals, most of which are offered by for-profit industry trade groups. Although there are a few exceptions, the certifications are generally based on past work experience and passing a multiple-choice exam that is often based on online study materials without any live instruction or training. Many of the programs attempt to describe the relevant laws and regulations, but they provide light to nonexistent training on the overall legal framework or legal reading. Margaret E. Tahyar, Legal Interpretation is Not Like Reading Poetry—How to Let Go of Ordinary Reading and Interpret the Legal Framework of the Regulatory State (2019).
[16] There is vast, confusing, and irrelevant literature comparing the in-house legal function to that of outside law firms. The role of independent outside counsel does not mean that the internal legal department does not play a role within the corporation as independent as that of the risk function and the compliance function.
[17] Even in 2018, around 61 percent of financial institutions reported plans to increase their compliance budget, and 46 percent of large banks planned to grow the size of their compliance staff. Beecher Tuttle, Compliance Hiring and Pay to Increase, but Not Everyone Will be Winning, eFinancial Careers, June 29, 2018. This increase seems to have swung too far, and many banking organizations are now looking to automate many of these processes in the coming years.
[18]See Randall D. Guynn, A Case for Full Model, Scenario and Results Transparency in the Federal Reserve’s Stress Testing Process, Presentation at Stress Testing: A Discussion and Review, Federal Reserve Bank of Boston (July 9, 2019).
[19] Rory Van Loo, Regulatory Monitors, 119 Columbia L. Rev. 369 (2019).
[20]See William H. Simon, The Kaye Scholer Affair: The Lawyer’s Duty of Candor and the Bar’s Temptations of Evasion and Apology, 23 L. & Soc. Inquiry 243 (1998). As a result, there is a body of consultants, many of them former supervisors, who advise banking organizations on examination responses.
[21] On both the agency and banking organization sides, this trend raises serious compliance issues due to the unauthorized practice of law.
[22] To be fair, some of these complaints, such as those relating to conflicts, should be leveled solely at outside counsel, not the agency lawyers or in-house counsel who have only one client.
[23] Franz Kafka’s writings, such as The Castle, in which a man attempts to establish residency and work in a village only to be subject to a barrage of mysterious and impenetrable administrative decisions by the bureaucrats in the local castle, have given rise to the use of the phrase “Kafkaesque” to describe bureaucracies that are labyrinthine in their processes and unpredictable and incomprehensible in their decision-making.
[24] The Star Chamber was a court established in 15th-century England. By the time of its abolition in 1641, the Star Chamber had become infamous as a tool of political oppression and deeply arbitrary decisions.
[25] David Brooks, The Lawyers Who Did Not Break, N.Y. Times, Feb. 21, 2019.
[26] Some of that increase in budget and resources is not called into question, but fundamentally what is happening is a recalibration and automation. Legal department budget and resources are still far behind risk management and compliance.
[27] The legal trade press is full of articles by in-house counsel calling upon law firms, themselves thinly capitalized, to develop legal technology, but the technology needed by an in-house legal department and that used by a law firm to provide more efficient advice to a company would be different. The technology budget at J.P. Morgan is approximately $11.4 billion. Michelle Davis, Dimon Sounds a Cautious Note as JPMorgan Prepares for Recession, Bloomberg, Feb. 26, 2019. The largest law firm in the United States had revenues of $3.76 billion in 2018. Ben Seal, The 2019 Am Law 100: Gross Revenue, Am. Law., Apr. 23, 2019. This mismatch speaks volumes about the false consciousness of the legal trade press. Its call is more a result of the lack of appropriate resources for the legal department than any realistic hope that law firms will create the technology.
[28] Margaret E. Tahyar, Legal Interpretation is Not Like Reading Poetry—How to Let Go of Ordinary Reading and Interpret the Legal Framework of the Regulatory State, Bus. L. Today, July 24, 2019.
[29] One area of concern is the maintenance of a regulatory inventory or regulatory change management. In some banking organizations, it is run by compliance, and lawyers play a secondary role, if they are involved at all. The wiser banking organizations have created structures where legal and compliance collaborate.
[32]Memorandum regarding Bank Regulators’ Legal Authority to Compel the Production of Material That Is Protected by Attorney-Client Privilege, Cleary Gottlieb Steen & Hamilton LLP; Covington & Burling LLP; Davis Polk & Wardwell LLP et al. (May 16, 2018).
[33] Office of the Comptroller of the Currency, Comptroller’s Handbook: Litigation and Other Legal Matters (Version 1.1, Dec. 2018).
[35] Former banking agency staff have informed the author that supervisory guidance in the last few years has frequently been issued with no review by agency lawyers.
[36] Richard K. Kim, Patricia A. Robinson & Amanda K. Allexon, Financial Institutions Developments: Revamping the Regulatory Examination Process, Wachtell, Lipton, Rosen & Katz (Nov. 26, 2018).
[37] Tahyar, Legal Interpretation is Not Like Reading Poetry—How to Let Go of Ordinary Reading and Interpret the Legal Framework of the Regulatory State, Bus. L. Today, July 24, 2019.
[38]See Guidance, Supervisory Expectations, and the Rule of Law: How Do the Banking Agencies Regulate and Supervise Institutions?, Hearing Before the United States Senate Committee on Banking, Housing, and Urban Affairs, Statement of Margaret E. Tahyar (April 30, 2019).
[39]See id. The author began her legal career as a paralegal after taking a paralegal certificate course of several weeks.
[40] For example, the American Bankers Association Certified AML and Fraud Professional requirements do not cover basic understanding of the legal framework or legal reading. The materials for the privacy specialist certification are a jumble on the legal framework.
[41] In the early 1990s, the then-OTS froze the assets of Kaye Scholer after a disagreement about advocacy in the examination context. Michael Barr, Howell Jackson & Margaret Tahyar, Financial Regulation: Law and Policy Ch. 8 (2d ed. 2018).
[42] Thomas C. Baxter, Jr., The Rise of Risk Management in Financial Institutions and a Potential Unintended Consequence—The Diminution of the Legal Function, Bus. L. Today, Apr. 2, 2019.
Regardless of one’s own views on the matter, the Trump Administration has introduced an altered geopolitical landscape for international relations and international law. Many call this the “Trump Effect,” referring to the gravity of the intended and unintended effects on the international community of this particular change in control of the U.S. executive branch.
International business disputes, often found at the intersection of international trade, commerce, and development, are not immune from these effects. This article briefly examines three areas where the Trump Administration’s approach to foreign policy and international relations is changing the ways in which international business disputes arise and may be resolved.[1]
1. The WTO: Systemic Stressors and Future Viability
The Trump Administration’s impact on international trade (and underlying business opportunities) cannot be minimized. In light of recent U.S. import restrictions under Section 232 of the Trade Expansion Act of 1962, several World Trade Organization (WTO) Member States have asserted claims against the United States before the WTO’s Dispute Settlement Body.[2] The U.S. defense is premised on the idea that these disputes are “non-justiciable,” as the measures relate to national security under Article XXI of the General Agreement on Tariffs and Trade 1994 (GATT 1994).[3]
The Russia – Measures Concerning Traffic in Transit Panel Report, issued in April 2019, became the first WTO decision interpreting Article XXI of GATT 1994. It rejected the Trump Administration’s non-justiciability argument.[4] This decision limits Member States’ range of defenses before the WTO and allows for more scrutiny of their actions, which may impact Member States’ commitments to the Dispute Settlement Body specifically, and the WTO generally.
Separately, the Trump Administration has blocked efforts to fill vacancies on the Dispute Settlement Body’s Appellate Body. Indeed, it has been more than two years since the Appellate Body has had a full roster of seven members.[5] Continued vacancies, with only three seats currently filled, exacerbate delays and make it impossible for the Appellate Body to issue reports by the required deadlines.[6] While this development impacts only appellate review of disputes, it certainly causes concern regarding the WTO’s future viability. Without action, by December 10, 2019, the terms of two further Appellate Body Members will expire and only one seat in the Appellate Body will be occupied. It will become impossible for the Appellate Body to function, as a minimum of three panel members are required to hear an appeal.[7]
Already Member States are developing work-arounds. At the end of July, Canada and the European Union issued a joint statement confirming that they had agreed to an Interim Appeal Arbitration Arrangement to resolve WTO disputes at the appellate level.[8] Recently, the European Commission announced a mandate reflecting its interest in extending the interim arbitration arrangement to other interested third-parties.[9] The arrangement aims to develop a parallel ad hoc system for dispute resolution, permitted under Article 25 of the WTO’s Understanding on Rules and Procedures Governing the Settlement of Dispute, but it has not previously been tested and is only a temporary solution to a systemic challenge.
2. From NAFTA to USMCA: A New Era in Regional Investor-State Dispute Settlement
The North American Free Trade Agreement (NAFTA) has been in effect for 25 years, enabling a free-trade zone between the economies of the United States, Canada, and Mexico. When it was negotiated, it was universally heralded for providing regional foreign investors (and the Member States in which they invest) with a benchmark for rights and obligations.[10] In particular, the Investor-State Dispute Settlement (ISDS) mechanism of Chapter 11, which allows foreign investors to assert claims against other Member States under certain conditions, was key to its success.
In October 2018, President Trump collaborated with his Canadian and Mexican counterparts to unveil the U.S.-Mexico-Canada Agreement (USMCA).[11] From a trade and economic perspective, the resounding view is that not much has changed.[12] From an ISDS perspective, USMCA’s Chapter 14, focused on resolution of investment disputes, reflects noteworthy shifts.[13]
In contrast with NAFTA, the proposed USMCA no longer adopts a “balanced” approach to rights and obligations among the three Member States. Indeed, Canada has withdrawn from Chapter 14 entirely. Its consent for legacy claims will expire three years after NAFTA’s termination (a currently undetermined date).[14] ISDS survives for the benefit of American and Mexican investors, but the types of disputes investors may pursue (and the procedural means to do so) have been changed, and certain elements are now dependent on national identity:
First, investors (i.e., prospective claimants) are now required to litigate claims “before a competent court or administrative tribunal of the respondent.”[15] Claimants must litigate until a “final decision from a court of last resort,” or, alternatively, 30 months have elapsed since local court proceedings were initiated.[16] There is an exception to this local litigation requirement “to the extent recourse to domestic remedies was obviously futile or manifestly ineffective.”[17] This scheme is accompanied by a four-year concurrent statute of limitations for asserting any treaty claim.[18]
Second, USMCA provides an “asymmetrical” fork-in-the-road provision.[19] If, during local court proceedings, an American investor alleges a breach of the USMCA itself (as opposed to a breach of Mexican law), this will bar any right to arbitration under Chapter 14 of the USMCA.[20] The USMCA does not contain a parallel provision for Mexican investors, thereby altering the scope of an investor’s rights based solely on nationality.
Finally, investors may only pursue claims concerning (a) direct (but not indirect) expropriation,[21] (b) violations of national treatment,[22] or (c) violations of the USMCA’s Most Favored Nation (MFN) provision.[23] There is a carve-out for MFN claims concerning “the establishment or acquisition of an investment.”[24] This is a departure from the approach of similar provisions in other investment agreements.
Further ISDS rights are available for claims concerning government contracts in several highly regulated sectors (including energy, telecommunications, transportation, and infrastructure).[25] They allow investor-claimants to pursue claims for violations of the minimum standard of treatment under customary international law, indirect expropriation, and the establishment or acquisition of an investment.[26]
Although leaders of all three Member States signed the USMCA at a ceremony in fall 2018, the treaty will not be binding until it is ratified domestically by each of them. Unsurprisingly, in June, Mexico became the first Member State to ratify the USMCA.[27] Compared to the other Member States, Mexican law provides for the shortest path for ratification and Mexico generally has been a very strong proponent of the USMCA.[28] Canada and the United States, on the other hand, have both initiated the ratification process and progress is expected during the upcoming months. Following ratification by the remaining two Member States, U.S. businesses with investments and business activities in Mexico will be better able to assess the impact on their rights.
3. U.S. Sanctions: Extraterritorial Application, Complexity in Compliance, and Increased Risks
The use of Office of Foreign Assets Control (OFAC) sanctions to implement U.S. foreign policy is not new, and U.S. businesses working abroad (including their foreign subsidiaries) are accustomed to complying with these laws. But the Trump Administration has increased the breadth of these sanctions and also increased OFAC’s enforcement efforts. In just the past few months, new sanctions targeting Venezuela, Russia, and Nicaragua have been introduced.[29] This is apart from the broad sanctions which continue to target Iran, now with greater force and complexity.
In May 2018, the Trump Administration announced its withdrawal from the Joint Comprehensive Plan of Action (JCPOA).[30] This is a change from the policy adopted by other P5+1 partners (China, France, Russia, the United Kingdom, and Germany), which remain committed to the 2015 agreement, which seeks to limit Iran’s nuclear activities in exchange for sanctions relief.[31] At initial review, the U.S.’s departure from JCPOA is not significant; even during its participation in JCPOA, the comprehensive U.S. embargo against Iran remained in place with very limited exceptions. U.S. persons remained prohibited from doing business with Iran or its government.
The impact on businesses is clear when examined from an international compliance perspective. During the Obama Administration, the U.S., E.U., and other allies cooperated to align their sanctions on common targets to create coherence and maximize impact (an example is the JCPOA). The Trump Administration adopts a unilateral approach toward sanctions, which creates divergence in both the timing and substance of global sanctions measures. This has caused the E.U. to expand the scope of its blocking regulation to prohibit E.U. companies from complying with U.S. secondary sanctions that target Iran.[32]
Secondary sanctions target foreign individuals and entities for engaging in enumerated activities that may have no U.S. jurisdictional nexus. The goal is to inhibit non-U.S. citizens and businesses abroad from doing business with a target of primary U.S. sanctions.[33] Violation of secondary sanctions by a non-U.S. entity can cause it to be subject to various sanctions by the U.S. government. Although OFAC provided 90- and 180-day wind-down periods, those periods have now expired, and the Trump Administration has signaled that it will fully enforce the sanctions now in effect.[34] This creates challenges for international businesses which must comply with both U.S. and E.U. law. Further challenges concerning available claims and defenses may emerge in the future as these businesses encounter disputes related to their international activities.
Conclusion
At the moment, it is difficult to discern whether businesses working internationally are faring better or worse than they have under past U.S. administrations. However, at the very least, businesses today may need to look to different fora and mechanisms to protect their investments and advance their rights. Separately, businesses may be exposed to increased or different risks than they may have experienced under the Obama Administration. These shifts make for a dynamic and evolving environment that should be closely monitored by international business litigators and dispute resolution specialists.
[1] This article draws upon themes discussed during a program at the ABA Section of International Law’s Annual Conference this past spring, chaired and moderated by the author (see Farshad Ghodoosi, Kiran Nasir Gore, Mélida Hodgson, Ting-Ting Kao & M. Arsalan Suleman, Panel Presentation at ABA Section of International Law Annual Conference: The Trump Effect on the Future of Global Dispute Resolution (Apr. 10, 2019)). All opinions expressed here are exclusively the author’s and should not be attributed to any of her fellow panelists or any organizations/firms with which they are affiliated.
[2] Challenges have been brought by China, India, the European Union, Canada, Mexico, Norway, Russia, Switzerland, and Turkey. Several other countries have joined these disputes as Third Parties.
[7] The international community has begun speculating how, without action to ensure a functional Appellate Body, the WTO may continue to oversee and adjudicate trade disputes going forward. See generally Pauwelyn above.
[14] A “legacy investment” is defined as “an investment of an investor of another Party in the territory of the Party established or acquired between January 1, 1994, and the date of termination of NAFTA 1994, and in existence on the date of entry of force of this agreement.” USMCA, Annex 14-C (Legacy Investment Claims and Pending Claims), Art. 6(a).
[15]Id., Annex 14-D (Mexico-U.S. Investment Disputes), Art. 14.D.5 (Conditions and Limitations on Consent).
[21] “Direct expropriation” occurs when “an investment is nationalized or otherwise directly expropriated through formal transfer of title or outright seizure.” Id., Annex 14-B (Expropriation), Art. 2.
[22] “National treatment” means “treatment no less favorable than that it accords, in like circumstances, to its own investors with respect to the establishment, acquisition, expansion, management, conduct, operation, and sale or other disposition of investments in its territory” Id., Art. 14.4.1 (National Treatment).
[23] An MFN claim arises when a State’s treatment of an investor is “less favorable than the treatment it accords, in like circumstances, to investors of any other Party or of any non-Party with respect to the establishment, acquisition, expansion, management, conduct, operation, and sale or other disposition of investments in its territory” Id., Art. 14.5.1 (Most-Favored-Nation Treatment).
[24]Id., Annex 14-D (Mexico-U.S. Investment Disputes), Art. 14.D.3 (Submission of a Claim to Arbitration), Art. 14.D.3 (Submission of a Claim to Arbitration), note 22.
[25]Id., Annex 14-E (Mexico-U.S. Investment Disputes Related to Covered Government Contracts), Art. 6.
[32]Council Regulation (EC) No. 2271/96 (Nov. 22, 1996), protecting against the effects of the extraterritorial application of legislation adopted by a third country, and actions resulting therefrom.
Good representation of business clients, both large and small, requires solutions through all of a businesses’ life-cycle including financial distress. It is not unusual for counsel (or other business advisors) to deal with liquidity challenges resulting in an inability to make tax payments that may ultimately culminate in a visit from the Internal Revenue Service (“IRS”). This article provides guidance on how to identify and address tax issues regularly confronted by vulnerable businesses.
Resolving Tax Issues with the Internal Revenue Service
As the revenue collection arm of the United States government, the IRS possesses many powerful tools to secure payment for taxes owed. The IRS has established procedures to assist taxpayers in paying their unpaid taxes in arrears in recognition that voluntary compliance maximizes revenue collection.
To collect a tax debt, the IRS must first establish a payment right – known as an “assessment.” Pursuant to 26 U.S.C. § 6201 (Title 26 of the United States Code is hereinafter referred to as the “IRC”) the IRS is “authorized and required to make the inquiries, determinations, and assessments of all taxes (including interest, additional amounts, additions to the tax, and assessable penalties)….” Taxes are generally assessed through two methods (a) deficiency procedures under IRC § 6212 (concerning generally, income taxes and estate and gift taxes) or (b) automatic assessment (otherwise referred to as a non-deficiency assessment). The primary difference between a deficiency and non-deficiency assessment is the taxpayer’s right to petition the United States Tax Court (“Tax Court”) for redetermination of deficiency assessments without prepaying the tax that is due.
Under the deficiency assessment process, the IRS must send a Statutory Notice of Deficiency (“SND”) to the taxpayer. The SND provides the taxpayer 90 days to petition the Tax Court for redetermination of the tax. If the taxpayer does not file a timely petition with the Tax Court, the assessment becomes final and the IRS then moves the case to collect from the delinquent taxpayer. A timely Tax Court petition, however, suspends collection only for the tax periods under protest until the case is resolved.
Where an assessment is not subject to deficiency procedures (such as a payroll or excise taxes), the tax is due when assessed. IRC § 7421(a), known as the “Anti-Injunction Act,” requires that, except for certain statutory exceptions, the taxpayer must pay the tax and file a lawsuit seeking a refund in order to obtain redetermination of the assessment. Such refund lawsuits must be brought in U.S. District Court or the Court of Federal Claims. Once the assessment becomes final and all appeals are exhausted, the IRS Collections Division will use whatever means available to procure payment.
Collection Alternatives for Taxpayers
The IRS divides unpaid tax payers into three broad categories of “collection alternatives,” for taxpayers to resolve their debts: (a) offers in compromise (“OIC”), (b) installment agreements (“IA”) and (c) currently not collectible status (“CNC”). An offer in compromise is an agreement by the government to accept less than full payment on a tax debt. An installment agreement permits the taxpayer to pay its tax debt over time. Currently not collectible status means the taxpayer cannot pay his or her debt and collection activities will be suspended, but the government may seek to collect the debt if the taxpayer’s situation changes. Each collection alternative is available to business and individual taxpayers.
Whether a taxpayer will qualify for a collection alternative depends on the reasonable collection potential of that taxpayer “RCP”. RCP is a defined formula that looks at the taxpayer’s current assets and future income to assess reasonable collection potential. The principal way in which the IRS obtains the taxpayer’s information is through a financial statement— Form 433A for individuals, and Form 433B for businesses. The financial statement provides the IRS with detailed information concerning the taxpayer’s income, expenses, assets and liabilities. Income producing assets may be retained by the taxpayer, but the IRS will ordinarily require the liquidation of non-income producing assets.
Offer in Compromise: The government will enter into an offer in compromise on a tax debt if the RCP demonstrates doubt about the collectability of the taxes . If the RCP provides that the taxpayer has sufficient income to satisfy in full the tax debt over the 10-year statute-of-limitations for collection, then the IRS will not enter into an offer in compromise with the taxpayer.
With regard to a business and evaluation of its assets, the IRS will consider whether it can extract greater collection if the business continues operations (resulting in an “in-business Offer in Compromise”); or whether the IRS can obtain more immediate recovery from shutting down the business and liquidating its assets. Before proceeding, a business taxpayer considering the propriety of an Offer in Compromise must first determine the value of its income producing assets,.
A taxpayer may elect to pay the amount due on the OIC in two ways; either a lump sum where the taxpayer pays 20% of the settlement amount at the time of filing the OIC and the remainder in no more than five installments following acceptance of the OIC, or in monthly deferred payments over two years, starting when the OIC is filed, not upon acceptance. A taxpayer must remain in tax compliance during the pendency of the OIC and for five years thereafter, or the OIC will be retroactively rejected, and the IRS may collect the full (pre-OIC) debt owed. Upon completion of the OIC, any federal tax liens will be withdrawn. Also, assets liquidated in the three years prior to making an OIC (known as “dissipated assets”) can be included in the RCP, if not used for income producing purposes.
Installment Agreements: Installment agreements (“IA”) come in two forms: (a) full pay and (b) partial pay. Under a general installment agreement, the taxpayer must pay off in full its obligation within the permissible number of months based on the income portion of his or her financial statement. Thus, if the taxpayer owes $100,000 and the RCP shows the taxpayer can pay $5000 per month, the installment agreement must be completed within 20 months.
Where a business taxpayer owes less than $25,000, and the debt can be paid within 48 months, the IA will be automatically accepted without the need to submit a financial statement. These so-called “streamlined installment agreements” may be processed on-line. For individuals, the IRS will automatically accept IA’s to pay less than $50,000 over 72 months. The IRS has also extended a pilot program that allows most individual taxpayers with less than $100,000 of back taxes to pay the IRS over 96 months without submitting a financial statement.
The IRS is generally flexible in working out longer term installment agreements for good cause shown. However, a federal tax lien will be filed to protect the government’s position. The IRS will also accept installment agreements that increase the payments over time or where the main payment is deferred to allow for a specific event, such as the sale of property or the liquidation of assets.
Partial Pay Installment Agreements: Where the RCP calculation provides that a taxpayer is unable to pay in full the taxes prior to the expiration of the statute of limitations on collection (which is 10 years following the assessment becoming final) the IRS can accept an installment agreement for the RCP-specified amount even if the payments will not fully pay the tax. This “partial pay installment agreement” (“PPIA”) ends when the collection statute expires. PPIAs are of particular interest to taxpayers who are not OIC candidates because their monthly income renders an OIC beyond their means (due to the requirement that the OIC be completed in no more than 2 years). For example, the taxpayer who shows the ability to pay $500 per month would be required to offer $24,000 for a deferred payment OIC (48 months multiplied by $500). If the statute of limitation has only 2 years left, that same taxpayer may be a candidate for a PPIA because of his or her ability to pay the same $500 per month over the remaining life of the statute, but only have to pay $12,000.
Currently Not Collectible Status: If it would be a hardship for the taxpayer to make payments on their tax debt, the taxpayer (including businesses) may be placed in “currently not collectible” (“CNC”) status. This does not mean that the tax debt is discharged.
The taxpayer must request CNC status by submitting a financial statement. The IRS will ask for updated financial statements every six to twelve months to verify the tax payer’s financial condition. Further, the IRS can unilaterally reinstitute collections. Notice will be afforded prior to doing so and the taxpayer will be entitled to request a new collection alternative. One benefit of CNC status is that the statute of limitation on collections continues to run.
Employment Taxes
Payroll tax proceeds constitute a key component of federal revenue. The IRS Data Book states that more than 50% of federal revenue is derived from payroll deducted taxes. Because of the importance of this revenue stream, both the Department of Justice Tax Division and the IRS have repeatedly stated that payroll tax liabilities will be subject to stricter civil and criminal compliance and enforcement actions.
IRC § 6672 allows the IRS to recover “trust funds” withheld from an employee’s pay from “any person required to collect, truthfully account for, and pay over any tax imposed” and “who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof.”
The “trust fund” portion of employment taxes is comprised of 7.65% of the Social Security and Medicare tax withheld from an employee’s pay and any income tax withheld from the employee’s pay. The employer is deemed to be holding these funds in trust for the U.S. Government. The penalty is referred to as a “100% penalty” which means that the entire amount can be recovered against anyone determined to be a “responsible person” who willfully fails to collect and pay over such tax. Trust fund taxes do not include the employer’s matching obligations.
A “responsible person,” including owners, managers, lenders, and creditors, can be held liable for a business’ failure to remit trust fund taxes. The term “responsible person” is broad, encompassing anyone responsible for collecting, accounting and paying over taxes to the government. All responsible persons are jointly and severally liable for the unpaid tax. SeeMcCray v. U.S., 910 F.2d 1289 (5th Cir. 1990).
To be personally responsible for a trust fund liability, a third-party must have willfully failed to collect and pay over the trust funds. Willfulness exists where “money withheld from employees as taxes, in lieu of being paid over to the Government, was knowingly and intentionally used to pay the operating expenses of the business, or for other purposes.” Revenue Ruling 54-158. Thus, if a corporate decision maker chooses to pay vendors instead of the IRS, he/she can be held liable for the unpaid trust fund taxes.
Cancellation of Debt Income Issues
Cancellation of debt (“COD”) income occurs when an asset is written down, foreclosed, surrendered, or a debt obligation is restructured. This is frequently a surprise to the taxpayer, who never considered the debt written off as “income.” When the taxpayer is unable to pay the tax on the debt forgiveness, it becomes an IRS collection case.
When dealing with COD income issues, taxpayer representatives should confirm that the creditor has in fact cancelled the debt. Unless the creditor has actually cancelled the debt, the taxpayer does not have COD income. Discharge of a personal guarantee of business debt does not generally trigger COD income to the guarantor.
There are a number of exceptions to the general rule that the cancellation of a debt gives rise to taxable income which provide relief for taxpayers and excuse them from realizing income. IRC § 108(a) lists five exceptions to the COD income rules. These include: the discharge occurs in a bankruptcy case, the discharge occurs when the taxpayer is insolvent, the indebtedness discharged is qualified farm indebtedness, the indebtedness discharged is qualified real property business indebtedness (for taxpayers other than a “C” corporation), or the indebtedness discharged is qualified principal residence indebtedness that is discharged on or after January 1, 2007 and before January 1, 2014.
One of the key elements to the Bankruptcy Code is the idea of granting honest debtors a “fresh start” free from the crushing debts they were carrying. A critical component of “fresh start” is not to have “income” recognized from the discharge of debts in a bankruptcy case. The avoidance of the COD income oftentimes makes a bankruptcy filing preferable to negotiating a reduction in a taxpayer’s debts with their creditors.
In analyzing the COD income issues, IRC § 108 tests bankruptcy at the shareholder level for corporations (both C and S corporations) and at the partner level for partnerships (including LLCs). Thus, even if an LLC is in bankruptcy, the COD income it recognizes flows through to the members and, unless the members are also in bankruptcy, the COD income must be recognized. Conversely, for S-corporations (which are pass-through entities), the S-corporation’s COD income will not flow through to the shareholders.
Under IRC § 108(a)(1)(B), taxpayers may avoid COD income to the extent the taxpayer was insolvent immediately before the discharge. To measure insolvency, the taxpayer’s total liabilities, just before the date the debt was discharged, are subtracted from the value of its assets (including exempt taxes), also valued on the date before the debt was discharged. The taxpayer can exclude from income the amount of the COD equal to the amount to which it is insolvent. This “insolvency exception” is important for parties that have not filed bankruptcy.
Where COD income is excluded from gross income by IRC § 108(a), the unrecognized COD income reduces tax attributes, such as net operating loss (“NOL”) carry forwards. A taxpayer may also make an election under IRC § 108(b)(5), to apply excluded COD to reduce basis in depreciable property; this election, however, cannot be used to reduce basis below zero.
Bankruptcy Specific Issues
Dischargeability: Income taxes owed by a business are dischargeable to the same extent as they are for individuals. Therefore, so long as the tax return was due more than three years prior to the petition date (including extensions), the tax return was in fact filed more than two years prior to the petition date, and there have been no additional assessments within the 240 days prior to the petition date, federal income taxes may be discharged. If tax returns have been belatedly filed for corporations, state income taxes may be determined to be nondischargeable under rulings in the First, Fifth and Tenth Circuits. It is important to remember, certain events may toll these period.
Under Chapter 11 of the Bankruptcy Code (Title 11 of the United States Code, hereafter the “Bankruptcy Code”), nondischargeable tax debts must be repaid within five years of the petition date. Any chapter 11 plan of reorganization must contain a provision ensuring that applicable tax debts are repaid within the applicable time frame, plus statutory interest. Therefore, businesses with significant tax debts should make immediate provisions to begin the repayment process or be faced with large plan obligations. Where a business is a pass-through entity (partnership, LLC or S-corporation) the income tax obligations will be recognized at the equity holder level.
Creditor Trusts: Trusts are frequently used as the vehicle to pursue any further recoveries for creditors under confirmed plans of reorganization or liquidation. Instead of finishing up the business of the debtor in possession through a confirmed plan using a trust vehicle, structured dismissals are becoming more prevalent as a “confirmation alternative.” Generally, a “structured dismissal” results in a sale of substantially all of the debtor’s assets, a settlement amongst the key players, and some claims resolution process followed by distributions. Where distributions to creditors will be deferred (i.e. due to payoff of a buyer’s note or resolution of litigation), it is necessary to establish a creditors’ trust to manage the post-dismissal assets. It is not possible to establish a liquidating trust in a dismissal scenario because Rev. Proc. 94-45 (the IRS ruling that establishes a safe harbor for liquidating trusts) requires that the trust be implemented through the plan and disclosure statement process. See Rev. Proc. 94-45.01.
Such “non-qualified creditors trusts” will be taxed as business trusts. If taxed as a corporation, the entity would have to pay taxes and file a tax return (Form 1120). If taxed as a partnership, the tax effects would continue to flow through to the creditor/owners, but the treatment would be different than under the trust rules. The entity would then file a tax return (Form 1065 – unless it is treated as a disregarded entity where there is only one creditor/owner). The arrangement may be taxed as a complex trust and would be responsible for taxes (IRC § 641) and must file a tax return (Form 1041). Bankruptcy lawyers crafting resolution alternatives that include trusts must consider these issues.
Conclusion
The IRS possesses powers no other creditors have. When a tax deficiency arises it can wreak havoc on a business’ ability to operate, or restructure. The IRS (and most state taxing authorities) can be flexible in resolving tax issues. However, practitioners must act early, know the correct questions to ask their clients, provide information in a manner that the governmental authorities can use, and understand the limitations of governmental tax resolution programs.
The Delaware legislature recently adopted amendments to the Delaware Revised Uniform Limited Partnership Act (DRULPA) that permit the “division” of Delaware limited partnerships (LPs), formation of “statutory public benefit” LPs, judicial cancellation of an LP for abuse, and formation of LP “registered series.”[1] Those amendments are in most respects similar to amendments adopted in 2018 to the Delaware Limited Liability Company Act (DLLCA).[2] In addition, the recent amendments have, among other things, made Delaware corporations’ use of e-mail for stockholder notices valid except as to stockholders who opt out (thus switching from the prior opt-in regime) and clarified the law regarding the use of electronic transmission and electronic signatures under the DRULPA, the DLLCA, and the General Corporation Law of the State of Delaware (DGCL). Except as otherwise indicated, all of the amendments discussed below took effect on August 1, 2019.
DRULPA Amendments Corresponding to 2018 DLLCA Amendments
The DLLCA was amended last year to permit the division of limited liability companies (LLCs), the formation of statutory public benefit LLCs, judicial cancellation of an LLC for abuse or misuse, and, effective August 1, 2019, the formation of LLC registered series. Now analogues of those provisions have been added to the DRULPA by the 2019 amendments.
Division
The division provisions enable an LP to “divide” into multiple LPs and to allocate its assets and liabilities among those LPs without thereby effecting a transfer for purposes of Delaware law.[3] The LP undertaking the division (termed the “dividing partnership”) may, but need not, survive the division.[4] If it does not survive, the dividing partnership is not deemed by default to have dissolved as a result of the division, but instead simply ceases to exist as a separate entity.[5] The terms of the division must be set forth in a “plan of division,” which shall include, among other things, the terms (if any) on which interests in the dividing partnership will be canceled or converted into interests in another entity or the right to receive cash, and how the assets and liabilities of the dividing partnership will be allocated in the division.[6] A division is effectuated by the dividing partnership’s filing of a certificate of division with the Delaware secretary of state and the simultaneous filing of a certificate of limited partnership for each LP formed in the division.[7]
Presumably because general partners of LPs are not afforded limited liability, division of an LP requires the approval of any person that, upon the effectiveness of the division, will be a general partner of any LP formed by or surviving the division.[8] In addition, a division requires, by default, the approval of all general partners of the dividing partnership and a majority-in-interest of its limited partners.[9] Any action pending against a general partner of a dividing partnership at the time of its division will be unaffected by the division and may be maintained not only against that general partner, but also against any general partner of any LP to which an asset or liability associated with the pending action is allocated in the division.[10]
The 2019 amendments have also made some changes affecting the LLC division provision adopted in 2018. First, the amendments have clarified that a certificate of division must be filed by the LLC undertaking the division (the dividing company), as opposed to any entity formed in the division.[11] Second, it now appears that, in the absence of fraud, the allocation of liabilities under the plan of division will determine the identity of the defendant LLC or LLCs in the continuation, post-division, of an action that was pending against the dividing company at the time of its division.[12] Third, the amendments have added language providing that in a division, members may be admitted to an LLC formed by or surviving the division, in accordance with the operating agreement of such LLC or the plan of division.[13] Provisions parallel to these DLLCA amendments were included in the DRULPA amendments respecting division.[14]
Statutory Public Benefit LPs
Like the 2018 DLLCA amendments permitting the formation of statutory public benefit LLCs (SPB-LLCs), the 2019 amendments to the DRULPA now permit the formation of statutory public benefit LPs (SPB-LPs).[15] The SPB-LP provisions generally track those adopted last year regarding SPB-LLCs.[16] An SPB-LP is a “for-profit” LP that is “intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.”[17] Its certificate of limited partnership must state in the heading (but not necessarily in the SPB-LP’s name) that it is an SPB-LP and must “set forth one or more specific public benefits to be promoted” by the SPB-LP.[18] For purposes of an SPB-LP, a public benefit is “a positive effect (or reduction of negative effects) on one or more categories of persons, entities, communities or interests (other than partners in their capacities as partners) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”[19]
The general partners of an SPB-LP are obligated to manage it “in a manner that balances the pecuniary interests of the partners, the best interests of those materially affected by the limited partnership’s conduct, and the specific public benefit or public benefits set forth in its certificate of limited partnership.”[20] Importantly, however, the amendments, by default, insulate the general partners of an SPB-LP from monetary damages for the failure to manage its affairs in accordance with that duty.[21] Moreover, no general partner shall have a duty, by virtue of the statutory public benefit provisions, “to any person on account of any interest of such person in the public benefit or public benefits set forth in its certificate of limited partnership or on account of any interest materially affected by the limited partnership’s conduct[.]”[22]
Judicial Cancellation
Judicial cancellation of an LP upon motion by the Delaware attorney general is now provided for in new section 17-112 of the DRULPA, which tracks section 18-112 added to the DLLCA in 2018.[23] Under section 17-112, if the attorney general so moves, the Delaware Court of Chancery may cancel an LP’s certificate of limited partnership “for abuse or misuse of its limited partnership powers, privileges or existence.”[24] In the event of a cancellation under section 17-112, the Court of Chancery is empowered, “by appointment of trustees, receivers or otherwise, to administer and wind up the affairs” of the LP, and to “make such orders and decrees with respect thereto as shall be just and equitable respecting its affairs and assets and the rights of its partners and creditors.”[25]
Registered Series
The DRULPA and the DLLCA have permitted the establishment of series of assets, interests, and partners or members, as the case may be, since 1996.[26] Both acts also specify certain conditions that, if met, will cause the assets associated with a given series to be shielded from claims of creditors against other series or against the entity as a whole.[27] In the case of an LP, a general partner associated with a given series could be similarly shielded from claims against other series or the LP itself.[28] Under the DRULPA and the DLLCA as amended, such shielded series are now termed “protected series.”[29]
Amendments to the DLLCA adopted in 2018, but not effective until August 1, 2019, enable LLCs to establish registered series, which constitute “registered organizations” under Article 9 of the UCC.[30] Thus, unlike the case with nonregistered series (including protected series), an Article 9 security interest in most types of assets of a registered series can be perfected simply by filing a UCC financing statement with the Delaware secretary of state, regardless of where the series’ principal place of business may be located. It is important to note, however, that a registered series will not have the shielding characteristics of a protected series unless the LLC complies with the notice and other requirements for shielding set forth in the DLLCA.[31]
The 2019 amendments have added comparable provisions to the DRULPA, effective August 1, 2019, allowing LPs to form registered series.[32] An LP registered series is formed by filing, with the Delaware secretary of state, a certificate of registered series, which must contain the name of the LP, the name of the registered series, and the name and address of each general partner associated with the registered series.[33] The registered series’ name must begin with the full name of the LP,[34] and at least one general partner must be associated with each registered series.[35]
An LP registered series, like an LLC registered series, can be dissolved independently, can merge with another registered series of the same entity, can be revived if it loses good standing, and can convert into a protected series of the same entity.[36] (Series conversion can also be from protected to registered.[37]) For each registered series of an LP, an annual tax of $75 must be paid to the state.[38]
As with divisions, the 2019 amendments have also made some changes affecting the LLC registered-series provisions adopted in 2018. These include amendments clarifying that references in the DLLCA to “members” and “managers” include members and managers associated with a series,[39] and confirming that any shielding characteristics a protected or registered series may have will not be lost solely because a different registered series has failed to pay its annual tax in Delaware.[40] Provisions parallel to these DLLCA amendments are included in the DRULPA amendments respecting registered series.[41]
Notice Provided by Corporations to Stockholders by E-mail
The provisions of the DGCL that pertain generally to the means by which a corporation may give notice to stockholders have been substantially revised and reorganized. The most important aspect of these changes affects the default rules governing notice to stockholders by electronic means. Before the 2019 amendments, the DGCL provided that notice to a stockholder by electronic transmission was effective only if the stockholder had consented to receive notice in the form in which it was given.[42] The amendments have reversed this rule insofar as it applied to e-mail. Now a corporation may give effective notice to a stockholder by “electronic mail” unless the stockholder has opted out.[43] In addition, to be effective, notice by e-mail “must include a prominent legend that the communication is an important notice regarding the corporation.”[44]
“Electronic mail” is defined as “an electronic transmission directed to a unique electronic mail address” and is “deemed to include any files attached thereto and any information hyperlinked to a website if such electronic mail includes the contact information of an officer or agent of the corporation who is available to assist with accessing such files and information[.]”[45] An “electronic mail address” is “a destination, commonly expressed as a string of characters, consisting of a unique user name or mailbox . . . and a reference to an internet domain . . . , to which electronic mail can be sent or delivered.”[46]
A stockholder who wishes to opt out of receiving notice by e-mail may so notify the corporation either in writing or by electronic transmission directed to the corporation.[47] In addition, as was the case before the 2019 amendments, notice by any form of electronic transmission, including e-mail, will not be deemed effective if the person responsible for giving notice has become aware that two consecutive notices sent by electronic transmission could not be delivered.[48] However, that person’s inadvertent failure to discover that the notices were undeliverable will not “invalidate any meeting or other action.”[49] Notice by means of electronic transmission other than e-mail (e.g., by posting on an electronic network) continues to be ineffective unless consented to by the stockholder.[50]
Notice by e-mail is deemed given when it is “directed” to the stockholder’s e-mail address.[51] The amendments further specify that notice delivered by courier service is deemed given upon “the earlier of when the notice is received or left at such stockholder’s address[,]” and (as was formerly provided in DGCL section 222(b)) notice by mail is deemed given when it is “deposited in the U.S. mail, postage prepaid[.]”[52]
Delivery of Stockholder Consents to the Corporation
The 2019 amendments also afford additional flexibility to corporations in how stockholder consents may be delivered. Under prior law, a stockholder consent by electronic transmission was not deemed delivered to the corporation until it had been printed out and delivered in paper form, unless the corporation’s board of directors provided by resolution for another means of delivery. The amendments have retained paper delivery as the default, but also provide that a stockholder consent by electronic transmission is deemed delivered “when the consent enters an information processing system, if any, designated by the corporation for receiving consents, so long as the electronic transmission is in a form capable of being processed by that system and the corporation is able to retrieve that electronic transmission[.]”[53]
Importantly, a corporation’s designation of an “information processing system” for the receipt of stockholder consents may be determined not only from the certificate of incorporation and bylaws, but also “from the context and surrounding circumstances, including the conduct of the corporation.”[54] In addition, a stockholder consent by electronic transmission is deemed delivered “even if no person is aware of its receipt.”[55]
Acting by Electronic Means
The DGCL, the DRULPA, and the DLLCA (together, the Entity Acts) have been amended to provide greater specificity about how electronic transmission and electronic signatures may be used in taking actions under the Entity Acts or organic entity documents.
Before the 2019 amendments, the Entity Acts already permitted the use of “electronic transmission” for multiple purposes, such as stockholder, member, or partner consents and proxies.[56] In addition, since its adoption in Delaware on July 14, 2000, the Uniform Electronic Transactions Act (DUETA) has provided for the use of “electronic records” and “electronic signatures” generally in business and government transactions.[57] The provisions in the Entity Acts regarding electronic transmission were not as thorough as those in the DUETA, however, whereas the DUETA—which “does not apply to a transaction to the extent it is governed by” the Entity Acts[58]—left unclear just when an Entity Act “governed” a transaction such that the DUETA was displaced.
The 2019 amendments to the Entity Acts have clarified when electronic means such as those permitted by the DUETA will be effective under the Entity Acts. Central to these amendments is an entirely new section added to each of the Entity Acts.[59]
These new sections contain general authorization for the use of electronic transmission and electronic signatures in entity actions or transactions, subject to important statutory exceptions summarized below and any restrictions expressly set forth in the organic entity documents.[60] Respecting electronic transmission, “[a]ny act or transaction contemplated or governed by” the applicable Entity Act or the relevant organic entity documents may “be provided for in a document, and an electronic transmission shall be deemed the equivalent of a written document.”[61] The definition of “electronic transmission” in each Entity Act has remained unchanged by the 2019 amendments. Specifically, an electronic transmission is “any form of communication, not directly involving the physical transmission of paper, . . . that creates a record that may be retained, retrieved and reviewed by a recipient thereof, and that may be directly reproduced in paper form by such a recipient through an automated process.”[62]
Respecting electronic signatures, the new sections provide that whenever a signature is required or permitted by the applicable Entity Act or the relevant organic entity documents, “the signature may be a manual, facsimile, conformed or electronic signature.”[63] “Electronic signature” is defined as “an electronic symbol or process that is attached to, or logically associated with, a document and executed or adopted by a person with an intent to authenticate or adopt the document.”
The new sections also specify safe-harbor conditions under which an electronic transmission will be deemed “delivered” for purposes of the applicable Entity Act and the relevant organic entity documents.[65] Specifically, unless “the sender and recipient” agree otherwise (or in the case of an LP or LLC, its operating agreement provides otherwise), the electronic transmission is deemed delivered to a person “when it enters an information processing system that the person has designated for the purpose of receiving electronic transmissions of the type delivered, so long as the electronic transmission is in a form capable of being processed by that system and such person is able to retrieve the electronic transmission.” Whether a recipient has designated an information processing system for purposes of this safe harbor depends upon the entity’s organic documents and “the context and surrounding circumstances, including the parties’ conduct.”[67] Finally, the new sections provide that a person need not be “aware” of the receipt of an electronic transmission for it to be deemed delivered under the safe harbor, and that an “electronic acknowledgement” from an information processing system “establishes that an electronic transmission was received” but not that the content received “corresponds to” what was sent.
As mentioned above, the new sections contain exceptions to their broad authorization of the use of electronic transmission and electronic signatures. Accordingly, that authorization does not apply to documents filed with any Delaware court or governmental body, including the office of the secretary of state; certificates of stock or of partnership or LLC interests; or acts under provisions that address registered agents in Delaware, foreign entities, or commencement of suits against entities or their fiduciaries.[69] Also excluded from coverage specifically under the DGCL are certain documents that may take electronic form pursuant to other sections, such as notices to stockholders and director and stockholder consents.[70]
Conforming changes have been made to other sections of the Entity Acts, generally eliminating language that is now surplusage or that could be interpreted as prohibiting the use of electronic transmission for certain actions.
Communications-Contact Information Now Required When a Registered Agent Resigns
Since 2006, every Delaware corporation, LP, and LLC has been required to provide to its registered agent in Delaware (but not to the state) “the name, business address and business telephone number of a natural person . . . who is then authorized to receive communications from the registered agent.”[71] Such person is known as the “communications contact” for the entity. Pursuant to the 2019 amendments, the Entity Acts now provide that when a Delaware registered agent resigns without appointing a successor registered agent for any affected entity, the information the resigning registered agent must provide to the secretary of state shall include the communications-contact information last provided to the registered agent by the entity.[73] Such information, however, “shall not be deemed public.”
Additional Amendments to the Entity Acts
The DRULPA and the DLLCA expressly permit LP and LLC operating agreements and merger agreements to afford “contractual appraisal rights” respecting interests in LPs or LLCs in the event of certain transactions, including mergers, conversions, and transfers of the entity; operating-agreement amendments; and sales of all or substantially all of the entity’s assets.[75] The 2019 amendments have confirmed that appraisal rights may also be made available in connection with divisions, mergers of registered series, and conversions of registered series to protected series (or the reverse).[76]
In connection with corporate mergers, stockholders seeking appraisal of their shares may now deliver appraisal demands by electronic transmission “if directed to an information processing system (if any) expressly designated for that purpose” in the corporation’s notice of appraisal rights.[77] Delivery of a written stockholder demand, however, remains the default.[78]
The DGCL’s requirement that a merger agreement be signed by corporate officers has been loosened. As a result of the 2019 amendments, a merger agreement may now be signed by any person who has been authorized to do so if (as is typically the case) a certificate of merger is filed with the secretary of state in lieu of filing the merger agreement itself.[79] Although textual changes in this regard were made only to DGCL sections 251 (merger of Delaware stock corporations) and 255 (merger of Delaware nonstock corporations), cross-references in other sections cause the amended signature requirement to apply also to mergers between Delaware and non-Delaware corporations, stock and nonstock corporations, and corporations and LLCs or partnerships.[80]
The provisions of the DGCL permitting a board of directors to act by unanimous written consent have been amended to remove the implication that a board consent was not effective until it had been filed with the board minutes. Although the amendment did not change the requirement that a board consent be filed with the minutes, the consent’s effective time no longer depends on such filing.[81]
In 2014, the DGCL was amended to permit director and stockholder consents to be made effective as of a future time, including upon the happening of a future event, “whether through instruction to an agent or otherwise[.]”[82] Similar amendments now make clear that the action taken by incorporators to organize a newly formed corporation may also be taken by means of a future-effective consent.[83] A future-effective consent may now be used as well for an organizational action by the corporation’s initial board of directors if the initial directors are named in the certificate of incorporation,[84] although an initial board was presumably already permitted to do so under the 2014 amendments.
Finally, the amendments have removed the implication that a nonprofit corporation could not be revived if its certificate of incorporation was declared forfeited because the corporation did not have a registered agent.[85] This was already clear as to for-profit corporations (under DGCL section 312), but the prior wording of DGCL section 313(a) implied that a nonprofit corporation could be revived only if it was void for failure to file its annual franchise tax report.
[1] Norman M. Powell and John J. Paschetto are partners in the Business and Tax section of Young Conaway Stargatt & Taylor, LLP, and Tammy L. Mercer is a partner in the firm’s Corporate Litigation and Counseling section. The views expressed in this article are those of the authors and are not necessarily those of any organization with which any of them is affiliated.
[2] The 2018 amendments to the DLLCA authorizing division, statutory public benefit companies, judicial cancellation, and registered series are described in detail in the September 2018 Delaware Transactional & Corporate Law Update.
[7]Id. § 17-220(h). The certificate of division may provide that it will be effective at a specific future date and time. If so, each certificate of limited partnership filed in the division must also provide that it will be effective at that date and time. Id. § 17-220(i).
[13]Id. § 18-301(b)(4). The plan of division will control in the event that its terms conflict with the terms of an operating agreement respecting the admission of members in a division. Id.
[14] 6 Del. C. §§ 17-220(h), (l)(9), 17-301(b)(4).
[43]Id. § 232(a). The legislative synopsis accompanying the amendments explains that, as regards to notices given pursuant to the DGCL or a corporation’s certificate of incorporation or bylaws, “no provision of the certificate of incorporation or bylaws (including any provision requiring notice to be in writing or mailed) may prohibit the corporation from giving notice in the form, or delivering notice in the manner, permitted by Section 232(a).” Del. S.B. 88 syn. § 11, 150th Gen. Assem. (2019).
[45]Id. § 232(d). Pursuant to the quoted text, the contact information of an officer or agent of the corporation must be supplied if an email notice is to be deemed to include attached files, not just hyperlinked information. Id.
[56] 8 Del. C. §§ 212(c)(2) (stockholder proxies), 228(d)(1) (stockholder consents); 6 Del. C. §§ 17-302(e) (limited partner consents and proxies), 17-405(d) (general partner consents and proxies), 18-302(d) (member consents and proxies).
[59] 8 Del. C. § 116 (for corporations); 6 Del. C. §§ 17-113 (for LPs), 18-113 (for LLCs).
[60] 8 Del. C. § 116(a) (for corporations); 6 Del. C. §§ 17-113(a) (for LPs), 18-113(a) (for LLCs). The legislative synopsis accompanying the amendments for each of the Entity Acts emphasizes that any restrictions contained in organic entity documents regarding the use of electronic transmission and electronic signatures must be “expressly stated” to be effective. “A provision merely specifying that an act or transaction will be documented in writing, or that a document will be signed or delivered manually, will not prohibit” application of the broad authorization contained in DGCL § 116(a), DRULPA § 17-113(a), and DLLCA § 18-113(a). Del. S.B. 88 syn. § 2, 150th Gen. Assem. (2019) (DGCL amendments); Del. S.B. 89 syn. § 7, 150th Gen. Assem. (2019) (DRULPA amendments); Del. S.B. 91 syn. § 4, 150th Gen. Assem. (2019) (DLLCA amendments).
[61] 8 Del. C. § 116(a)(1) (for corporations). See also 6 Del. C. §§ 17-113(a)(1) (for LPs), 18-113(a)(1) (for LLCs).
[62] 8 Del. C. § 232(d) (for corporations). See also 6 Del. C. §§ 17-101(4) (for LPs), 18-101(5) (for LLCs).
[63] 8 Del. C. § 116(a)(2) (for corporations); 6 Del. C. §§ 17-113(a)(2) (for LPs), 18-113(a)(2) (for LLCs).
[64] 8 Del. C. § 116(a)(2) (for corporations); 6 Del. C. §§ 17-113(a)(2) (for LPs), 18-113(a)(2) (for LLCs). The definition of “electronic signature” in the Entity Acts is broadly similar to the definition in the DUETA, i.e., “an electronic sound, symbol or process attached to or logically associated with a record and executed or adopted by a person with the intent to sign the record.” 6 Del. C. § 12A-102(9).
[65] 8 Del. C. § 116(a)(3) (for corporations); 6 Del. C. §§ 17-113(a)(3) (for LPs), 18-113(a)(3) (for LLCs).
[66] 8 Del. C. § 116(a)(3) (for corporations); 6 Del. C. §§ 17-113(a)(3) (for LPs), 18-113(a)(3) (for LLCs). The conditions for when an electronic transmission is deemed delivered under the Entity Acts are substantively similar to the conditions for when an “electronic record” is “received” under the DUETA. See 6 Del. C. § 12A-115(b).
[67] 8 Del. C. § 116(a)(3) (for corporations); 6 Del. C. §§ 17-113(a)(3) (for LPs), 18-113(a)(3) (for LLCs).
[68] 8 Del. C. § 116(a)(3) (for corporations); 6 Del. C. §§ 17-113(a)(3) (for LPs), 18-113(a)(3) (for LLCs). Similar provisions are contained in the DUETA. 6 Del. C. § 12A-115(e)-(f).
[69] 8 Del. C. § 116(b) (for corporations); 6 Del. C. §§ 17-113(b) (for LPs), 18-113(b) (for LLCs).
[70] 8 Del. C. §§ 232 (notice to stockholders), 141(f) (director consent), 228(d) (stockholder consent).
[71] 8 Del. C. § 132(d) (for corporations); 6 Del. C. §§ 17-104(g) (for LPs), 18-104(g) (for LLCs).
[72] 8 Del. C. § 132(d) (for corporations); 6 Del. C. §§ 17-104(g) (for LPs), 18-104(g) (for LLCs).
[73] 8 Del. C. § 136(a) (for corporations); 6 Del. C. §§ 17-104(d) (for LPs), 18-104(d) (for LLCs).
[74] 8 Del. C. § 136(a) (for corporations); 6 Del. C. §§ 17-104(d) (for LPs), 18-104(d) (for LLCs).
[75] 6 Del. C. §§ 17-212 (for LPs), 18-210 (for LLCs).
[79]Id. §§ 251(b) (merger between Delaware stock corporations), 255(b) (merger between Delaware nonstock corporations).
[80]Id. §§ 252 (merger between Delaware and foreign stock corporations), 254 (merger between corporation and joint-stock association), 256 (merger between Delaware and foreign nonstock corporations), 257 (merger between Delaware stock and nonstock corporations), 258 (merger between Delaware and foreign stock and nonstock corporations), 263 (merger between corporation and partnership), 264 (merger between corporation and LLC).
Learn more at the meeting of the ABA Business Law Section’s Legal Analytics Committee in Washington, D.C. from 8:00 a.m. to 10:00 a.m. on September 13th.
“Software is eating the world,” renowned venture capitalist Marc Andreessen observed in 2011. “Over the next 10 years, I expect many more industries to be disrupted.” Sure enough, an important theme in the decade-long, post-recession economic expansion has been “disruption,” with nimble, venture-backed upstarts upending mature industries, from real estate to retail and finance.
One sector, however, has proven largely resilient to Silicon Valley’s Schumpeterian narrative. Years of “lackluster” investment in legal technology, or LegalTech, have led to the “conventional wisdom” that investors have “no interest” in the space. However, a growing confluence of factors—adoption by industry leaders, a maturing innovation ecosystem, and increasingly available venture funding—suggest that LegalTech may finally be nearing its long-sought inflection point.
Over the last decade, venture capital activity has expanded, paralleling the growth of the rapidly-scaling companies VC investment supports. As shown below, in 2018, U.S. VC firms invested over $136 billion—up fivefold from 2009—across nearly 10,000 transactions. Average transaction values rose to almost $14 million in 2018, double the 2014 figure.
A well-documented theme has been data-driven optimization of mature industries that have historically underutilized technology—e.g., transportation, office rentals and television. More recently, financial services—a complex, competitive and intricately-regulated industry—has seen a surge of activity. According to CB Insights data, in 2018, global FinTech investment exceeded $40 billion; the sector boasts 39 “unicorns,” which are companies valued at over one billion-dollars each; collectively they are worth $147.4 billion.
In contrast, for myriad reasons, LegalTech investment volume and performance “as a whole, has been more-or-less disappointing.” To put that in perspective, between 2009 and 2019, the global LegalTech sector (as defined below) raised an aggregate $8.9 billion—about $400 million less than the $9.3 billion Uber raised in a single January 2018 round.
Estimates of LegalTech’s market size and investment trends vary considerably based on how one defines the space, which encompasses a broad range of products and services across the legal value chain, including analytics, research, case management and marketplaces. The analysis below aims to provide a macro view of global investment trends in LegalTech and, correspondingly, uses an intentionally broad definition, encompassing companies applying technology to law as well as compliance.[1]
In 2010, investors expressed growing interest in LegalTech, committing $700 million to the space, more than double 2009 investment levels. However, a relatively slow adoption curve—particularly compared to other sectors—disappointed the market, largely muting activity between 2011 and 2016.
Somewhat ironically, the drop-off in LegalTech investment coincided almost perfectly with the “tipping point” in LegalTech company formation around 2010 and 2011, shown below at left. Growth was particularly robust in data-intensive sub-sectors, such as legal analytics and document automation, which have been buttressed by development of essential technologies like machine learning, AI, and natural language processing. At the same time, as shown below at right, LegalTech exits—overwhelmingly through M&A (in blue) rather than IPOs (in orange)—have been steadily increasing. 2018 saw nearly 200 liquidity events and 2019 is well on track to exceed that.
LegalTech Company Formation
Investment Exits (Global)
Venture capital investment in LegalTech renewed in 2017, and 2019 is on track to be a record year for both investments and exits. Past ebbs notwithstanding, the confluence of a large total addressable market, increasing demand, a growing value proposition, and favorable venture markets provide powerful tailwinds to support the sustainability of LegalTech investment.
First, LegalTech has the potential to disrupt significant parts of a large and profitable space, thus far largely untouched by technology. In 2016, U.S. legal service revenues totaled $437 billion; average AMLaw100 margins typically exceed 40%. At the same time, the sector chronically underinvests in technology—spending, by some measures, ten times less than financial firms—thus remaining “persistently stuck in the 90s.” Together, these conditions suggest a particularly target-rich environment for disrupters across large parts of the legal value chain.
Second, LegalTech is benefitting from a robust, secular shift in demand. This has been particularly notable in the B2B space, with forward-thinking law firms embracing technology as a logical competitive advantage. The pressure to maintain margins in a highly competitive environment is also likely to encourage investment in efficiency enhancements. Correspondingly, law firms have started LegalTech innovation labs, venture capital arms, and development partnerships.
Third, technological innovation and business model maturation have increased LegalTech’s value proposition in both the B2B and B2C spaces. For instance, on the B2C side, innovative companies like Atrium provide viable substitutes for legal services; on the B2B end, platforms like Clio help optimize firm operations. This maturation has benefitted considerably from a growing legal innovation ecosystem, which includes law firms, along with in-house legal departments—e.g., Liberty Mutual’s “legal tech transformation”—and research hubs, like Georgia State’s Legal Analytics and Innovation Initiative.
Finally, venture market dynamics appear favorable for continued LegalTech investment. VC firms have raised increasingly large funds and as a result have record ‘dry powder’ available. At the same time, perception of the LegalTech space has been materially ‘de-risked’ following high-profile transactions by blue-chip investors, like Andreessen and Y-Combinator. Furthermore, the final chart below illustrates that LegalTech is still very much in its early innings, with 85% of investments at the seed or Series A stages and over 50% under $1 million. This nascency highlights LegalTech’s largely untapped potential for disruptive impact as well as outsized returns.
[1] Analysis based on Crunchbase Insights’ database. Methodologically, data set aggregates the following seven categories of legal and compliance-focused start-up companies: (i) internet Software & Services – legal; (ii) Internet Software & Services – compliance; (iii) Software (non-internet/mobile) – legal software; (iv) Software (non-internet/mobile) – compliance software; (v) mobile software & services, specific sub-industries – legal; (vi) mobile software & services, specific sub-industries – compliance; and (vii) Business products & services – legal services.
From the intersection of the gig economy, faster payments technology, and legislators’ failure to address the dearth of small-dollar credit options, there has emerged a new type of payment product that gives workers immediate access to their wages even if their next payday isn’t scheduled for another week or more. These products go by a number of names—wages-on-demand, advance wage payment, earned income access, wage-based and work-based advances—but all make it possible to deliver payments within minutes of a worker’s request. Studies tells us that many people live paycheck to paycheck, would not be able to cover an unanticipated expense of a few hundred dollars, and lack access to credit at reasonable rates. For these workers, immediate access to wages that have been earned but are not due to be paid can be an important benefit. Immediate access products are also popular with “gig workers” who drive for rideshare companies, deliver food and groceries, or perform other piecework tasks and who want to be paid immediately at the end of their shift.
At first glance these products may seem simple and straight forward, but they are in fact complex financial products that raise a number of novel legal issues. Because there are so many different business models in the marketplace, discerning the legal and operational framework of a particular service can be challenging. Without such information, business lawyers may have difficulty assessing the legal risks these new products posed to workers and employers. This article describes how these products work and identifies several potential legal issues that employers and financial institutions should be evaluate before participating in one of these programs.
How Do Wage Advance Products Work?
Wages advance products fall into two broad business models: direct-to-consumer and employer-integrated. In the direct-to-consumer model, the worker interacts directly with the provider who collects work history and other information from the consumer. The provider funds the advance and recoups it by debiting the worker’s bank account on the next payday. In the employer-integrated model, the employer markets the program to its workers and shares information on hours worked with the provider. The employer may also fund the advance and may assist in the collecting the advance through payroll deduction. Some programs charge a monthly “participation” fee while others assess a fee for each transaction. Frequently, there are multiple options for how quickly the employee may receive the advance, with the slower payment method (one to two days) having a lower or no fee and the faster payment method (a few minutes) being more expensive. The employee usually pays the fees but some providers allow the employer to subsidize some or all of the cost. There are a number of variations on these models, and providers describe their products in different ways. Some characterize the service as providing an advance of wages already earned, others as the purchase of an asset (future wages), and others as an assignment of wages. Employees and employers should review the details of any services they are considering to determine exactly what legal rights and obligations they are taking on.
Are Wage Advance Products An Extension of Credit?
A fundamental question raised by wage advance companies is whether the advances being provided are in fact loans governed by the federal Truth in Lending Act (TILA) or state lending laws. Some proponents of wage advance products argue that they are not forms of credit because they don’t charge interest (although they may charge fees or accept “tips”) or because there is no recourse against the employee except the wage deduction. One theory is that the use of a single payroll deduction as opposed to debiting a consumer’s a bank account prevents the provider from being deemed a “creditor” under TILA regulations. Critics of wage advance programs view them as an updated form of payday lending. Opponents are especially concerned about models in which the worker authorizes the provider to debit her bank account because such automatic withdrawals often lead to overdrafts which can subject the consumer to additional bank fees and penalties.
In its recent payday lending rule, the federal Consumer Financial Protection Bureau (CFPB) acknowledged that some wage advance services may not be providing a loan. CFPB states that there is a “plausible” argument that there is no extension of credit when an employer allows an employee to draw accrued wages ahead of a scheduled payday and then later reduces the employee’s wage payment by the amount drawn. The strength of the argument is increased when the employer does not reserve any recourse to recover the advance other than through payroll deduction. Unfortunately, the Bureau failed to provide more detailed guidance on how to determine which business models are covered by the lending rules and which are not. For wage advance products that do involve the provision of credit and thus are subject to the rule, CFPB carved out exemptions for services that meet certain requirements.
Even if a particular wage advance service is not a lender under federal rules, it may still be subject to regulation at the state level. The New York Department of Financial Services (NYDFS) recently announced a multistate investigation of allegations of unlawful online lending in the payroll advance industry with a dozen jurisdictions participating. NYDFS says the investigation will focus on whether companies are violating state banking, licensing, payday lending, and other consumer protection laws. The inquiry will look at whether wage advance programs collect usurious or otherwise unlawful interest rates, whether characterized as transaction fees, monthly membership fees, or “tips,” and whether collection practices generate improper overdraft charges for consumers. According to press reports, at least twelve wage advance providers received letters requesting information on their practices. The outcome of this investigation will, we hope, provide much needed clarity on the application of state lending law to the wage advance industry.
State Wage and Hour Issues
Wages-on-demand services must also comply with state wage and hour laws. A key question is whether a payment for hours worked, but for which wages are not due until a future date, should be categorized as a payment of wages earned or an advance of wages. If it is a payment of wages, then the employer has to withhold taxes and other deductions, ensure the funds are transferred via a permissible method of wage payment and potentially provide a detailed wage statement. If, on the other hand, the payment is as an advance of wages, then the employer must comply with wage advance and payroll deduction regulations. For example, in New York, an advance payment that assesses interest or charges a fee does not qualify as a “wage advance” and may not be reclaimed through payroll deduction.
Some business models have the employee assign some or all of their wages to the provider—a practice which may not be valid in all jurisdictions. Wage assignments are prohibited in some states and regulated to varying degrees in others. In California, for example, an assignment of wages to be earned is valid only if it is to pay for the “necessities of life.” Ohio limits the assignment of future wages to paying court-ordered spousal or child support. If the employee is married, a number of states require the spouse’s consent to the assignment. A provider may characterize the wage advance transaction as a sale of an asset in order to avoid the wage assignment issues. In a number of states, however, such a transaction is deemed to be a loan. In Alaska and Florida, for example, the sale of wages, earned or to be earned, is deemed to be a loan secured by an assignment of the wages and the amount the wages exceed the amount paid is deemed to be interest.
Employers offering payroll cards to their employees should make sure the wage advance product they choose is compatible with their card program. A number of states prohibit the payment of wages to a payroll card that charges a fee for the loading of wages to the account. In these jurisdictions, wage advance products that assess a transaction fee may be problematic. Other states prohibit payroll cards from linking to any form of credit, “including a loan against future pay or a cash advance on future pay.” Employers selecting a wage advance product need to be careful not to create problems for their employees who elect to be paid via payroll card.
California Considers Legislation to Regulate Wage Advance Providers
Given the uncertainty that surrounds wages-on-demand products under state law, some providers have sponsored legislation that would clarify the law in this area. For example, the California legislature is currently considering a bill, SB 472, which would authorize wage advances by qualified providers who register with the state and meet certain bonding and insurance requirements. Qualified providers could provide advances only on a non-recourse basis, be limited in debt collection activities and prohibited from reporting payment history to credit reporting agencies. The National Consumer Law Center (NCLC) initially said it would support the bill if the scope was limited to authorize only products that are integrated with the employer and to exclude any products that directly debit a consumer’s account. NCLC also advocated for tighter restrictions on fees and limits on usage. The legislation was amended in committee but not in the manner NCLC was seeking, and the organization now opposes the initiative. The bill is continuing to move forward in the legislature, but its fate is unclear.
The Future for Wage Advance Services
While wage advance services face some serious legal obstacles, the demand for such products amongst workers is high and employers are motivated to provide these services in order to keep their workforces happy. Business lawyers should expect to see significant legal and regulatory developments related to these products in the next year. The outcome of the pending multistate investigations should contribute to a better understanding of which business models are legally viable. Legislative and regulatory activity should also be expected and may significantly impact the service models available in the market.
Learn more about wage advance products and earn CLE credits at the ABA Business Law Section’s Annual Meeting in Washington, D.C.
Legal Issues Associated With Wages-on-Demand Products
Friday, September 13, 2:00-3:00 pm
Panelists: Alicia W. Reid, U.S. Bank
Abbie Gruwell, National Conference of State Legislatures
Limited liability companies went mainstream in 1988, began to capture the market for closely held businesses in 1997, and now have the lion’s share of that market. Since the advent of limited liability companies, a corporate-like liability shield, in addition to pass-through status under federal income tax law, has been one of two hallmarks of a limited liability company. Indeed, for many years courts have described the limited liability company as “a hybrid business entity [that] provides members with limited liability to the same extent enjoyed by corporate shareholders.”[1]
The LLC shield should therefore be easy to understand: a limited liability company shields its members in essentially the same way as a corporation shields its shareholders. Yet courts and practitioners still occasionally misunderstand the intended purpose and proper effect of the LLC shield.
The two poster children for this problem are Dass v. Yale,[2] a decision of the Illinois court of appeals, and SDIF Limited Partnership 2 v. Tentexkota, an action brought in federal district court in South Dakota.[3]Dass held that the LLC shield immunizes a member-manager for direct liability for the member’s own tortious conduct.[4] In Tentexkota, members of a South Dakota limited liability company sought to escape their personal guarantees of the LLC’s debt by arguing that the LLC liability shield invalidated the guarantees. The federal court rephrased the guarantors’ argument as a question and certified the question to the South Dakota Supreme Court.[5]
Both cases turned on what the relevant statutory language did not say. In Dass, the court noted that “the language of the [Illinois] LLC Act [had been] changed by removing language explicitly providing for personal liability,”[6] pointed out that “[g]enerally, a change to the unambiguous language of a statute creates a rebuttable presumption that the amendment was intended to change the law,” ignored the possibility that the deleted language had been redundant, and allowed the rebuttable presumption to override the plain meaning of the Illinois shield language. The defendants in Tentexkota argued that the South Dakota shield language should be interpreted as invalidating personal guarantees, in part because South Dakota had failed to revise its shield language (derived from the first Uniform Limited Liability Company Act) in accord with revisions made in 2006 by the Revised Uniform Limited Liability Company Act).[7]
Neither Dass nor Tentexkota are still at issue. This year, Illinois legislatively abrogated Dass,[8] and Tentexkota settled before the South Dakota Supreme Court answered the certified question.[9] However, the problem illustrated by these cases remains. Hence this article, which seeks “to make clear beyond peradventure”[10] the proper purpose and intended effect of the LLC shield.
The analysis is necessarily rooted in history and begins with sole proprietorship and ordinary general partnerships:
Fully understanding the LLC shield requires understanding owner liability in sole proprietorships and ordinary general partnerships, the two principal structures for doing business that predated the advent of corporations. In both these structures, owners are personally liable for the debts of the business merely on account of being an owner. It was the purpose of the corporation to negate that status liability[,] …. sever the relationship between owner status and personal liability[,]… andto do nothing else.[11]
From this perspective, two fundamental points are clear. As a matter of concept, the liability shield follows ineluctably from an entity’s status as a legal person separate and distinct from each and all the entity’s owners. Because in general one person is not responsible for the obligations of another, “[t]he ‘separate entity’ characteristic is fundamental to a limited liability company and is inextricably connected to … the liability shield.” ULLCA (2013) § 108(a), cmt.
In practical terms, the liability shield’s sole function is to negate the automatic “pass through” liability that owners once had for the obligations of their business. Thus, the shield has nothing to do with liability arising from a person’s own conduct in connection with an entity’s business—whether that person is an owner, a manager, an employee, an independent contractor, or otherwise.
Because the member or manager liability at issue is solely vicarious, the shield is irrelevant to claims seeking to hold a member or manager directly liable on account of the member’s or manager’s own conduct. Put another way, “[t]here is no question” that “the member-manager of a limited liability company who causes his business to breach common law and statutory duties may be held independently liable for his personal torts.”[12]
The official comments to ULLCA (2013) contain several examples of this proposition, including one applicable to law firms in particular:
EXAMPLE: A limited liability company provides professional services, and one of its members commits malpractice. The liability shield is irrelevant to the member’s direct liability in tort. However, if the member’s malpractice liability is attributed to the LLC under agency law principles, the liability shield will protect the other members of the LLC against a claim that they must make good on the LLC’s liability.[13]
Put another way:
A Tort Is a Tort Is a Tort—Being an agent does not immunize a person from tort liability. A tortfeasor is personally liable, regardless of whether the tort was committed on the instructions from or to the benefit of a principal. A tortfeasor cannot defend itself by saying, “Well, I did what I did to serve my principal.”[14]
Likewise, when a member makes a contract in the member’s own name, the member’s contractual obligations are outside the shield—even if the contract’s purpose is to benefit the company. For example: “A manager personally guarantees a debt of a limited liability company. [The liability shield] is irrelevant to the manager’s liability as guarantor.”[15]
One additional, very practical point warrants mention—namely, role liability.[16] “Provisions of regulatory law [both state and federal] may impose liability on a member or manager due to a role the person plays in the LLC.”[17] In some instances the liability results from conduct, in others from status or position (e.g., more than 10% of the existing ownership interests), in others from a combination.
In any event, when “role liability” is at issue, the LLC shield is inapposite, because the liability is not “of a limited liability company” and almost never arises “solely by reason of the member acting as a member or manager acting as a manager.”[18]
A New York case, Pepler v. Coyne, provides a good example. A limited liability company terminated an employee, the employee sued the company for unlawful termination on the basis of disability, and named the two manager-members of the company as individual defendants. When one of the member-managers (Coyne) invoked the LLC liability shield as a defense and moved to dismiss, the trial court granted the motion. The appellate court reversed:
Coyne’s contention that he is personally exempt from liability by virtue of [the LLC shield] is without merit. The general statutory exemption [under the LLC statute] from personal responsibility for an organization’s debts, obligations and liabilities does not extend to violations of [the anti-discrimination statute] by a person with an ownership interest in, [and] the power to make personnel decisions for, the organization. Thus, Coyne is amenable to liability upon proof that he became a party to Stone’s discriminatory termination of plaintiff “‘by encouraging, condoning, or approving it.’”[19]
Finally (though contrariwise), the corporate and the LLC shield may differ in one important respect—that is, whether disregard for “entity formalities” is grounds for disregarding the liability shield and “piercing the veil.” This topic is somewhat complicated, and a future column will discuss the issue in some detail. In the meantime, you can hear the topic discussed as part of a panel discussion at the ABA Business Law Section’s 2019 Annual Meeting in Washington, D.C. —“10 Things Corporate Lawyers Must Understand about How a Limited Liability Company is NOT a Corporation” (Thursday, September 12 from 2 to 3:30 PM, Salon 1, M2).
But otherwise, as per a decision of the 11th Circuit: “The limited liability company (LLC) is a … hybrid form of business entity that combines the liability shield of a corporation with the federal tax classification of a partnership.”[20] Thus, consistent with the LLC shield’s corporate law antecedents, the LLC shield’s proper purpose is to disallow purely status-based member liability for an LLC’s debts. The effect of the LLC shield should be limited accordingly.
[1] PacLink Commc’ns Int’l, Inc. v. Superior Court, 90 Cal. App. 4th 958, 963, 109 Cal. Rptr. 2d 436, 439 (2001) (quoting 9 Witkin, Summary of Cal. Law (2001 supp.) Corporations, § 43A, p. 346; internal quotation marks omitted).
[2] Dass v. Yale, 2013 IL App (1st) 122520, 3 N.E.3d 858.
[3] SDIF Limited Partnership 2 v. Tentexkota, LLC (U.S. Dist. Ct. S.D.) 1:17-CV-01002-CBK. The author was retained as an expert by the law firm representing the creditors.
[4] Dass v. Yale, 2013 IL App (1st) 122520, ¶ 28, 3 N.E.3d 858, 864. The South Carolina Supreme Court came very close to making the same error as the Illinois appellate court. In 2012, the Court concluded that the LLC liability shield “only protects non-tortfeasor members from vicarious liability and does not insulate the tortfeasor himself from personal liability for his actions.” but the two of the five justices dissented. 16 Jade St., LLC v. R. Design Const. Co., 398 S.C. 338, 349, 728 S.E.2d 448, 454 (2012). Opinion withdrawn and superseded on reh’g sub nom. 16 Jade St., LLC v. R. Design Const. Co., LLC., 405 S.C. 384, 747 S.E.2d 770 (2013). The superseding opinion decided the case on entirely different grounds, allowing the Court to “find it unnecessary to reach the novel issue of whether the LLC Act absolves an LLC member of personal liability for negligence committed while acting in furtherance of the company business.” 16 Jade St., LLC v. R. Design Const. Co., LLC., 405 S.C. 384, 390, 747 S.E.2d 770, 773 (2013).
[5] SDIF Ltd. P’ship 2 v. Tentexkota, LLC, No. 1:17-CV-01002-CBK, 2018 WL 6493160, at *1 (D.S.D. Dec. 10, 2018).
[6] Dass v. Yale, 2013 IL App (1st) 122520, 3 N.E.3d 858. The deleted language was: “A manager of a limited liability company shall be personally liable for any act, debt, obligation, or liability of the limited liability company or another manager or member to the extent that a director of an Illinois business corporation is liable in analogous circumstances under Illinois law.” Id. (quoting 805 ILCS 180/10–10(b) (West 1996)). For a more detailed discussion of Dass, see Steven G. Frost, Jeff Close and Joe Lombardo, Dass v. Yale: Members and Managers of an Illinois LLC Are Not Liable for Their Tortious Conduct, J. Passthrough Entities (May-June 2014) 31-37.
[7] Brief of Defendants to S.D. Sup. Ct., at 10. The Defendants’ Brief cited and relied on Dass. Brief at 2, 12,13.
[8] Ill. Public Act 101-0553, amending 805 ILCS 180/10-10 by adding a new Section 10-10(a-5). The new section refers specifically to Dass and a tort-related case which Dass cited: “The purpose of this subsection (a-5) is to overrule the interpretation of subsections (a) [shield] and (d) [powers of the articles to change shield] setvforth in Dass v. Yale, 2013 IL App (1st) 122520, and Carollo v. Irwin, 2011 IL App (1st) 102765, and clarify that under existing law a member or manager of a limited liability company may be liable under law other than this Act for its own wrongful acts or omissions, even when acting or purporting to act on behalf of a limited liability company.” http://www.ilga.gov/legislation/BillStatus.asp?DocNum=1495&GAID=15&DocTypeID=SB&LegId=118397&SessionID=108&GA=101 , last visited 8/28/19.
[9] The federal court accordingly dismissed the case, and the South Dakota Supreme Court promptly deemed the certified question moot. SDIF Ltd. Phip 2 v. Tentexkota, LLC, Order Rendering Certification Moot (South Dakota Supreme Court; File No: 1:17-CV1002-CBK; #28825) August 27, 2019.
[10] Cyan, Inc. v. Beaver Cty. Employees Ret. Fund, 138 S. Ct. 1061, 1074, 200 L. Ed. 2d 332 (2018).
[11] Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies: Tax and Business Law (Warren Gorham & Lamont, 1994; Supp. 2019-1) (“Bishop & Kleinberger, LIMITED LIABILITY COMPANIES”), ¶ 6.01[1][b] (The Shield as Negating the “Status Liability” of a Sole Proprietor and Partner) (emphasis in original; footnotes omitted).
[12] ULLCA (2013) § 304, cmt. (Shield Inapposite for Claims Arising from a Member’s or Manager’s Own Conduct) (quoting Dep’t of Agric. v. Appletree Mktg., L.L.C., 485 Mich. 1, 4, 18, 779 N.W.2d 237, 239, 247 (2010)).
[13] ULLCA (2013) § 304(a), cmt., Shield Inapposite for Claims Arising from a Member’s or Manager’s Own Conduct.
[14] Daniel S. Kleinberger, Agency, Partnership and LLCs: Examples and Explanations (5th ed.; Wolters Kluwer; 2017) § 4.2.3a at 182 (footnote omitted).
[15] ULLCA (2013) § 304(a), cmt., Shield Inapposite for Claims Arising from a Member’s or Manager’s Own Conduct.
[16] This phrase was coined as the caption for a section of Bishop & Kleinberger, LIMITED LIABILITY COMPANIES, ¶ 6.04[4].
[17] ULLCA (2013) § 304, cmt., Shield Inapposite to Role Liability Claims
[19] Pepler v. Coyne, 33 AD3d 434, 435, 822 NYS2d 516 (2006) (quoting Matter of State Div. of Human Rights v. St. Elizabeth’s Hosp., 66 NY2d 684, 687 (1985)).
[20] United States v. ADT Sec. Servs., Inc., 522 F. App’x 480, 486 (11th Cir. 2013) (emphasis added) (quotation marks and citation omitted).
On June 5, 2019, a Financial Industry Regulatory Authority (FINRA) hearing panel handed down a groundbreaking decision against a registered crowdfunding portal member.[1] The 148-page decision tackled multiple issues of first impression involving crowdfunding portals. Ultimately, the hearing panel expelled the portal member and barred its chief executive for violating the crowdfunding rules of both FINRA and the Securities and Exchange Commission (SEC),[2] but did not rule in favor of FINRA’s Department of Enforcement on all claims. The decision is a must-read for those seeking guidance on crowdfunding regulation, particularly for those seeking to operate as crowdfunding intermediaries under SEC and FINRA funding portal rules.
Crowdfunding Background
Crowdfunding originated as a means of raising capital for charities and small-business projects, where the public (i.e., the “crowd”) could evaluate the merits of a fundraiser’s proposal and decide whether to donate to the charitable cause or contribute small amounts of money to the business idea (usually in exchange for a token of value, such as early access to or discounted products, tickets to a performance, or other perks). Until relatively recently, crowdfunding did not involve the offer of a share in any profits that the fundraiser expected to generate from business activities financed through crowdfunding. This is because any crowdfunding offering involving the offer or sale of securities would trigger the application of costly registration requirements and regulatory obligations under the federal securities laws.
In an effort to give small-business owners and start-ups access to a broader base of capital, Congress in April 2012 enacted Title III of the JOBS Act, which established a regulatory framework for crowdfunding offerings of securities (also referred to as “equity crowdfunding”).[3] By adding Section 4(a)(6) to the Securities Act of 1933 (Securities Act), the JOBS Act created an exemption from registration for internet-based securities offerings by issuers that raise no more than $1 million in aggregate over a 12-month period.[4] This exemption is available only if a crowdfunding securities offering is conducted exclusively through an intermediary. Intermediaries are required under the JOBS Act to be registered with the SEC and FINRA as either a broker-dealer or a “funding portal.”
Section 3(a)(80) of the Securities Exchange Act of 1934 (Exchange Act) defines a funding portal as “any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to [the April 2012 exemption from registration for crowdfunding securities offerings].”[5] Section 3(a)(80) further provides that funding portals are not permitted to: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy the securities displayed on their platforms; (iii) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on their platforms; or (iv) hold, manage, possess, or otherwise handle investor funds or securities.[6]
Pursuant to the JOBS Act, the SEC promulgated Regulation Crowdfunding in October 2015,[7] and FINRA adopted its Funding Portal Rules shortly thereafter in January 2016.[8] FINRA oversees the crowdfunding industry’s adherence to both sets of rules, and, currently regulates nearly 50 funding portals.[9]
SEC and FINRA crowdfunding rules authorize issuers to conduct small offerings exclusively through websites operated by an intermediary funding portal. Through the portal, potential investors can review information about the issuer and the offering and can discuss the offering with other interested investors. If an investor makes an investment commitment, that money is held in escrow. There is a mandatory waiting period before the offering can close, during which investors retain the right to rescind their investment commitment. If the issuer’s target capital raise is reached by the specified target date, the offering is closed and investor funds are released to the issuer. If, however, the target amount is not reached by the target date, then the offering is canceled and all escrowed funds are returned to investors.
Any investor can participate in a crowdfunding offering, subject to two limitations: (1) if an investor’s annual income or net worth is less than $107,000, then, during any 12-month period, they can invest up to the greater of either $2,200 or five percent of the lesser of their annual income or net worth; and (2) if an investor’s annual income and net worth are equal to or more than $107,000, then, during any 12-month period, they can invest up to ten percent of their annual income or net worth, whichever is less, but not to exceed $107,000.[10]
Pursuant to crowdfunding rules and regulations—specifically SEC Crowdfunding Rule 201—issuers are required to publicly disclose on SEC Form C the following information to potential investors: (1) name, legal status, address, and website; (2) names of directors and officers (with business history); (3) names of persons holding 20 percent or more of the outstanding voting equity; (4) business plan; (5) headcount; (6) cap on number of investments; and (7) intended use of offering proceeds.[11] This disclosure must be filed before an offering can open to investors.[12] An issuer must also disclose the type of security offered, the target amount of the offering, and the deadline for reaching the target amount. SEC Form C also requires disclosure of an issuer’s basic financial information, total assets, cash, cash equivalents, accounts receivable, short-term and long-term debt, revenues and sales, costs of goods sold, taxes paid, and net income.
Pursuant to SEC Crowdfunding Rule 400(a), intermediaries must register with the SEC and FINRA as a broker or a funding portal. FINRA Funding Portal Rule 110(a)(10) promulgates five standards used to measure an applicant’s fitness to become a funding portal. These registration standards mandate that the applicant: (1) is neither subject to statutory disqualification under the Exchange Act or subject to pending regulatory action or investigation; (2) has established business relationships with banks, broker dealers, transfer agents, escrow agents, etc.; (3) has a supervisory system in place reasonably designed to achieve compliance with applicable federal securities laws and rules, including FINRA’s Funding Portal Rules; (4) has fully disclosed and provided support for all direct and indirect sources of funding; and (5) has a recordkeeping system that enables it to comply with federal, state, and FINRA recordkeeping requirements.[13]
An intermediary generally provides educational materials on its funding portal platform (i.e., website) that explain the process for investing via a crowdfunding platform, the types of securities being offered by the issuers on the platform, and the risks associated with investing in these types of securities. SEC Crowdfunding Rule 303(a) requires an intermediary to make an issuer’s required disclosures available to the SEC and investors. This includes posting an issuer’s Form C on its funding portal website.[14] Such information must be available on the website for at least 21 days before any securities can be sold.[15]
Although intermediaries involved in a crowdfunding offering are not required to conduct due diligence related to the offering, they do serve a critical gatekeeping function.[16] Under SEC Crowdfunding Rule 301(a), an intermediary must have a “reasonable basis” for believing that an issuer on its platform is in compliance with the various applicable statutory and regulatory requirements.[17] Critically, SEC Crowdfunding Rule 301(c) mandates that an intermediary deny an issuer access to its platform if the intermediary has a “reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.”[18] Should an intermediary become aware of such concerns after granting access to its platform, it must promptly remove and cancel the offering, and return any invested funds.[19]
An intermediary is also responsible for notifying investors when their investment commitments have been received; when material changes are made to the terms of the offering; when changes are made in the company’s ownership; and when an offering closes early. Intermediaries are also subject to the recordkeeping requirements set forth in SEC Crowdfunding Rule 404, which include keeping records of issuers’ SEC filings and notices to investors, and other communications regarding offerings on its platform. All of these records must be available for SEC and FINRA inspection and examination.
FINRA’s Case Against Manuel Fernandez and DreamFunded Marketplace, LLC
Manuel Fernandez established DreamFunded Marketplace, LLC (DFM) in early 2016 and registered DFM with FINRA as a funding portal (the Portal) several months later. As CEO of DFM, Fernandez became an associated person of a funding portal member and was assigned a FINRA Central Registration Depository (CRD) number. Notably, “Fernandez had no experience working in the securities industry, but the applicable rules did not require him to take any classes or training, or to take any licensing or qualifying examination to qualify to operate a funding portal.” [20]
Between July 2016 and October 2017, DFM served as an intermediary for 15 crowdfunding offerings, two of which closed and released investors’ funds to the issuers. The FINRA hearing panel’s decision in the Fernandez matter focused on three of these offerings:
Company A, a social networking company with no assets, revenue, or operating history sought initially to offer 100,000 securities with a $10,000 target capital raise and a September 27, 2016, closing date, but ultimately closed early on June 26, 2017 with a $4,000 target.[21]
Company B, a company hosting a library of short videos about health and well-being, targeted issuing 10,000 securities in an aggregate of $10,000 with a closing date of June 30, 2017, and ultimately closed early on April 14, 2017 after raising and distributing $10,500.[22]
Company C, which produced a special type of fire hose and harness, sought a $10,000 target capital raise with a target closing date of September 30, 2017, but did not reach its target amount before DFM removed it from the Portal on April 30, 2017.[23]
In October 2016, FINRA conducted ongoing surveillance of DFM and noticed a YouTube video clip showing Fernandez purporting to make an offer to invest $1 million into Company C. Suspecting that the video may have violated SEC Crowdfunding Rule 300(b), which prohibits officers of intermediaries from holding interests in issuers on their platforms, FINRA opened a “for cause” examination of DFM and Fernandez.[24] Thereafter, FINRA issued a series of Rule 8210 requests to Fernandez seeking documents and information relating to the 15 offerings on the the Portal’s website, DFM’s financial records, bank account statements, and investor agreements.[25] FINRA also took on-the-record testimony from Fernandez. As FINRA continued its investigation, it became concerned that Fernandez and DFM might have violated a number of SEC Crowdfunding and FINRA Portal Rules.
On February 23, 2018, Enforcement filed a complaint against Fernandez and DFM alleging ten causes of action.[26] Between September and November 2018, FINRA argued its case in an eight-day, two-session hearing. During the hearing, Fernandez essentially repudiated much of the on-the-record testimony he previously provided to FINRA. The hearing panel characterized Fernandez’s hearing testimony as “evasive, vague, and inconsistent,” contrasting it with the largely credible testimony of FINRA staff and investigators. The panel therefore discredited much of his testimony, noting that it appeared that “very little of Fernandez’s hearing testimony was candid or true.”[27]
First Cause of Action—Failing to Provide Documents and Information (FINRA Funding Portal Rules 800(a) and 200(a) and FINRA Rule 8210): FINRA Funding Portal Rule 800(a) provides that funding portal members and their associated persons are subject to FINRA Rule 8210, which, among other things, requires compliance with FINRA requests for information and testimony. Throughout the litigation, Fernandez and DFM challenged FINRA’s jurisdiction to issue Rule 8210 requests and bring a disciplinary proceeding. The hearing panel rejected these jurisdictional challenges, determining that while the JOBS Act distinguishes between broker-dealers and funding portals, “it folds funding portals into the existing disciplinary system for broker-dealers,” and therefore grants jurisdiction to FINRA to discipline funding portals as it would broker-dealers.[28] The panel also determined that “[u]nder Funding Portal Rule 100(b)(1), all officers, owners, controlling persons, and employees of a funding portal are associated persons. As the CEO of the Portal, Fernandez was an associated person of a FINRA member who received a CRD number.”[29] Therefore, Fernandez was required to comply with FINRA Rule 8210 requests and was subject to FINRA’s broker-dealer disciplinary procedures.
The panel determined that Fernandez, in his capacity as CEO of the Portal, failed to respond fully and completely to FINRA’s Rule 8210 requests. His conduct violated FINRA Rule 8210, as made applicable to funding portals by Funding Portal Rule 800(a), which requires anyone subject to FINRA’s jurisdiction to provide information orally, in writing, or electronically, and to testify with respect to any matter involved in an investigation, complaint, examination, or proceeding. The panel also found that Fernandez violated FINRA Funding Portal Rule 200(a), the funding portal equivalent of FINRA Rule 2010, which requires industry members to conduct business pursuant to high standards of commercial honor and just and equitable principles of trade.
Under FINRA’s Sanction Guidelines, a bar is standard in situations where an individual fails to respond at all to a Rule 8210 request, as well as for a partial but incomplete response, unless the respondent demonstrates substantial compliance with the request. In determining the appropriate sanctions in this matter, the hearing panel heavily considered Fernandez’s “pattern of disclaiming responsibility,” his false and misleading statements to regulators, and his attempts to delay the investigation using “dubious” medical excuses.[30] These factors outweighed two key mitigating factors: Fernandez’s lack of experience and training (which led to ignorance of his responsibilities), and the minimal investor harm at issue. After concluding that Fernandez and DFM “were proven unfit to continue in the securities industry,”[31] the hearing panel expelled DFM from FINRA membership as a funding portal and barred Fernandez from association with any FINRA funding portal member.
Takeaway: FINRA has jurisdiction over all funding portal members and associated persons. Current and prospective intermediaries need to educate themselves about their obligations under FINRA funding portal rules and must comply with any requests for information and testimony from FINRA.
Second Cause of Action—False or Misleading Issuer Communications (FINRA Funding Portal Rules 200(c)(3) and 200(a) and SEC Regulation Crowdfunding Rule 301(c)(2)): As noted above, SEC Regulation Crowdfunding Rule 301(c)(2) requires an intermediary to deny an issuer access to its platform if it has a “reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection,” or, if the intermediary already granted an issuer access to its platform, to rescind access and return investor funds after it becomes aware of such information.[32]
The panel determined that Fernandez violated SEC Regulation Crowdfunding Rule 301(c)(2) and FINRA Funding Portal Rule 200(a) based on the following facts that were known to him. First, Company A’s Form C filings contained numerous deficiencies, including inconsistencies in ownership information, changes in the number of securities to be sold to investors, and different offering deadline dates. Second, Fernandez was asked by the CEO of Company A to lower the target amount for its offering, close the offering early, and transfer investor funds to his personal bank account. The panel found that these were red flags that would have led a reasonable person to have serious investor protection concerns.[33] Furthermore, instead of terminating Company A’s access to the Portal, cancelling the offering, and returning investors’ money, Fernandez facilitated the transfer of funds to Company A’s CEO. For this misconduct, the panel determined that it would generally suspend the Portal for 30 days and suspend Fernandez for six months and fine him $10,000. However, due to the Portal’s expulsion and Fernandez’s bar for other violations, the panel did not impose these lesser sanctions.[34]
In contrast, the hearing panel dismissed the portion of the Second Cause of Action pertaining to FINRA Funding Portal Rule 200(c)(3). FINRA Funding Portal Rule 200(c)(3) establishes content standards for funding portal communications with investors. These standards include not only communications created by the funding portal, but also communications created by the issuer for the funding portal to provide to investors. A funding portal is not responsible for false or misleading issuer communications that have been prepared solely by the issuer unless the portal is aware of, or has reason to be aware of, the false or misleading statements. In its complaint, Enforcement alleged that Company A’s and Company B’s projections and forecasts were false and misleading, and that Respondents violated FINRA Funding Portal Rule 200(c)(3) by knowingly posting them. The hearing panel disagreed, determining that it was unclear whether the projections and forecasts were in fact misleading, and that Respondents did not have a duty to conduct due diligence on those projections and forecasts.
Takeaway: Although intermediaries are not required to conduct due diligence into issuer projections or forecasts, as gatekeepers they must evaluate information in their possession regarding issuers and offerings and deny issuer access if investor protection concerns are implicated.
Third Cause of Action—False or Misleading Funding Portal Communications (FINRA Funding Portal Rules 200(b), 200(c)(2), and 200(a)): FINRA Funding Portal Rule 200(b) prohibits a funding portal from “effect[ing] any transaction in, or induc[ing] the purchase or sale of any security by means of, or by aiding or abetting, any manipulative, deceptive or other fraudulent device or contrivance.”[35] FINRA Funding Portal Rule 200(c)(2)(A) prohibits a funding portal from distributing or making available communications to investors that are false, exaggerated, unwarranted, promissory or misleading; that omit any material fact that, in light of the context of the material presented, should be disclosed in order to prevent the communication from being misleading; that state or imply that FINRA or another self-regulatory organization endorses, indemnifies, or guarantees the portal’s business practices; that predict or project performance; or that make any exaggerated or unwarranted claim, opinion, or forecast.[36] As seen above, communications prepared solely by issuers are exempt from prosecution under Rule 200(c)(2)(A) unless the member portal knows or has reason to know the communications are false or misleading.
Enforcement alleged that Respondents made false and misleading statements, and induced the purchase of a security by engaging in deceptive practices, in violation of FINRA Funding Portal Rules 200(b), 200(c)(2), and 200(a) when Fernandez: (1) posted through social media and on the Portal’s website a video clip of himself striking a purported deal to make a $1 million investment in Company C; and (2) posted information on the Portal regarding (a) the Portal’s issuer due diligence and deal flow screening, and (b) real estate tombstones that created a misleading impression that the real estate deals offered a 10 percent return and were part of the Portal’s crowdfunding business when they were not.
The panel determined that the video clip contained two untrue statements: (1) that Fernandez had invested over $100 million in start-up businesses, and (2) that the $1 million offer by Fernandez to Company C’s CEO was accepted. The panel found that by posting the false and misleading video clip on the Portal’s platform and Fernandez’s social media accounts, the Respondents had intentionally or recklessly engaged in a “deceptive device” in violation of the Funding Portal rules.[37] The panel also determined that Respondents intentionally or recklessly made false statements on the Portal regarding their allegedly vigorous issuer due diligence and screening. Notably, the panel concluded there was “no screening team and Fernandez had no system for evaluating issuers or their offerings.”[38] The panel also determined that Respondents’ posting of real estate tombstones on the Portal was misleading in violation of Rule 200(c), and that all of these actions violated Rule 200(a). The panel concluded that the appropriate sanctions for Respondents’ Rule 200(a) violations were expulsion for DFM and a bar for Fernandez. Noting that the misleading statements about real estate transactions would generally have resulted in the lesser sanction of a Letter of Caution, the panel declined to impose this sanction in light of the myriad other violations.
Takeaway:Funding portal member communications regarding issuers and offerings have the potential to mislead investors and must be carefully vetted by intermediaries prior to publication on funding portal websites.
Fourth Cause of Action—No Reasonable Basis for Believing Issuer Compliance (SEC Regulation Crowdfunding Section 301(a) and FINRA Funding Portal Rule 200(a)): SEC Regulation Crowdfunding Rule 301(a) provides that an intermediary must have a reasonable basis for believing that a crowdfunding issuer is in compliance with the applicable requirements.[39] An intermediary can rely on an issuer’s representations concerning compliance unless the intermediary has reason to question the veracity of those representations.[40] Enforcement alleged that Respondents violated Rule 301(a) because they had no reasonable basis for believing that either Company A or Company B had complied with their required disclosure obligations. The complaint alleged that (1) Company A falsely claimed in its SEC disclosure that it had provided investors with true and complete financial statements when, in reality, it did not submit financial statements, and (2) Company B both failed to provide a basis for its valuation of its video library—its main asset—and provided to DFM an SEC filing with inconsistencies regarding asset valuation and projections for revenue.
The panel dismissed the Fourth Cause of Action in its entirety and noted that when Company A filed its Form C, it had no operating history and no financial statements to disclose. According to the panel, the absence of a financial statement did not mean that the Respondents failed to comply with SEC Crowdfunding Rule 301(a) or any other rule. The panel also dismissed the claims relating to Company B because funding portals do not have a duty to analyze and evaluate issuers’ projections and forecasts.[41]
Takeaway: Although funding portals are not required to analyze issuers’ projections and forecasts, they must have a reasonable basis for believing that an issuer seeking to offer and sell securities through their platform complies with the requirements in Section 4A(b) of the Securities Act and the related requirements in Regulation Crowdfunding.
Fifth Cause of Action—Failure to Perform Meaningful Background Checks (SEC Regulation Crowdfunding Rule 301(c)(1) and FINRA Funding Portal Rule 200(a)): SEC Regulation Crowdfunding Rule 301(c)(1) requires an intermediary to conduct a background check and review securities enforcement regulatory history for: (1) each issuer whose securities are to be offered through the intermediary; (2) each officer or director (or persons occupying a similar status or performing a similar function); and (3) any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities.[42] Enforcement alleged that Respondents violated SEC Regulation Crowdfunding Rule 301(c)(1) and Funding Portal Rule 200(a) by failing to perform any meaningful background checks or securities enforcement regulatory history searches on the issuers making offerings on the Portal.
The hearing panel determined that the evidence established that Fernandez failed to conduct the required background checks and failed to review securities enforcement regulatory histories for the Portal’s issuers and parties associated therewith in violation of Regulation Crowdfunding Rule 301(c)(1) and Funding Portal Rule 200(a). For this misconduct, the panel would have suspended the Respondents for 30 days, but in light of the expulsion and bars for the other violations, did not impose these lesser sanctions.[43]
Takeaway: Funding portals must be diligent in conducting background and securities enforcement regulatory history checks on issuers. That diligence must be carefully reviewed by the intermediary before granting issuers funding portal access.
Sixth, Seventh, Eighth and Ninth Causes of Action—Failure to Provide Investors with Notice of Material Changes, Change of Offering Deadlines, Required Information and Completion of Transactions (SEC Regulation Crowdfunding Rules 304(c)(1), 304(b)(2), 303(d), 303(f) and FINRA Funding Portal Rule 200(a)): SEC Crowdfunding Rule 304(c)(1) provides that if there is a material change to the terms of an offering or the information provided by the issuer, then the intermediary must give notice of the material change to any investor who has made an investment commitment. The notice must inform the investor that the investment commitment will be canceled unless the investor reconfirms the commitment within five business days of receiving the notice. If an investor fails to do so, then within five business days after that the intermediary must provide notice that the commitment was canceled, the reason for the cancellation, and the amount of money the investor should expect to receive as a refund.[44]
Enforcement alleged in its Sixth Cause of Action that Respondents failed to provide any notices of material change to investors when Company A filed three Form C amendments that included material changes. The panel agreed that the Respondents violated Crowdfunding Rule 304(c)(1) when Company A’s Form C amendment was “marked as containing a material change in the terms of the offering” but Respondents did not notify any investors of such changes.[45] The panel also found that this conduct violated FINRA Funding Portal Rule 200(a).
Next, SEC Crowdfunding Rule 304(b)(2) provides that if an issuer reaches its target offering amount prior to the deadline specified in its offering materials, it may close the offering on an earlier date, as long as the offering is open for a minimum of 21 days. An intermediary is required to provide notice to any potential investors, and any investors who have made investment commitments, informing them of the new offering deadline and their right to cancel their investment commitments for any reason up to 48 hours prior to the new deadline. The new offering deadline must be at least five business days after the notice to investors is provided. The offering cannot close if, at the time of the new offering deadline, the issuer does not meet or exceed the target offering amount.[46]
In the Seventh Cause of Action, Enforcement alleged that Respondents failed to provide notice to investors of early closings for Company A and Company B and of the investors’ rights to cancel their investment commitments. The panel agreed, and determined that the Respondents violated SEC Regulation Crowdfunding Rule 304(b)(2) and FINRA Funding Portal Rule 200(a) by failing to give notice to investors when the offerings of Company A and Company B closed early. According to the panel, “Respondents deprived investors in both offerings of their right to cancel their investment commitments up until 48 hours of the closing.”[47]
SEC Regulation Crowdfunding Rule 303(d) provides that upon receiving an investment commitment, an intermediary must promptly give notice to an investor of the following: (i) the dollar amount of the commitment; (ii) the price of the securities, if known; (iii) the name of the issuer; and (iv) the date and time by which the investor may cancel the investment commitment.[48]
In the Eighth Cause of Action, Enforcement alleged that Respondents, in connection with offerings made by Company A and Company B, failed to provide required information to investors in the notices of investment, including the price of securities and the date and time by which investors could cancel their commitments. The panel determined that Respondents violated SEC Regulation Crowdfunding Rule 303(d) by sending notices to investors in the offerings of Company A and Company B that did not provide any information of the investors’ right to cancel their investment commitments up until a specific date and time, and in doing so, also violated FINRA Funding Portal Rule 200(a).[49]
SEC Regulation Crowdfunding Rule 303(f) requires an intermediary to provide a notification to each investor that contains certain information. The rule requires the following: (i) the date of the transaction; (ii) the type of security that the investor is purchasing; (iii) the identity, price, and number of securities purchased by the investor, along with the total number of securities sold by the issuer in the transaction and the price at which the securities were sold.
In the Ninth Cause of Action, Enforcement alleged that Respondents did not provide investor confirmations when the Company A and Company B offerings closed. The panel reviewed the record and determined that the Respondents violated SEC Crowdfunding Rule 303(f), and thereby FINRA Funding Portal Rule 200(a), by failing to provide investors with confirmation of the Company A and Company B offering closings.[50]
In its sanctions analysis for the sixth, seventh, eighth, and ninth causes of action, the panel aggregated the misconduct because, taken together, the violations of SEC Regulation Crowdfunding Rules 304(c)(1), 304(b)(2), 303(d) and 303(f) represented a “systemic failure to give investors the information to which they were entitled.”[51] For these violations, the panel would have imposed a 30-day suspension on both Fernandez and DFM, but in light of the expulsions and bars, it did not impose these sanctions.
Takeaway: Funding portals have a number of obligations to provide adequate notices to investors, including those regarding material changes to the terms of an offering, early closings, prices of securities, and the date and time by which investors can cancel their commitments. Funding portals must also maintain appropriate systems and procedures to track the occurrence of notice-related events and ensure that investors are provided with timely and proper notices.
Tenth Cause of Action—Supervision (FINRA Funding Portal Rules 300(a) and 200(a) and SEC Regulation Crowdfunding Rule 403(a)): SEC Regulation Crowdfunding Rule 403(a) requires a funding portal to implement written policies and procedures reasonably designed to achieve compliance with applicable laws, regulations, and rules. FINRA Funding Portal Rule 300(a) requires a funding portal member to establish and maintain a system for supervising associated persons that is “reasonably designed” to achieve compliance with securities laws and Funding Portal Rules.[52]
In the Tenth Cause of Action, Enforcement alleged that DFM’s written policies and procedures were not reasonably designed to achieve compliance with applicable rules, regulations and laws because they lacked substance, were not provided to the Portal’s employees, and were rarely referenced or used. The panel determined that Respondents violated SEC Crowdfunding Rule 403(a) and FINRA Funding Portal Rules 300(a) and 200(a) by failing to establish any concrete or practical system for supervising the Portal’s conduct of its business to ensure compliance with legal and regulatory requirements. For this failure, the panel noted that it would have suspended Respondents for 30 days and required them to submit a remediation plan to FINRA for approval and implementation. However, because of the expulsions and bars, the panel did not impose these sanctions.[53]
Takeaway: Funding portal members must maintain adequate written policies and procedures that are reasonably designed to achieve compliance with securities laws and FINRA Funding Portal Rules.
Upon reviewing all of the facts and circumstances in this matter, the panel suggested it had no other choice but to impose stringent sanctions: “Respondents committed numerous violations in a systemic, wholesale compliance breakdown. Fernandez failed to tell FINRA staff the truth prior to the hearing, and he failed to tell the Extended Hearing Panel the truth at the hearing. Fernandez also attempted to shift responsibility for all missteps to others. We have no confidence that in the future, if permitted to continue in the securities industry, Respondents would comply with regulatory requirements or fully and truthfully respond to regulatory inquiries.”[54]
In reaching its decision, the panel noted that it “might hesitate to impose stringent sanctions in other circumstances—as, for example, where a person operating a funding portal makes mistakes from a lack of understanding of the rules, but expresses a sincere desire to correct those mistakes, and develops and implements policies and procedures to avoid mistakes in the future.”[55] The panel also recognized that “[t]o some degree, Respondents’ violations may be partly attributable to the lack of a mechanism for educating and qualifying a person to run a funding portal. Fernandez may not have fully comprehended the applicable rules or the nature and degree of regulatory oversight exercised by the SEC and FINRA.”[56]
Conclusion
In the three years since the SEC’s Crowdfunding and FINRA’s Funding Portal Rules took effect, the use of equity crowdfunding to facilitate capital formation has been relatively modest. Recently, the SEC, in an effort to review and improve its general regulatory framework for securities offerings that are exempt from registration requirements, issued Concept Release on Harmonization of Securities Offering Exemptions.[57] The SEC published the release to solicit comments on possible ways to simplify and improve the exempt offering framework to promote capital formation and expand investment opportunities.
As part of the release, the SEC reported that from the inception of crowdfunding through the end of 2018, a total of 519 crowdfunding offerings have been completed, raising $108.2 million, or an average capital raise of $208,400 per offering.[58] The SEC’s data also indicate that the majority of crowdfunding issuers raised less than the maximum amounts targeted in the original offering documents, with only 29 issuers raising the full $1.07 million allowed by law over 12 months.[59]
The decision against DFM and Fernandez represents the first litigated FINRA enforcement action against a funding portal and serves as important guidance for current and future crowdfunding participants. Despite its seemingly slow start, equity crowdfunding is a powerful tool for small companies and entrepreneurs seeking access to start-up capital. As reflected by the lengthy hearing panel decision in the DFM/Fernandez case, however, SEC and FINRA crowdfunding rules are complex and can easily lead to compliance quandaries for issuers and intermediaries.
[1] Extended Hearing Panel Decision, Dep’t of Enforcement v. DreamFunded Marketplace LLC and Manuel Fernandez, Disciplinary Proceeding No. 2017053428201 Financial Industry Regulatory Auth., Office of Hearing Officers (June 5, 2019), available at https://bit.ly/2XwyeRr (“Extended Hearing Panel Decision”). This matter has been appealed. See Adjudication and Decisions, FINRA, https://www.finra.org/rules-guidance/oversight-enforcement/decisions (last visited August 29, 2019).
[2] Hearing Officer McConathy and the Extended Hearing Panel decided it was “necessary to write at length” on this matter because of issues of first impression and the numerous causes of action. Extended Hearing Panel Decision, at 7.
[3] 157 Cong. Rec. S8458 (daily ed. Dec. 8, 2011) (statement of Sen. Jeff Merkley) (“Low-dollar investments from ordinary Americans may help fill the void, providing a new avenue of funding to the small businesses that are the engine of job creation. The Crowdfund Act [Title III of the JOBS Act] would provide startup companies and other small businesses with a new way to raise capital from ordinary investors in a more transparent and regulated marketplace.”), available at https://www.congress.gov/112/crec/2011/12/08/CREC-2011-12-08.pdf; 157 Cong. Rec. H7295-01 (daily ed. Nov. 3, 2011) (statement of Rep. Patrick McHenry) (“[H]ighnet worth individuals can invest in businesses before the average family can. And that small business is limited on the amount of equity stakes they can provide investors and limited in the number of investors they can get. So, clearly, something has to be done to open these capital markets to the average investor[.]”), available at https://www.congress.gov/112/crec/2011/11/03/CREC-2011-11-03.pdf.
[4] Jumpstart Our Business Startups Act [JOBS Act], H.R. 3606, 112th Cong. (2012), Section 302(a) and (b), available at https://www.govinfo.gov/content/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Securities Act Section 4(a)(6) exempts offerings of up to $1 million in a 12-month period, subject to adjustment for inflation required by Section 4A(h) at least once every five years. Accordingly, issuers are currently permitted to raise a maximum aggregate amount of $1.07 million in a 12-month period. 17 C.F.R. § 227.100(a)(1) (2017).
[5] Extended Hearing Panel Decision, supra note 1, at 91; see also Section 3(a)(80) of Exchange Act of 1934, 17 C.F.R. § 227.300(c)(2) Intermediaries (2017), available at https://www.govinfo.gov/content/pkg/CFR-2017-title17-vol3/pdf/CFR-2017-title17-vol3-sec227-300.pdf.
[7] SEC Crowdfunding Rules, 17 C.F.R. § 227.100, et seq. (2015), available at https://www.govinfo.gov/content/pkg/FR-2015-11-16/pdf/2015-28220.pdf.
[8] Self-Regulatory Organizations; Financial Indus. Regulatory Auth., Inc.; Notice of Amendment No. 1 and Order Granting Accelerated Approval to a Proposed Rule Change, as Modified by Amendment No. 1, to Adopt the Funding Portal Rules and Related Forms and Rule 4518, SEC Release No. 34-76970, File No. SR-FINRA-2015, available at https://www.sec.gov/rules/sro/finra/2016/34-76970.pdf; Jumpstart Our Business Startups (JOBS) Act (SEC
Approval of FINRA Funding Portal Rules and Related Forms, FINRA Regulatory Notice 16-06, Effective Jan. 29, 2016), available at https://www.finra.org/sites/default/files/Regulatory-Notice-16-06.pdf.
[9] FINRA, Funding Portals We Regulate (last updated June 17, 2019), available at https://www.finra.org/about/funding-portals-we-regulate.
[10] SEC Crowdfunding Rules, supra note 7, at 100.
[13] FINRA Funding Portal Rule Application, 110(a)(10) Standards for Granting or Denying Application (effective Jan. 29, 2016), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=12222.
[14] SEC Crowdfunding Rules supra note 7, at 303(a).
[16]See, e.g., Section 4A(a)(5) of the Securities Act, implemented through the JOBS Act, stating: “[An intermediary shall] take such measures to reduce the risk of fraud with respect to such transactions, as established by the [SEC] by rule,” available at https://legcounsel.house.gov/Comps/Securities%20Act%20Of%201933.pdf.
[17] SEC Crowdfunding Rules supra note 7, at 301(a).
[57] SEC Concept Release on Harmonization of Securities Offering, Release No. 33-10649 (June 18, 2019, available at https://www.sec.gov/rules/concept/2019/33-10649.pdf.).
[59] SEC Report to the Commission Regulation Crowdfunding, at 4 (June 18, 2019), available at https://www.sec.gov/files/regulation-crowdfunding-2019_0.pdf.
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