ESOPs: A Tax Advantaged Exit Strategy for Business Owners

Posted on March 12, 2015 by - Uncategorized

As the business owners of the baby boomer generation reach retirement age and seek liquidity for their life-long investments, many will need an exit strategy to transition ownership of their businesses. This is often a very difficult time for a business owner. The owner wants and needs to receive fair value for the business, but often does not want the business to be acquired by a third party who may relocate the business outside of the owner’s community. The owner may also want to reward loyal employees who have made significant contributions to the business’ successes. If the owner is willing to receive fair market value rather than a strategic value, an employee stock ownership plan, commonly known as an “ESOP,” may provide a practical exit strategy. Although an ESOP is one of several alternatives that will enable an owner to gain liquidity and transition ownership, ESOP strategies have several advantages that are unavailable with alternative transition strategies. Unfortunately, there is a lot of misinformation circulating about ESOPs. This article will describe ESOPs, discuss how they provide a reasonable exit strategy for a business owner, and review the advantages and disadvantages of selling all or a portion of a business to an ESOP.

What Is an ESOP?

An ESOP is a type of qualified retirement plan similar to a profit-sharing plan, except that an ESOP is required by statute to invest primarily in shares of stock of the ESOP sponsor. Unlike other qualified retirement plans, ESOPs are specifically permitted to finance the purchase of employer stock by borrowing from the corporation or selling shareholders. ESOPs are, therefore not just tax-qualified retirement plans, but also tools of corporate finance. When Congress authorized ESOPs, the intent was to use tax incentives to provide an exit strategy for owners of privately held businesses that are not readily marketable, while at the same time creating ownership opportunities and retirement assets for working-class Americans. According to the National Center for Employee Ownership, there were an estimated 7,000 ESOP-owned companies with around 13.5 million plan participants in 2011 (the most recent year for which information is available). Importantly, as retirement vehicles, ESOPs held over $942 billion in retirement plan assets in 2011.

How Does an ESOP Acquire Ownership?

In a typical leveraged ESOP transaction, a corporation’s board of directors adopts an ESOP plan and trust and appoints an independent ESOP trustee. After obtaining an appraisal of the corporation’s equity, the ESOP trustee negotiates the purchase of all or a portion of the corporation’s issued and outstanding stock from one or more selling shareholders. In general, the corporation sponsoring the ESOP will borrow a portion of the purchase price from an outside lender (the “outside loan”) and immediately loan the proceeds of the outside loan to the ESOP (the “inside loan”) so that the ESOP can purchase shares. The two-phase loan process is used because lenders are generally unwilling to comply with restrictive ERISA loan requirements. If only a portion of the purchase price is funded with senior financing, the remaining portion of the purchase price will generally be funded through the issuance of subordinated promissory notes to the selling shareholders, whereby the sellers receive a rate of interest appropriate for subordinated debt. See Diagram A.

Diagram A

To provide the ESOP the funds necessary to repay the inside loan, the corporation is required to make tax-deductible contributions to the ESOP each year, similar to contributions to a profit-sharing plan. Upon receipt of these annual contributions, the ESOP trustee immediately uses the funds to make payments to the corporation on the inside loan. In addition to these contributions made to the ESOP by the corporation, the corporation can declare and issue tax-deductible dividends (C corporation) or earnings distributions (S corporation) on shares of the corporation’s stock held by the ESOP which, in addition to employer contributions, can be used by the ESOP trustee to pay down the inside loan. Shares purchased by the ESOP from selling shareholders (or the corporation) are held in a “suspense account” within the ESOP trust. As the ESOP trustee makes its annual principal and interest payment on the inside loan, shares of the corporation’s stock acquired by the ESOP from the selling shareholders (or corporation) are released from the suspense account and allocated to the ESOP accounts of employees participating in the ESOP. See Diagram B.

Diagram B

As opposed to a leveraged transaction described above, some ESOPs acquire shares from a business owner without the corporation incurring any debt. Unless the corporation has significant available cash on its balance sheet, this approach requires some advanced planning. For example, one strategy for selling the business to the ESOP without incurring debt is to prefund the ESOP trust. Under this approach, the corporation initially establishes a qualified profit-sharing plan, with the intention to convert the plan to an ESOP at a future time. The corporation makes cash contributions to the plan, which contributions are allocated to employees’ accounts and invested by the plan’s trustee. After a sufficient amount of cash accumulates in the employees’ accounts, the plan converts to an ESOP and the ESOP trustee uses the amounts allocated to the employees’ accounts to purchase shares from the selling shareholder(s), which shares are then allocated to the employees’ accounts based on each employee’s account balance.

Tax Benefits of an ESOP Exit Strategy

The tax benefits of the ESOP exit strategy accrue to the selling shareholder, the corporation, and the employees who participate in the ESOP. The tax benefits to the selling shareholder and corporation vary depending on whether the corporation is taxed as an S corporation or as a C corporation.

Selling Shareholders

Section 1042 of the Internal Revenue Code (the “Code”) provides that, if the ESOP sponsor is a C corporation, shareholders selling to the ESOP may elect to defer the recognition of gain on the sale if: (i) the ESOP owns at least 30 percent of the shares or value of the corporation following the sale; (ii) the selling shareholder held the shares for at least three years prior to the sale; and (iii) the selling shareholder uses the sales proceeds to purchase “qualified replacement property” or “QRP” (defined generally as any security of a domestic operating corporation). The gain can be deferred as long as the selling shareholder holds the QRP. Further, if the shareholder dies while holding the QRP, the QRP receives a “stepped-up” tax basis, meaning the gains realized on the sale to the ESOP will never be recognized.

Although this Section 1042 gain deferral election is not available to an S corporation shareholder (without a conversion to a C corporation), there are significant benefits for an S corporation shareholder selling to an ESOP. The primary benefit is that because of the extremely beneficial tax treatment of an ESOP-owned S corporation, an S corporation typically has greater cash flow on a post-transaction basis to repay the ESOP loan and, therefore, can often purchase 100 percent of the corporation’s stock in a single transaction rather than engaging in multiple transactions over a number of years to acquire full ownership of the corporation.

Corporation

An ESOP sponsor also receives significant tax benefits. Up to certain statutory limits, employer contributions to an ESOP are tax-deductible, whether such contributions are allocated directly to participants’ accounts or used to make payments on the inside ESOP loan.

If the ESOP sponsor is an S corporation, that portion of the corporation’s earnings attributable to the ESOP’s ownership interest is not subject to federal income tax (or state income tax in most states). Thus, if the ESOP is the sole shareholder of an S corporation, the corporation will function much like a tax-exempt entity. How can this be? As a pass-through entity, an S corporation does not pay federal income taxes at the corporate level. Rather, the income tax liability is passed through to the shareholders which, if the sole shareholder is a tax-exempt ESOP trust, means that no federal income taxes will be paid on the corporation’s earnings until participants’ ESOP accounts are distributed. See Diagram C.

Diagram C    

Example of Benefit of ESOP in an “S” Corporation

S Corp Net Income $5,000,000

with No ESOP

S Corp Net Income $5,000,000

with 50% ESOP Ownership

S Corp Net Income $5,000,000

with 100% ESOP Ownership

Corporate Tax:                           $0

Corporate Tax:                          $0

Corporate Tax:                           $0

Individual Shareholders’ Taxes:

on $5,000,000 @ 40% = $2,000,000

Individual Shareholders’ Taxes:

on $2,500,000 @ 40% = $1,000,000

ESOP Shareholders’ Taxes

on $5,000,000 = $0

Total “Tax Dividend” = $2,000,000

ESOP Shareholder Tax on $2,500,000 = $0

ESOP’s Share of Tax Dividend = $1,000,000

ESOP’s “Share” of Historic Tax Dividends = $2,000,000 or the Corporation doesn’t have to pay a tax dividend and may retain the entire $2,000,000

ESOP Participants

Employees participating in an ESOP also receive favorable tax treatment. As in other tax-qualified retirement plans, tax on amounts allocated to participants’ ESOP accounts is deferred until distribution of the participants’ accounts. Additionally, distributions from ESOP are eligible to be rolled over to an IRA or another eligible retirement plan. Further, if the ESOP permits participants to receive distributions of their ESOP accounts in shares of employer securities, the tax on any appreciation of the shares while allocated to the participants’ account (i.e., the “net unrealized appreciation”) is: (i) deferred until the distributed stock is subsequently sold; and (ii) taxed as capital gains rather than ordinary income. Another benefit of an ESOP is that, unlike a 401(k) plan, which generally requires an employee to defer his or her own salary to receive additional employer contributions, most ESOPs are funded solely by employer contributions, meaning that an employee does not have to defer compensation in order to share in the ESOP benefits.

Non-Tax Benefits of an ESOP Exit Strategy

In addition to the tax advantages described above, an ESOP exit strategy provides many non-tax benefits that business owners should consider, depending on the business owner’s goals for transitioning the business. One advantage of selling to an ESOP is the creation of a ready market for the business owner’s stock, providing a buyer for the business when there is no other readily apparent buyer. Because the ESOP provides a market for the shares, the marketability discount applied when valuing shares in an ESOP is typically only 5 percent to 10 percent. In addition, an ESOP permits a business owner who so desires to gradually transition ownership over an extended period of time, allowing the business owner to remain actively involved in the corporation. This is particularly helpful, for example, if the business owner desires some liquidity but is not yet ready to sell 100 percent of his or her ownership interest. The owner can sell a minority interest in an initial transaction and sell his or her remaining ownership interest in later transactions.

Many owners would prefer to sell their businesses to the next level of management, but rarely do these individuals have the funds to acquire the business. A partial or full sale to an ESOP allows the business owner to get the desired liquidity without selling to a competitor or other third party. Senior managers can be rewarded through equity-based performance plans. In addition, although ESOPs are broad-based plans that generally provide a retirement benefit to all of the corporation’s employees, shares are typically allocated to participants’ accounts in proportion to their relative compensation, which will generally result in the more highly-compensated management employees receiving larger ESOP allocations.

Further, unlike a sale to a private equity firm or strategic buyer, there is often no need to implement operational restructuring prior to executing an ESOP exit strategy. This is because the corporation’s management team and employees remain in place post-transaction. Also, because the corporation is not “shopped” (e.g., by an investment bank), it is not necessary to risk releasing confidential information to any competitors who may otherwise be bidding to buy the corporation. Additionally, an ESOP is a long-term financial investor that will not be seeking to sell the corporation after a relatively short time period.

Importantly with respect to an ESOP-owned corporation operating as an ongoing concern, numerous studies have shown that employee-owned companies tend to outperform their peers by motivating and rewarding employees through their equity interests in the corporation.

Special Considerations in Implementing an ESOP Exit Strategy

Selling to an ESOP also involves considerations beyond those relating to tax and non-tax benefits. First, it is essential to keep in mind that the ESOP is a qualified retirement plan governed not only by the Code, but also by the fiduciary and disclosure rules of the Employee Retirement Income Security Act of 1974 (ERISA). The sale to an ESOP is not an “inside transaction” in the sense that the terms of the transaction may be unfair. Rather, the ESOP trustee is subject to a high fiduciary duty standard, and must assure that the ESOP does not purchase shares of stock at a price which exceeds “fair market value,” as such term is defined under Section 3(18) of ERISA. In addition, the ESOP trustee’s financial advisor must be independent of all parties to a transaction in which an ESOP acquires stock from a selling shareholder (or corporation), which requirement is rigorously enforced by the U.S. Department of Labor. The need to comply with ERISA and the Code will potentially involve added cost to executing an ESOP exit strategy, including the need to retain an independent trustee, independent financial advisor, and independent legal counsel to advise the ESOP trustee. The corporation also needs to engage qualified ESOP counsel experienced with ESOP stock purchase transactions, in addition to its corporate counsel.

Another consideration involves the ongoing administrative, fiduciary, and legal costs associated with an ESOP exit strategy that might not be present in a typical sale to a third party. In addition to expenses incurred to maintain the ESOP plan and trust documents and costs for a recordkeeper/third-party administrator to administer the ESOP, a corporation will incur annual expenses of an ESOP trustee and the costs of an annual valuation to determine an updated share value for ESOP administration purposes.

There are limits on the amount of tax-deductible contributions that can be made to the ESOP each year. Additionally, if a shareholder of a C corporation elects Code Section 1042 gain deferral in a sale to an ESOP, the selling shareholder and certain family members will be restricted from participating in the ESOP, even if they are employees of the corporation. In addition, in an S corporation ESOP, because the potential tax benefit is so significant, Code Section 409(p) provides an anti-abuse provision that prohibits any one participant or family from receiving excessive share allocations in the ESOP or in other synthetic equity issued by the corporation. Compliance with these restrictions must be monitored and maintained.

Finally, as the ESOP matures, participants will become eligible to receive distributions of their ESOP stock accounts as they retire and terminate employment. Because the corporation is obligated to purchase the shares for their fair market value, the corporation will have a stock repurchase obligation that must be monitored and funded on an ongoing basis.

Characteristics of Good ESOP Candidates

When considering whether an ESOP may be a reasonable exit strategy for a business owner, it is important to consider various characteristics of both the owner and the business.

Selling Shareholders

Owners should be looking for a fair valuation rather than a strategic valuation. Because ERISA prohibits the ESOP trustee from paying more than fair market value, a shareholder who wants to get every last penny for the corporation, regardless of the impact on the employees or the community, is probably not a good candidate for an ESOP. A business owner interested in rewarding those employees who helped build the business, who wants to preserve his or her legacy and the independence of the corporation in a tax-efficient transaction, will more likely be a good candidate for the ESOP exit strategy.

Corporation

The corporation should also have certain characteristics to be a viable ESOP sponsor. Profitability, good financial reporting and controls are necessary, as is capacity for additional leverage. Most importantly, however, it is critical to have a good management team ready to lead the business. The ESOP trustee is exercising its fiduciary duty when making a decision to purchase shares of a selling shareholder. Lack of a strong management team will negatively affect the fair market value of the business, and might even result in an ESOP trustee’s refusal to buy the shares. Unlike a private equity investor, an ESOP trustee does not want to run the business or serve on the board. Therefore, without a strong management team to grow the business and create the necessary cash flow to repay the debt associated with the stock purchase, the ESOP trustee will likely pass on the stock purchase. 

Corporate Governance in an ESOP Company

Confusion exists relating to the corporate governance of a business following implementation of an ESOP exit strategy. In this regard, it is important to remember that the corporation will continue to operate as a corporation following an ESOP transaction. The corporation will continue to be governed in accordance with its articles of incorporation and bylaws and the corporate laws of the state of incorporation. An ESOP sponsor’s board of directors will continue to monitor management, and management will continue to make all day-to-day operational decisions. Employees will still be employees and will not take over the management or control of the corporation. 

The ESOP trustee will not run the business of an ESOP sponsor and typically will not be directly represented on its board of directors. The ESOP is a shareholder of the corporation sponsoring the ESOP, and votes the shares held in the ESOP trust. In privately-owned corporations, ESOP participants generally do not direct the voting of the shares in their ESOP accounts except on significant corporate matters that require shareholder approval under state law, including a merger, sale of all or substantially all the assets, recapitalization, reorganization, liquidation, or dissolution. An ESOP trustee may either be a discretionary trustee, with full discretion to vote the ESOP shares on most matters, or a directed trustee, voting only as directed by the board of directors or a committee appointed by the board, unless the ESOP trustee determines such direction violates ERISA. As a result, if the ESOP holds a majority of the stock in a corporation, corporate governance is somewhat circular, inasmuch as the board of directors appoints the ESOP trustee and the ESOP trustee elects the board of directors. 

Why Should I Talk to My Client About an ESOP? 

Although you may not be an expert on the ESOP exit strategy, basic knowledge about an ESOP is important for all business and M&A attorneys to have in their toolboxes. Especially because of ERISA fiduciary requirements applicable to ESOPs, companies considering an ESOP exit should consult an experienced ESOP attorney who can work with business and M&A attorneys to effect the required transactions. As is the case in other business acquisition transactions, a due diligence review of the corporation will be undertaken by the buyer and its advisors, and the buyer’s financial advisor will assist the buyer in determining the equity value the ESOP will offer for the corporation. In addition, there are typical financing documents, a stock purchase agreement with customary representations, warranties, covenants, and conditions. It is also critically important that all parties understand the tax benefits and the constraints associated with transition to an ESOP. 

Because of the possibility that an ESOP transaction will be best suited to meeting a business owner’s needs for an exit strategy, and due to the significant tax benefits available, it is important that business attorneys be acquainted with ESOPs and prepared to present ESOP strategies to their clients when discussing the available exit alternatives. 

Sections 409A and 162(m) of the Internal Revenue Code: Top Compliance Pitfalls

Posted on March 12, 2015 by - Uncategorized

The early part of the year is a time during which many companies and their compensation committees, management teams, and outside advisors are focused on both developing new compensation arrangements and reviewing existing compensation arrangements for executives and other employees. These arrangements must be structured and maintained in a way that not only meets the company’s desired business needs, but also complies with the complex and often counterintuitive rules contained in various applicable sections of the Internal Revenue Code.

Two sections of the Internal Revenue Code that continue to challenge both companies and their advisors in creating compensation arrangements are Section 409A, which governs the treatment of nonqualified deferred compensation arrangements, and Section 162(m), which limits the annual compensation deduction that a public company may take with respect to certain of its executive officers. This article highlights some of the key pitfalls and other traps for the unwary that can cause unintentional failures and result in unintended consequences and penalties under these two sections.

Section 409A

Section 409A contains a comprehensive set of requirements that govern the broadly defined universe of so-called nonqualified deferred compensation arrangements. Violations of Section 409A, whether documentary or operational, can result in significant monetary penalties for the employees and executives who are parties to these arrangements.

While many companies have gained significant familiarity with Section 409A over the past 10 years, the 2014 announcement by the Internal Revenue Service that it has begun auditing Section 409A arrangements has put enhanced pressure on the need to ensure that all arrangements are in compliance with Section 409A. This makes it even more critical that companies and their advisors place extra emphasis on developing procedures for identifying potential Section 409A risks and ensuring compliance with Section 409A rules, to avoid the taxes and penalties that can result from even innocent mistakes.

The following sets forth some of the main Section 409A compliance issues frequently encountered in practice.

General Application of Section 409A

One reason for many inadvertent violations of Section 409A is the failure to identify that the arrangement at issue is subject to its requirements. This happens because Section 409A applies to a wide variety of arrangements that may not be thought of as providing for deferred compensation. Section 409A covers not only traditional deferred compensation arrangements involving the deferral of salaries and bonuses, but also many employment, change in control, and severance arrangements, awards of phantom stock, deferred shares and restricted stock units, and bonus payments. In addition, and unlike some other sections of the Internal Revenue Code, Section 409A is not limited to public companies or certain high-ranking or highly paid executives. Rather, Section 409A applies to both private and public companies and to nearly all service providers, including executives and other employees, nonemployee directors, and most independent contractors. As a result, nearly every compensation arrangement must be examined to determine if it is potentially subject to Section 409A.

The application of Section 409A also is not limited solely to individuals providing services in the United States, but instead has a broad reach that extends to certain foreign deferred compensation arrangements. Section 409A applies to all income payable to United States taxpayers, regardless of the country in which the compensation is earned, unless an exemption applies. For this purpose, U.S. taxpayers include U.S. citizens, legal permanent residents (i.e., green card holders), and temporary residents (as determined by the “substantial presence” test under the Internal Revenue Code). However, for nonresident aliens, deferred compensation is generally subject to Section 409A only if the underlying services were performed in the United States.

In light of the potential reach of Section 409A to foreign arrangements, companies should take action to:

  • perform a thorough review of their employee population, to identify all employees who are U.S. taxpayers,
  • identify all foreign benefit arrangements applicable to U.S. taxpayers that could provide for deferred compensation under Section 409A, and
  • determine whether, in each case, an exemption applies to the particular foreign deferred compensation arrangement, such as arrangements that may be covered by a tax treaty.

Timing of Initial Deferral Elections

The initial election to defer the payment of nonqualified deferred compensation must be made in compliance with a detailed set of rules in Section 409A. In general, an initial election to defer compensation must:

  • be in writing,
  • be irrevocable,
  • specify a payment date or event that is permissible under Section 409A, and
  • be made prior to the beginning of the year in which the compensation is earned.

The final rule noted above regarding the timing of the election continues to create issues for companies and their advisors, because the timing deadline is often counterintuitive. For example, assume that an employee would like to defer a portion of his or her 2016 base salary and a portion of the annual bonus that will be paid to him or her in early 2016 in respect of that person’s performance in 2015. The base salary deferral must be made by December 31, 2015, because it relates to compensation that will be earned in 2016. The annual bonus deferral, on the other hand, generally must be made by December 31, 2014, because while the payment of the bonus will not be made until 2016, the bonus itself was earned in 2015. This is the case even if the bonus is paid by the company on a purely discretionary basis.

Limited exceptions to these general rules are available for certain deferrals, but they are complex and can be difficult to apply, so a careful review is necessary before applying them to a specific situation.

Equity Awards

Section 409A contains exemptions for certain kinds of equity awards, but not for others, so extra care must be taken to ensure that equity awards are structured in a way that is either compliant with or exempt from Section 409A.

Section 409A generally does not apply to restricted stock, partnership interests (including profits interests), or stock options or stock appreciation rights (SARs) that are granted with an exercise price that is at least equal to the fair market value of the underlying stock on the grant date. However, if stock options or SARs have an exercise price that is less than the fair market value of the underlying stock on the grant date, then Section 409A will apply, and the award must be carefully structured in a manner that complies with the applicable Section 409A rules (for example, by limiting the exercise period to a single year).

Restricted stock units (RSUs) are a common type of equity award that are not specifically exempt from Section 409A. While an RSU that is paid out only upon vesting is exempt from Section 409A under its short-term deferral exception, some common design elements may result in an RSU which is subject to Section 409A. These include accelerated vesting upon retirement or upon termination of employment for “good reason,” where good reason is defined in a manner that does not meet the Section 409A standard for treatment as an involuntary termination, or continued vesting following retirement or other termination of employment, including during a post-termination noncompetition period.

RSUs subject to Section 409A are afforded far less flexibility than RSUs that are exempt under the short-term deferral exception. For example, RSUs that are subject to Section 409A:

  • must be paid only on permissible payment events (such as a fixed payment date or payment schedule),
  • must define terms, such as change in control or disability, in a manner that complies with Section 409A, and
  • generally cannot have payment accelerated, although vesting may be accelerated.

To identify RSUs structured in a manner that subjects them to Section 409A, companies should review all agreements and arrangements that may contain provisions applicable to RSU awards. Often, termination terms applicable to RSU awards, and other equity awards, are contained in employment agreements or change in control agreements, so it is critical to review all arrangements that may potentially impact the terms of RSUs. Once all applicable agreements and arrangements are identified, the terms must be carefully reviewed to ensure compliance with Section 409A.

Separation from Service

Separation from service is a permissible payment event under Section 409A, but not all events that would generally be considered to result in the separation of an individual’s service from his or her employer will qualify under the section rules, so care must be taken to ensure that a qualifying separation from service has occurred before making the payment of nonqualified deferred compensation to a service provider as a result of the separation.

For employees, a separation from service generally occurs on the date the employer and employee reasonably expect that the employee’s level of services will be reduced by at least 80 percent from the employee’s average service level for the trailing pretermination three-year period. Although this definition clearly includes a complete cessation of services, it is also mandatory that a continuing service level of 20 percent or less be treated as a separation from service. As the test is based on service level and not employment status, treatment as an employee or independent contractor on an ongoing basis does not change the analysis. Determinations regarding expected future services must be made based on the reasonable expectations of the parties, which may or may not turn out to be accurate. In the event that the reasonable expectations of the parties turn out not to be accurate, there are rebuttable presumptions to evaluate actual service levels in connection with separation from service determinations, including that a service level in excess of 50 percent of the trailing three-year average will presumptively indicate that a separation from service has not occurred, and an 80 percent or more reduction in service level will presumptively indicate that a separation from service has occurred.

For an independent contractor (including a nonemployee member of the board of directors), a separation from service occurs upon a complete termination of the contractual relationship. In general, a continuing contractual relationship, even if under a different status (for example, a change in status from outside director to consultant), will delay separation from service until the good faith, complete termination of all contracts for services with the independent contractor. However, if an individual who serves as both an employee of a company and a member of the company’s board of directors terminates employment with the company, the individual’s continuing service as a director will generally be disregarded for purposes of determining whether the individual has incurred a separation from service.

The separation from service rules can be unexpectedly complex and it is therefore critical to use extra caution to ensure that a separation from service has occurred before making the payment of nonqualified deferred compensation to a service provider as a result of the separation.

Payments Conditioned on a Release of Claims

Many severance arrangements require a terminating service provider to execute a release of claims before the underlying severance payments will be made. The period of time that the service provider is given to consider the release before signing it may make an otherwise exempt arrangement subject to Section 409A, and therefore care must be taken to avoid creating the unintended consequence of a Section 409A failure.

The IRS has clearly indicated in Section 409A corrections guidance that it views as problematic a plan provision that provides for payment following execution of a release if the requirement may effectively allow a service provider to influence the year of payment through the timing of delivery of a release. Even in situations where the employer has not committed to a particular time frame for payment, other than to specify a Section 409A, compliant payment period and to make payment subject to delivery and non-revocation of a release, the IRS has indicated that these provisions may trigger a documentary violation under Section 409A unless the plan terms preclude the service provider from influencing the year of payment.

The two principal ways to address this issue are to provide that either payment will always be made on a fixed date following the date of termination, subject to the earlier delivery and non-revocation period (e.g., 60 days following termination), or, where the specified period for delivery and non-revocation of a release spans two taxable years, payment will always be made in the second taxable year but within Section 409A’s timing requirements. All arrangements that condition payments upon the service provider’s execution of a release of claims should be reviewed to ensure compliance with these rules.

Section 162(m)

Section 162(m) generally limits the deduction that a public company may take with respect to the compensation paid to each of its chief executive officer and three other most highly compensated executive officers, other than its chief financial officer, to $1 million in any single year, unless the compensation complies with the technical “performance-based compensation” rules under Section 162(m). Typical arrangements include annual and long-term cash bonuses and performance-based equity awards. While the scope of Section 162(m) is much narrower than Section 409A, in that it only applies to the top officers of public companies, the potential loss of deduction and resulting backlash from institutional shareholders and proxy advisory firms makes the consequences every bit as significant for the companies to which it applies.

The following sets forth a few of the key Section 162(m) compliance issues that are frequently encountered in practice.

Administration of Section 162(m) Performance-Based Compensation by Outside Directors

Section 162(m) requires that the performance goals applicable to the payment of performance-based compensation must be established early in the performance period and ultimately certified prior to payment by members of the board who qualify as “outside” directors. An outside director is generally a member of the board who:

  • is neither a current employee of the company nor a former employee of the company who receives compensation for prior services other than through a tax-qualified retirement plan,
  • is neither a current nor former officer of the company, and
  • does not receive direct or indirect remuneration from the company other than in the individual’s capacity as a director.

Companies should ensure on an annual basis that each of the members of their compensation committee, or any other committee of directors that administers arrangements intended to qualify as performance-based compensation, qualify as outside directors under Section 162(m). Satisfying the independence rules under other standards, such as stock exchange rules and Section 16 of the Securities Exchange Act of 1934, is not automatically sufficient to qualify for outside director status under Section 162(m).

Shareholder Approval of Performance Goals

The payment of compensation will generally qualify as performance-based compensation under Section 162(m) only if it is payable solely on the achievement of preestablished and objective performance goals that are based on business criteria that were approved by the company’s shareholders. The shareholders do not need to approve the specific targets or metrics, just the underlying business criteria. Often, this is accomplished by adopting a compensation plan with an expansive “menu” of potential business criteria, including items such as revenue, sales, net income, and the like. The compensation committee then chooses one of the business criteria from the menu and sets specific targets.

Companies must take care to ensure that the performance measure chosen by the compensation committee is included on the list of business criteria contained in the shareholder-approved plan. It is advisable to have shareholders approve the broadest list of potential business criteria possible to ensure that the compensation committee has maximum flexibility in setting future performance goals. If the compensation committee uses a measure that is not on the shareholder-approved list, the compensation payable upon achievement of that goal will generally not qualify as performance-based compensation under Section 162(m).

Section 162(m) provides that if the compensation committee is permitted to select the actual performance targets from the menu of business criteria approved by the shareholders, then the business criteria must be disclosed to and reapproved by the company’s shareholders every five years. Companies should implement a system to ensure that this re-approval takes place before the deadline is reached.

Use of Discretion and Adjustment of Performance Goals

Performance-based compensation under Section 162(m) can only be paid upon the attainment of an objective performance goal and cannot be paid if the applicable goal is not achieved. The compensation committee cannot be permitted to pay the compensation if the goal is not achieved, and cannot use its discretion to increase the amount payable upon the achievement of the performance goal, although the compensation committee is permitted to use so-called “negative discretion” to decrease the amount that would otherwise be paid upon achievement of the goal.

Companies would often like to adjust the performance goals during the performance period to respond to changing business circumstances or to otherwise ensure that the goals continue to properly incentivize their executives. While these adjustments are often necessary or desirable from a business standpoint, the ability to make them under Section 162(m) is very limited. In general, Section 162(m) permits the adjustment of performance goals only for certain objective unforeseen events, such as a sale of a substantial division of the company, and only where the provisions for such adjustments are included at the time the goal was established.

Since the circumstances under which performance goals may be adjusted is very limited, compensation committees must be as careful as possible in setting targets that are likely to continue to appropriately incentivize executives throughout the duration of the performance period without any need for adjustment.

Payment of Compensation Upon Termination of Employment

Compensation will not qualify as performance-based under Section 162(m) if it may be paid without the achievement of the underlying performance goal upon the executive’s retirement, involuntary termination of employment without cause or a constructive voluntary termination for “good reason.” This is the case regardless of whether any of these terminations actually occur, meaning that the mere inclusion of this type of a provision in an arrangement (including an employment agreement or similar arrangement) will result in the compensation failing to qualify as performance-based under Section 162(m).

It is critical that companies structure arrangements intended to provide for performance-based compensation under Section 162(m) in a way that does not provide for payment upon any of these types of terminations without the achievement of the underlying performance goal. All applicable compensation arrangements, including employment agreements and award agreements, should be reviewed to ensure that they do not include any provisions that may result in the failure of the compensation to comply with the Section 162(m) rules.

Compliance with Annual Plan Limits

Section 162(m) requires that the shareholder-approved plan under which the compensation is payable includes annual limits on the amount of cash or number of shares that may be paid or provided to any executive subject to Section 162(m) in any single year. Compensation committees must be very careful in setting these plan limits at an appropriately high amount that is still likely to be relevant in five years, and in ensuring that the limits are not exceeded.

Conclusion

Section 409A and Section 162(m) contain many technical and often complicated rules that continue to challenge companies in developing and maintaining their compensation programs. It is critical to pay very close attention to these rules in creating compensation arrangements and to have specific procedures in place to ensure that the arrangements continue to be maintained in a manner that does not cause unwanted consequences and tax penalties.

Affordable Care Act Considerations in Mergers and Acquisitions

Posted on March 12, 2015 by - Uncategorized

Employee benefit plans, with their arcane web of underlying rules and regulations, have long been an important consideration in M&A transactions. Historically the greatest emphasis has been placed on qualified retirement plans, equity compensation, and since the enactment of Internal Revenue Code Section 409A, nonqualified deferred compensation. But now the Affordable Care Act (ACA) has given group health plans a starring – if not somewhat villainous – role. This article provides some background on the aspects of the ACA that are most likely to raise issues in the M&A context and identifies key considerations at various stages of a transaction.

ACA Background

It is difficult to overstate the breadth and depth of the legal rules created or affected by the ACA and its implementing guidance. And it is beyond the scope of this article to address even a representative sample of the ACA’s substance. But two features of the ACA encompass what we’ll consider here: (1) the insurance-market reforms that apply to health insurance policies and employer-sponsored group health plans, and (2) the employer shared-responsibility mandate.

Insurance-Market Reforms

The insurance-market reforms are federal standards that govern the terms and conditions of group health plans, as well as insurance policies offered in both the individual and group insurance markets. They are codified in the Public Health Service Act, but apply to nongovernmental organizations through ERISA and the Internal Revenue Code. Some of the more important market reforms include:

  • Prohibition on preexisting condition exclusions
  • 90-day maximum waiting period
  • Prohibition on lifetime and annual limits
  • Provision of preventive-care benefits without cost sharing
  • Coverage of dependent children to age 26
  • Requirement for a summary of benefits and coverage
  • Nondiscrimination requirements for insured plans

The market reforms garner special attention because the consequences for failure to comply can be substantial. Under Code Section 4980D, an employer sponsoring a group health plan that fails to comply with one of the market reforms is subject to an excise tax of $100 per person, for each day that the failure persists ($36,500 per person, per year). The employer is affirmatively required to report and pay any tax that is due by filing IRS Form 8928, although as a practical matter this rarely happens, leaving the statute of limitations perpetually open. The IRS has the discretion to waive some or all of the excise tax if a compliance failure is due to reasonable cause and not willful neglect and the tax would be excessive relative to the failure. But due to lack of guidance and enforcement experience, very little is known about how or under what circumstances the IRS would exercise this discretion.

Employer Mandate

The employer shared responsibility mandate (or “play-or-pay”) under Code Section 4980H requires employers with 50 or more employees to offer affordable, valuable health coverage to all full-time employees and their dependents or risk paying a nondeductible penalty. The penalty amount varies depending on the nature and degree of health coverage that is offered and whether one or more employees qualify for premium tax credits to subsidize health coverage obtained on a public exchange.

Beginning in 2015, if an employer fails to offer health coverage to at least 95 percent (70 percent for 2015) of its full-time employees and their dependents and at least one full-time employee obtains subsidized coverage on a public exchange, the employer generally will be subject to an annual penalty of $2,000 for each full-time employee. This is sometimes called the “subsection (a)” penalty, in reference to Code Section 4980H(a), which imposes this penalty.

If the employer offers health coverage to at least 95 percent (70 percent for 2015) of its full-time employees and their dependents, but the coverage is not “affordable” or does not provide “minimum value,” the employer will be subject to an annual penalty of $3,000 for each full-time employee who actually obtains subsidized coverage on a public exchange. This is sometimes called the “subsection (b)” penalty, in reference to Code Section 4980H(b).

Although the subsection (b) penalty is a larger per-person dollar amount than the subsection (a) penalty, the total subsection (b) penalty will generally be less than the total subsection (a) penalty because it is triggered only by those full-time employees who actually obtain subsidized coverage on a public exchange. And in any case, the total subsection (b) penalty will not exceed what the employer would have paid if the subsection (a) penalty applied.

A key issue in complying with the employer mandate (or calculating the penalty that must be paid due to noncompliance) is identifying the employer’s employees who qualify as “full-time.” As a general rule, a full-time employee for ACA purposes means any employee who works (or is paid for) an average of 30 or more hours per week.

Recognizing that employee work schedules can fluctuate from week-to-week and that employers benefit from predictability in understanding who is treated as full-time for a given period of time, IRS regulations allow for identifying full-time employees under a “look-back measurement method” that involves measuring an employee’s hours of service over a prior period of time (the measurement period), determining whether the employee averaged 30 or more hours of service per week over that measurement period, and then assigning the employee a status (full-time or not) that the employee will retain for a fixed future period (the stability period) based on whether the employee averaged 30 or more hours of service during the measurement period.

For example, to identify the employees who will be considered full-time employees during 2016, an employer might measure hours of service over a 12-month measurement period beginning November 1, 2014, and ending October 31, 2015. Those employees who average 30 or more hours of service per week during the measurement period will be considered full-time employees for a 12-month stability period that begins January 1, 2016. Those employees who average less than 30 hours of service per week during the measurement period will be considered non-full-time employees for that same 12-month stability period.

Properly applying the look-back measurement method requires collection and maintenance of detailed information regarding employee hours of service. And it may be necessary to retain that information for many years to establish that the employer has met its obligations under the employer mandate.

Beginning with the 2015 calendar year, employers are required to file annual information returns with the IRS (Forms 1094-C and 1095-C) that will allow the IRS to review compliance with the employer mandate and, if necessary, to assess penalties. Accurate reporting will be critical, because it will set the stage for the IRS’ enforcement activity.

Due Diligence Considerations

With that background, let’s first consider how these features of the ACA may affect the due diligence or other pre-transaction aspects of M&A transactions.

Review of Plan Documents

Collecting plan documents and reviewing them for compliance will already be on the due diligence checklist, but certain plan types deserve extra attention.

Grandfathered plans. Health plans that have been in existence since the ACA was enacted in 2010 may qualify as “grandfathered” plans. Grandfathered plans are exempt from compliance with some of the insurance-market reforms, such as the requirement to provide preventive-care benefits without cost sharing. But stringent rules must be followed to ensure a plan that’s intended to be grandfathered remains grandfathered. These include a notice requirement and limitations on changes to cost-sharing provisions and employee premium contributions.

A plan that has been operated as a grandfathered plan but, in fact, is not (e.g., because it failed to satisfy at least one requirement for remaining grandfathered) will likely have violated one or more insurance-market reforms, perhaps over a period of many years. For example, a plan that is erroneously believed to be grandfathered likely will not have provided all required preventive-care benefits without cost sharing. This leaves the plan sponsor exposed to liability for the $100 per person, per day excise tax under Code Section 4980D, as well as to potential liability for re-processing of claims, which the Department of Labor might require in an ERISA audit.

If a potential M&A target maintains a plan that purports to be a grandfathered plan, the plan’s status as a grandfathered plan should be carefully verified.

Premium reimbursement plans. Some employers have maintained programs that pay or reimburse (often on a pretax basis) premiums incurred by employees for coverage under individual health insurance policies. Under IRS Notice 2013-54, these arrangements are treated as group health plans. Group health plans are required to comply with the ACA’s insurance-market reforms, but premium reimbursement plans typically violate at least two of the reforms. They generally limit benefits (premium reimbursement) to the maximum amount of premiums due under the individual policy each year, which is a type of prohibited annual limit. And they generally don’t pay for preventive care, thereby violating the preventive-care mandate.

As with grandfathered plans, these violations expose the plan sponsor to significant excise taxes. Steps should be taken to identify any premium reimbursement arrangements and carefully review their terms and provisions.

Health reimbursement arrangements (HRAs). HRAs are typically account-based plans that allow for reimbursement of medical expenses up to the amount credited to the employee’s account. (They are similar to health flexible spending account plans, except that employees cannot contribute to an HRA.) HRAs are also treated as group health plans under IRS guidance and, when viewed in isolation, will typically violate the annual-limit rule and the preventive-care mandate.

An exception is made for “integrated” HRAs, meaning HRAs that are used only in connection with another group health plan that does satisfy the insurance-market reforms. But specific requirements must be satisfied for an HRA to qualify as an integrated HRA, and compliance with these requirements should be carefully reviewed. Like other plans that violate the insurance-market reforms, an HRA that is not an integrated HRA will expose the plan sponsor to significant excise taxes.

Summary of Benefits and Coverage

The standard list of documents to collect and review with respect to a plan includes the plan document and summary plan description that are required by ERISA. That list now must also include the “summary of benefits and coverage” (SBC) for each group health plan.

The SBC is an additional disclosure document mandated by the ACA’s insurance-market reforms. It provides an overview of key plan information, such as deductibles, copays, covered services, and noncovered services, and is organized in a standard format to facilitate comparison of two or more different plans. It is generally required to be distributed in connection with plan enrollment and at other times upon request.

As a market reform, the failure to properly maintain and distribute an SBC can result in excise-tax liability under Code Section 4980D. In addition, a specific statutory penalty of $1,000 applies to any willful failure to provide an SBC to a plan participant or beneficiary. Regulators have indicated that both penalties can be applied. Thus, verifying that all required SBCs have been prepared and properly distributed is critical.

Target Company Financial Information

If the target company is subject to the employer mandate, due diligence should verify whether the company has taken the necessary steps to avoid penalties under Code Section 4980H. If not, due diligence should include reviewing whether the penalty amounts have been appropriately reflected in the target company’s financial statements.

The catch with respect to the employer mandate penalties under Code Section 4980H is that they likely will not be assessed by the IRS until a significant period of time after the year to which they relate. The IRS has indicated that it will not begin reviewing data from information returns until at least October following the calendar year to which the penalty relates. If the IRS identifies a case in which it believes a penalty is owed, it will then provide the employer with a preliminary letter stating the proposed penalty amount. The employer will then have an opportunity to respond to the preliminary letter before a final assessment is made. It’s not yet clear how long the total process will take (nor is it clear what types of appeal rights or other procedures will be available to an employer challenging a proposed assessment), but it seems reasonable to expect that final assessment will not occur until at least 14–18 months after the close of the year to which the penalty relates.

A target company that keeps its books on a cash basis may not reflect a liability for this penalty until it is finally assessed by the IRS, which could be months, if not years, after the year to which the penalty relates. So it may be necessary to calculate the potential liability independently for any years for which a final assessment has not yet been made.

A target company that keeps its books on an accrual basis may be more likely to reflect liability for a penalty in advance of formal assessment. In fact, there is some anecdotal evidence of auditors requiring a footnote (if not an actual accrual) of the penalty, if a company cannot demonstrate that appropriate steps have been taken to avoid all penalties. Thus, financial statements may also be a useful tool for identifying cases in which closer review of the penalty issue is warranted.

Document Considerations

Although ACA compliance issues generally can be addressed in the deal documents in a manner similar to other benefits compliance issues, some items may merit specific attention.

Representations and Warranties

SBCs. Given the significant penalty exposure for failure to distribute an SBC, a specific representation that the SBC has been properly distributed should be included. Depending on the extent of due diligence conducted, it may also be appropriate to require a representation that copies of SBCs have been provided for at least three years (or as long as the SBC requirement has applied).

Grandfathered plans. Because grandfathered plans present a similar risk of significant penalty exposure, the document should require a representation that any group health plan intended to be a grandfathered plan has continuously satisfied the requirements to be a grandfathered plan since March 23, 2010.

Worker classification. Compliance with the employer mandate requires properly identifying all common-law employees who are full-time employees. The IRS has declined to provide relief from penalties that may be triggered due to misclassification of employees as independent contractors. Thus, if not otherwise addressed in connection with employment or benefit matters, the document should require a representation that all workers have been properly classified and, specifically, that all workers who are common-law employees within the meaning of the ACA and Code Section 4980H have been classified as employees.

Tax compliance. In the representations related to tax filing and compliance, specific reference should be made to timely filing of any required Form 8928 (the excise tax return under Code Section 4980D) and timely payment of the required excise taxes. Reference also should be made to timely and accurate filing of Forms 1094-C and 1095-C, which are the information returns required under Code Section 6056 relating to the employer mandate. Other tax-filing or similar requirements that are unique to the ACA and may warrant specific treatment include:

  • The Patient Centered Outcomes Research Institute trust fund tax imposed under Code Section 4376 with respect to self-insured health plans, including the timely filing of IRS Form 720 to report and pay the tax.
  • The Transitional Reinsurance Program contribution required under Section 1341 of the ACA and 45 CFR §153.400 with respect to major medical plans for each year from 2014 to 2016.

Covenants and Closing Conditions

Whether through a covenant, closing condition, or similar provision, the deal document should obligate the target to provide the acquirer with the information needed to enable the acquirer to address any enforcement issues that may arise with respect to the employer mandate and to comply with the mandate going forward. This will primarily consist of records related to employee hours of service, but may also include calculations of average hours of service and other documentation regarding determinations of full-time status. As discussed further below, this information may be necessary to ensure the acquirer can properly apply the look-back measurement method following the transaction.

Indemnification

There may be a long period of time between the year in which events occur that establish the basis for ACA-related excise taxes or penalties and the time at which those taxes or penalties are actually assessed. The statute of limitations may never run on excise taxes attributable to market-reform failures, if Form 8928 is not filed. And even in the normal course of business it may take the IRS months, if not years, to evaluate and assess penalties related to the employer mandate. These horizons should be taken into account in determining how long indemnification rights will be available to remedy a breach of representations or warranties related to these matters.

Post-Closing Considerations

After a transaction closes, some tricky administrative issues may arise in connection with ACA compliance as employees of the target company are integrated into the acquiring company’s workforce. These issues may be especially acute in mergers and asset acquisitions, after which target company employees are employed by a different entity than before the transaction.

Look-Back Measurement Method

Employers using the look-back measurement method to identify full-time employees for purposes of the employer mandate have considerable flexibility in designating the measurement and stability periods they will use. For example, one employer might use a 12-month measurement period beginning October 1 each year, while another might use 6-month measurement periods beginning on January 1 and July 1 each year.

If the acquiring company and the target company in a transaction use different measurement and stability periods, it can be difficult to sort out how target company employees should be treated under the look-back measurement method following the transaction. IRS Notice 2014-49 provides companies in this situation with a couple of options. (This guidance is preliminary, but may be relied on at least until the end of 2016.)

One option is to treat acquired employees as if they transferred to a new position with different measurement and stability periods. Under this approach, if an acquired employee has been employed by the target company for a full measurement period at the time of the transaction, the employee will retain the status dictated by that measurement period through the end of the target company stability period associated with that stability period, after which the acquiring company’s measurement and stability periods apply. And if an acquired employee has not completed a target company measurement period at the time of the transaction, the employee’s status will be determined using the acquiring company’s measurement and stability periods, but applying those periods by taking into account hours of service with the target company.

A second option is to continue applying the target company measurement and stability periods to the target employees during a transition period following the close of the transaction. This transition period begins on the date the transaction closes and ends after the completion of a full measurement period and stability period, using the target company’s measurement and stability periods. (In some cases, this transition period could exceed three years, depending on the length of the target company’s measurement and stability periods and the timing of the transaction.) After the transition period, the acquiring company’s measurement and stability periods apply.

Under either of these approaches, it will be necessary for the acquiring company to obtain detailed pre-transaction information about the target company employees. For example, if the acquiring company’s measurement and stability periods will be applied, it will be necessary to understand the pre-transaction hours of service of the acquired employees, so those hours can be taken into account in applying the acquiring company’s measurement and stability periods. And if the target company’s measurement and stability periods will continue to be used for a transition period, it will be necessary to understand the status of the acquired employees at the time the transaction closes, so that status can be carried forward.

Prior Service Credit

Notwithstanding these special rules, in an asset acquisition it may also be possible to simply treat the target employees as new hires of the acquiring company. If that will be done, attention should be paid to whether or how prior service credit will be granted. For example, if the intent is for target employees to start over under the acquiring company’s measurement and stability periods but the deal documents give target employees a broad grant of prior service credit, it may be necessary to take service with the target company into account when applying the acquiring company’s measurement and stability periods. This may result in many acquired employees being immediately treated as full-time employees of the acquiring company.

Information Reporting

The information reporting that large employers are required to do under Code Section 6056 applies on an entity-by-entity (EIN-by-EIN) basis. Each separate entity that has employees during the year is required to file a separate information return, even if it is part of a controlled group.

It is unclear how this reporting is handled when two entities merge during a year. One approach is for the surviving entity to treat itself as a continuation of the merged entity and file a single return reporting information on the acquired employees for the entire year. Another approach is for the surviving entity to file two separate returns with respect to the acquired employees – one under the acquired entity’s EIN for the period before closing and one under its own EIN for the period after closing. The guidance doesn’t tell us which of these approaches is correct.

This conundrum may be illustrative of other challenges that will arise in applying these more arcane features of the ACA in the M&A context.

Conclusion

The ACA has raised the stakes on compliance problems with group health plans, warranting thorough treatment of such plans in both due diligence and risk allocation. Complex administrative and compliance obligations also have been created that will require access to detailed information about acquired employees during and after a transaction. And the landscape is continually developing and evolving, leading to questions and uncertainties that may take time to resolve. All of this is manageable and will become more routine over time. But as the law continues to develop, a thoughtful and cautious approach to ACA issues in transactions is advised.

Family Business Disputes

Posted on February 17, 2015 by - Uncategorized

As any experienced litigator could attest, family business disputes tend to be ugly, protracted, and destructive. For a case in point, consider the recent discord among members of the Demoulas family regarding control of the Market Basket supermarket chain. Demoulas family hostilities stretch back decades and include courtroom fisticuffs. The latest flare-up, which was reported extensively in the Boston Globe and other national newspapers this past summer, jeopardized the viability of the business and approximately 25,000 jobs. Ultimately, one of the two warring factions agreed to a buyout, but achieving that commonsense result apparently required the personal involvement of the governors of Massachusetts and New Hampshire. 

Needless to say, most family businesses cannot expect gubernatorial assistance in resolving their private disputes. Yet, even if typical family business disputes involve lower economic stakes, family businesses in the aggregate are tremendously important for the U.S. economy. Family businesses represent the majority of all businesses, employ about half the nation’s workforce, and contribute a substantial amount to the nation’s gross domestic product. Also, apart from any wider economic implications, family business disputes can be devastating for those involved. Accordingly, the distinctive characteristics of family business merit careful study. 

This article offers an overview of issues relevant for lawyers who represent family businesses. First, it identifies typical sources of conflict in family businesses that practitioners should recognize in order to understand the underlying dynamics of family business disputes. Second, it shows how family law can affect business outcomes and, accordingly, emphasizes the need for contractual planning that includes both business and family considerations. However, even if represented by counsel at formation, family business participants may be reluctant to negotiate at arm’s length and cannot, in any event, hope to anticipate every possible dispute that might arise. Therefore, as family businesses increasingly gravitate toward the LLC form, this article contends that there remains a need to apply standard judicial remedies for abuse of control, mostly developed in the corporate law context, which protect the parties’ reasonable expectations. 

Sources of Conflict

In a “family business,” a single family controls business decisions and at least two family members are involved in the business. A more complete definition would require significant elaboration, but in most instances, the family status of a business will be perfectly clear to the owners, to the employees, and, of course, to legal counsel. Fundamentally, family businesses are extensions of family relationships – the business system and the family system are deeply interrelated. 

Unfortunately, while business values and family values overlap, they do not necessarily align. In part, this can be understood as a problem of social roles. For most of us, our workplace identity is very different from the role that we play in family life. But in a family business, role separation becomes more difficult. If Mom is the boss, when she talks to one of her employees, she may also be addressing one of her children. The expectations that we have of members of our family – that we put the family’s interests first, that we take care of each other – may conflict with the goal of maximizing economic return in a business. To the extent social roles are incompatible, family business has a built-in conflict. 

Also, the overlap of family and business enables conflict to spread from one domain to the other. In one case, an individual who worked for his family’s business married outside the religious faith and was then frozen out of the business by his father and his brother. In another case, a woman refused a buyout offered by her parents, not because the price was too low, but because her brother would be the beneficiary. Family problems become business problems and vice versa. Depending on how they are managed, family relationships can serve the interests of the business, or fatally undermine it. 

Conflict can arise from any direction, but succession often poses a serious challenge for family businesses. If a family business is to survive as such, each generation must eventually cede control to the next – and yet many family businesses fail to plan for succession, dealing with the issue only after the death or incapacitation of a controlling family member. Such avoidance can be understandable. For instance, to the extent work and family are linked, stepping down from a position of responsibility within the business may seem like a surrender of status in the family. Also, parents may hesitate when faced with the choice whether to treat all children equally or transfer control to the most able member of the next generation. Yet, the tax and governance consequences of ignoring the inevitable can cripple a business that would otherwise have been well positioned for continued success. 

Family Law’s Influence

Setting aside the myriad difficulties of combining family intimacy with the workplace, family relationships may also have straightforward legal implications for family businesses. While this statement may not seem revolutionary for some, for many, business law and family law fall in separate categories. In law school, we teach business law courses and family law courses. Family business law courses are almost non-existent. Legal academia adheres to the same artificial distinction – there are academics who write about family law issues, and academics who write about business law issues. Family business lawyers, however, are well aware that legal principles relevant to the parties’ family relationships can affect the outcome of their business disputes. In this regard, the laws governing divorce and inheritance are particularly important. 

If a family business is co-owned by a married couple, for instance, a divorce will have enormous implications. Not only must the parties exit the marital relationship, but their separation will also in most cases involve the exit of one or both parties from the co-owned business. Just as a practical matter, the simultaneous disruption of two different legal entities – the marriage and the family business – creates problems of coordination. Further, the parties’ rights are not identical in each context and equitable principles of divorce law often trump conflicting business law rules.

Regardless of the parties’ allocation of control and ownership rights as to a particular business venture, a family court overseeing a divorce has broad, equitable discretion to divide marital assets, which can include business assets. In the context of divorce, the relevant economic partnership is the marriage, not the business, and equity is the overriding consideration. For example, in a recent case involving the L.A. Dodgers, Jamie McCourt owned none of the stock, but was able to claim half the value of the business in her divorce from Frank McCourt, the team’s sole owner. By contrast, the Texas oil tycoon Harold Hamm was recently ordered to pay his ex-wife Sue Ann Hamm $1 billion; a staggering sum, to be sure, but far less than 50 percent of the value of his stake in Continental Resources, a company that he led as CEO during the marriage. Had the award been higher, Harold Hamm might have been forced to sell his controlling stake in the business in order to satisfy the judgment. 

Family considerations can also affect business outcomes when control of a family business passes to the next generation. For instance, the six siblings who now own Luray Caverns, a tourist-attraction cave near Washington, D.C., have been battling for years, aligned roughly in two camps – the older siblings and the younger siblings. As reported in the Washington Post, the dispute turns in large part on the parents’ will and related trust instruments. The older siblings have objected to the appointment of certain trustees for the trusts that manage the family’s stock interest in the business. Of particular note, the will contains a no-contest provision that purports to disinherit anyone who challenges the parents’ choices with regard to trustee appointments. Relying upon that provision, which would be unheard of (and likely unenforceable) in a corporate charter or LLC operating agreement, the younger siblings have sought to obtain full control of the business by disinheriting their older siblings according to the terms of the will. 

Moreover, as the Luray Caverns litigation shows, inheritance issues often implicate trust law. If the business founders establish a trust to hold company stock for the benefit of family members, the applicable governance and fiduciary rules are thereafter a matter of trust law as well as business law. Technically, the trust owns the stock and the family members, who are beneficiaries of the trust, are not themselves owners. Thus, as part of a plan of succession, a more capable child or an outside manager could be selected to serve as trustee while the remaining offspring receive some measure of economic security through their beneficial trust interest. Alternatively, parents might give children a stake in a business, even a majority share, without relinquishing their own control. In trust-controlled businesses, the law of trusts can supersede otherwise applicable business law. 

Contractual Considerations

In advising family businesses, a lawyer’s most important resource is usually contract. The choice of entity form matters, but no existing type of business association contains default rules that smoothly reconcile business values and family values. The available business forms – chiefly, partnerships, corporations, and LLCs – do not presume any preexisting relationships among the investors. Moreover, given the variety of objectives that any family might have in operating a business, it is not clear what rules would best suit the majority of family businesses. Therefore, private ordering through contract is crucial to ensure that all participants are treated fairly and their expectations are taken into consideration. 

Consider the example of marital divorce. Since nearly half of all marriages fail, divorce litigation should be seen as a regular, recurring feature of family business ownership. Proper planning is essential. In some cases, shareholder agreements can help to ensure that business assets stay in family hands, for instance, by providing a right of repurchase should stock end up with an ex-spouse. But shareholder agreements aren’t enough to get the job done; as noted previously, the equitable division of marital assets in a divorce takes precedence. Marital agreements, however, can state whether business assets count as marital property and, if so, how those assets should be allocated. The point is that the shareholder agreement and the marital agreement are, in fact, two pieces of the same puzzle. 

In a contested divorce, the enforceability of a marital agreement may determine the fate of the family business. To return again to the McCourts’ dispute over the Dodgers, Jaime’s claim to 50 percent was valid under the default rules governing divorce in California. The Dodgers were acquired during the marriage and there was no question that Jamie had contributed substantially to the effort.  However, shortly after acquiring the Dodgers, the couple had entered into a marital property agreement. Apparently, in order to limit exposure to creditors, the agreement put their several houses and personal property in Jamie’s name, and the businesses in Frank’s name. Jamie claimed that she never read the agreement and failed to understand that it would affect her rights in a divorce. In the end, Jamie convinced the judge to throw out the agreement – otherwise, the divorce settlement would have looked very different, and Frank McCourt would probably still own the Dodgers. 

Marital agreements are not the only device available to protect family business assets from intra-family dissension. As mentioned earlier, parents often use trust instruments to give children a stake in the business without relinquishing control. Because the trust owns the stock, trust agreements may protect family assets should a child (or grandchild) divorce. Also, the trust structure can be used in some cases as part of a plan to minimize taxes. Indeed, many family businesses are structured in substantial part to achieve estate planning and related tax objectives, so that trusts, wills, and other testamentary documents may be as much a part of the business as articles of incorporation, bylaws, and shareholder agreements. 

Judicial Monitoring

Although the parties to a prospective business venture, family owned or not, should clarify key points before investing – for instance, when capital contributions may be required, how business decisions will be made, how earnings (or losses) will be distributed, and what types of opportunities belong to the business – the resources of contract are limited. The parties cannot anticipate every contingency that might arise in a long-term business relationship. Also, because bargaining is expensive, the costs of negotiating a more complete contract will eventually outweigh the benefits. Moreover, the participants in a closely held business may rely upon trust, even as to matters that could have been specified in advance. 

Family businesses present distinctive challenges for private ordering because they combine the values and expectations of the workplace with more intimate family bonds. Even if it were realistic to suppose that the parties would engage in arm’s-length contracting to define their mutual expectations, those expectations are complex and difficult to specify within the four corners of an operating agreement. Moreover, to the extent that arm’s-length negotiation reflects the values of the workplace and may be an affront to the informal norms that characterize family life, it cannot provide a neutral method for finding an appropriate reconciliation between the two sets of values. 

In the corporate context, most jurisdictions recognize a need for judicial monitoring of the parties’ relationship to prevent the opportunistic exploitation of gaps in the contractual bargain. This is true for family businesses and non-family businesses alike. For instance, even when they have not negotiated specific protections, minority shareholders can seek relief for oppression, often premised on the notion that controlling shareholders owe fiduciary duties and must honor the minority’s reasonable expectations. While courts will not rescue investors from the consequences of entering a one-sided bargain, neither will courts stand by and allow controlling shareholders to deprive minority shareholders of any return on their investment. 

In recent years, the LLC has overtaken the corporation as the entity form of choice for most small business owners. Notably, the LLC combines the flexibility of a traditional partnership and flow-through taxation with the stability and limited liability benefits of incorporation. Also, for tax reasons, families may use LLCs to hold real property for personal use. Thus, the continued vigor of judicial monitoring may depend upon whether well-established shareholder protections apply in disputes involving LLC members. 

In some respects, the difference in organizational form between a corporation and an LLC does not matter because the fundamental problem – an overreliance on trust and a failure to document basic understandings among co-owners – is identical. Regardless of formalities, the family members may view themselves as partners in a common enterprise. However, in corporations and LLCs alike, controlling family members can abuse their power when informal consensus evaporates; the majority has the formal right to control business decisions, and there is no default exit right for a minority owner frozen out of any return on her investment. Therefore, to the extent the law has already developed an approach for protecting minority shareholders in corporations, it would seem counterproductive to insist upon new, possibly less effective tools for dealing with a shared problem. 

However, while the contours of the problem may be familiar, one cannot assume that the available legal recourse is the same. Corporate law and LLC statutes in a jurisdiction may provide different standards for relief and offer different remedies. Also, to the extent LLC law places greater emphasis on private ordering, courts may be reluctant to imply equitable obligations not set forth in an operating agreement, and they may defer to waivers of fiduciary protections that would otherwise have applied. As a policy matter, one could argue that it would undermine the LLC’s value as a distinctive legal form if courts simply imported corporate law principles and failed to respect the difference between LLCs and corporations. The salience of this objection, in turn, might depend upon whether one can distinguish intelligent borrowing from blind copying. (It does not instill confidence when courts persist in using corporate-law terminology when addressing LLC disputes). 

Yet, even if LLCs follow a more explicitly contractual approach, perceiving a family business in contractual terms should not entail a narrow approach to the interpretation and enforcement of relevant bargains. That is, a contractual approach does not require courts to abandon minority investors, family or otherwise, to the explicit terms of their bargain, regardless of whether those terms are consistent with the parties’ reasonable expectations. If the business is a contract, it is a relational contract intended to endure over time and not a discrete, bargained-for exchange. Judicial protection of vulnerable minority investors conflicts with private ordering only if we assume the artificially rational world of neoclassical economics. But LLC members and corporate shareholders live in the real world, not in the pages of a game theory treatise, and the ties of family and friendship, the social norms of business, and the constraints imposed by transaction costs all affect the likelihood that the parties will negotiate adequate protections against possible future discord. 

Conclusion

For better or worse, so long as family ownership remains a prominent feature of the business landscape, courts will be called upon to adjudicate business disputes among family members. Although unfortunate, the family grievances that tore apart the Demoulas family and caused the Market Basket fiasco are not uncommon. In this regard, perhaps we can supply a lawyerly caveat to Tolstoy’s famous dictum that “each unhappy family is unhappy in its own way.” Where the novelist might observe an infinite variety of miseries, the experienced lawyer will perceive repetitions of a relatively small number of themes: sibling rivalries motivated by competition for parental affection; aging patriarchs who cannot let go; parents who invite disaster by distributing business assets to children without regard for their ability or interest; active participants who resent uninvolved family members for expecting to profit from a business that they do not contribute to building; and, in what some might characterize as the central problem of business law, the ever-present temptation for those who control a resource to use it, disproportionately, for their own benefit.

The Liability of Managers and Other Agents for Their Own Actions on Behalf of an LLC

Posted on February 17, 2015 by - Uncategorized

The eponymous characteristic of the limited liability company (LLC) is that the LLC, as a separate legal entity, is liable for its obligations to others and that no other person, whether as owner or agent, is vicariously liable for those same obligations. Of course, an LLC, like any legal entity, must act through individuals or other legal entities with the authority to act on behalf of the LLC. The individual or legal entity with this authority may be known by a number of designations: managers, managing members, authorized persons, officers, or employees, or simply as agents (collectively “Actors”). Under all LLC statutes, the general rule is that the members of the LLC are not personally liable for obligations of the LLC, subject to such exceptions as personal guarantees or “piercing” of the organizational veil. This article discusses a different aspect of vicarious liability: when an Actor will be liable to a third party for actions taken on behalf of the LLC. It does not address the liability of the LLC (or its owners qua owners) to the third party or the relationship between the LLC and its Actors.

Whether an Actor will be personally liable to the third party for an obligation incurred by the Actor while acting on behalf of the LLC is a complex question which will turn on: (1) whether the obligation is based in contract or in tort; (2) whether the duty breached by the Actor is a duty to the LLC or to the third party; and (3) if the obligation is a liability for damages, whether the damages are physical harm to the person or property of the third party or for economic loss suffered by the third party.

Contract

Actors, in their capacities as agents of an LLC, are generally subject to the same rules applicable to other agents. The Restatement (Third) of the Law of Agency (“Restatement of Agency”) § 6.01(2) provides the general rule that an agent (here the Actor) is not a party to – and thus is not liable to – a third party on a contract between a fully-disclosed principal (here, the LLC) and a third party, even if the agent, in its representative capacity as such negotiates and performs the contract. This rule is based on the concept that the agent, in contracting, is creating a contract that is binding on its principal and that the third party is relying on the principal for performance under the contract. Thus, other than the agent’s duty to the principal and the agent’s warranty of authority to the third party insuring that the agent does have the legal power to bind the principal (Restatement of Agency § 6.10), the agent does not have an individual role in the contract between the principal and the third party.

This result can be modified by the agreement of the agent, as, for example, where the agent has agreed to become a party to, or guarantee, the contract. But as a general rule, when an Actor on behalf of an LLC enters into a contract with a third party, the third party’s relief under the contract is limited to the LLC. The Actor’s conduct in entering into or performing the contract is immaterial to the liability for breach and the third party’s exclusive remedy is against the LLC. If the Actor is performing the contract on behalf of the LLC, the only person to whom the Actor is answerable is the LLC.

Tort

The Restatement of Agency has a different rule when an agent commits a tort that results in damage to a third party. Section 7.01 of the Restatement of Agency provides that an agent is liable to a third party harmed by the agent’s tortious conduct, irrespective of whether the agent is acting in a representative capacity or whether the principal is also liable to the third party. This rule is well-demonstrated by the idea that an Actor who negligently causes an automobile accident while driving in the course of his or her duties as Actor on behalf of an LLC is nonetheless personally liable to the third party injured in the accident. This is true regardless of whether the LLC is also liable to the injured third party. As discussed below, many LLC acts recognize this rule, although they recite it in different ways.

Not all tortious conduct of an agent that results in liability to a third party will subject the agent to liability to the third party. As explained in Section 7.02 of the Restatement of Agency, the tort must violate a duty owed directly by the agent to the third party. Thus, an agent (or any other person) who operates a motor vehicle on a public highway owes a duty to others on the highway not to cause damages to them through negligence. Section 7.02 notes that an agent’s breach of a duty owed to the principal is not an independent basis for the agent’s tort liability to a third party. For example, when a basketball player’s agent negotiates a contract with a third party for the player’s services and then negligently fails to inform the player about the contract or the player indicates he cannot perform, but the agent fails to inform the third party, the third party may not recover damages for agent’s negligence because the agent owes duties to the player but not the third party.

Physical Harm vs. Economic Loss

Even if the third party has a claim in tort for negligence, the liability of both the Actor and the LLC may be limited by a general rule that has developed significantly over the past few decades. The “Economic Loss Rule” is expressed in case law and described in the Restatement (Third) of Torts: Liability for Economic Harm (“Restatement of Torts: Liab. for Econ. Harm”), which is currently being completed by the American Law Institute. The Restatement describes the Economic Loss Rule as holding that there can be no liability in tort for causing pure economic loss. The definition of “economic loss” for purposes of this rule is generally defined as a loss or damage other than one resulting from personal injury to the plaintiff or physical damage to the plaintiff’s property, and encompasses such matters as lost profits, diminution in value, lost opportunity, and other monetary losses. The Economic Loss Rule is sometimes stated as precluding an action in tort by a party suffering only economic loss from a breach of an express or implied contract absent an independent duty of care under tort law.

The Restatement of Torts: Liab. for Econ. Harm § 3 Comment a expressly does not adopt the Economic Loss Rule, which it characterizes as the “minority view” and proposes a much more limited rule. Restatement of Torts: Liab. for Econ. Harm §§ 1 (“an Actor has no general duty to avoid the unintentional infliction of economic loss on another”) and 3 (“there is no liability in tort for economic loss caused by negligence in the performance or negotiation of a contract between the parties”). While the basic rules governing economic loss are neither settled nor simple, they do represent an important current in rules governing liability. The rationale for the rules dealing with economic loss or economic harm is that, in matters involving economic loss (generally, pecuniary damage other than that arising from damage to the plaintiff’s person or property), the contract between the parties, as opposed to general tort law, should govern, even where the damage results from the negligence of one of the parties. The basis supporting this rationale is that the parties may readily establish the standards of conduct and protect themselves from the failure to meet those standards under the contract between them, so there is no need for a tort remedy.

When this limitation on tort liability is combined with the general rule that an agent (here the manager or other Actor) is not liable to a third party on a contract between a fully disclosed principal (here the LLC) and a third party, this concept, even as defined by the Restatement of Torts: Liab. for Econ. Harm, will further limit the liability of an Actor to the third party.

While the Economic Loss Rule and the Restatement of Torts: Liab. for Econ. Harm both protect Actors from tort liability for economic loss arising in the course of negotiating or performing contracts, there are important exceptions to this protection. Not surprisingly, the protection does not apply to professional services (thus, an attorney may be liable in tort for economic loss arising from the attorney’s negligence) or fraud. The Restatement of Torts: Liab. for Econ. Harm also provides an extensive discussion of the sort of fraudulent or negligent misrepresentations (including promissory fraud) that will subject an Actor to liability in tort even if the tort occurred in the negotiation or performance of a contract.

Application of LLC Statutes

All of the concepts discussed above will be generally applicable to persons acting on behalf of limited liability partnerships and corporations, and, with respect to all such persons other than general partners, limited and general partnerships. Those rules that are based on agency principles will apply to all agents. There are some additional rules that may have unique application to LLCs as a result of state LLC legislation. Many – but not all – of the LLC statutes have an express statement to the effect that Actors (sometimes limited to statutorily-defined managers, sometimes including employees and other agents) are not liable solely by reason of being or acting as an Actor. The statutes tend to divide into three general categories: (1) silence on the liability of Actors, (2) a general statement that managers are not liable for the obligations of the LLC, or (3) a statement that managers (or, in some cases, all Actors) are not liable for the obligations of the LLC “solely by reason of” (being or acting as) a manager (or other Actor). In addition, some of the statutes providing for non-liability of managers or other Actors include an express exception for Actors who are professionals. For a table showing the different formulation of these provision in different states, see Larry E. Ribstein and Robert R. Keatinge, Ribstein and Keatinge on Limited Liability Companies at Appendix 12-3.

Recently, a few cases have considered the liability of managers or managing members under statutory language stating that a member or manager is not liable for a debt or obligation solely by reason of being or acting as a member or manager. In Dass v. Yale, 2013 IL App (1st) 122520 appeal denied, 117224, 2014 WL 1385161 (Ill. Mar. 26, 2014), the court held that the manager of an LLC was not personally liable in connection with a warranty of condition of certain sewer lines and promise to conduct further testing of those lines made by an LLC of which the defendant was manager. Similarly, in 16 Jade St., LLC v. R. Design Const. Co., LLC., 398 S.C. 338, 728 S.E.2d 448 (2012), reh’g granted (May 4, 2012), opinion withdrawn and superseded on reh’g sub nom. 405 S.C. 384, 747 S.E.2d 770 (2013), after a somewhat convoluted appellate history concluded that the defendant (a member of the LLC that acted as contractor on a construction project) owed no duty to plaintiff (the property owner) for certain construction defects.

Both of these cases looked at certain legislative history in the Uniform Limited Liability Company Act (1996) which provides: “A member or manager, as an agent of the company, is not liable for the debts, obligations, and liabilities of the company simply because of the agency. A member or manager is responsible for acts or omissions to the extent those acts or omissions would be actionable in contract or tort against the member or manager if that person were acting in an individual capacity.” This language, appears to be a clumsy restatement of the concept better enunciated in Restatement of Agency § 7.02 (“An agent is subject to tort liability to a third party harmed by the agent’s conduct only when the agent’s conduct breaches a duty that the agent owes to the third party.”). As such, the manager in Dass and the member in 16 Jade Street were not held individually liable for negligence that occurred in the LLC’s discharge of its contract with the plaintiff.

Conclusion

Much attention has been given to the vicarious liability of members qua owners of an LLC because members are not vicariously liable for the obligations of the LLC solely by reason of their status as owners – thereby distinguishing them from general partners in general and limited partnerships. Only recently has the liability of Actors in LLCs and other organizations for actions taken on in their capacity as agents of the organization become the subject of extensive legal analysis. Recent case law, statutory provisions, and the Restatement of Torts: Liab. for Econ. Harm have focused greater attention on this issue and provided some guideposts that may help in developing a clear set of principles. As a general matter, the following rules should apply:

  • To the extent that an LLC’s obligation to third party liability arises under a contract between the LLC and the third party, the Actor will not be liable even if the Actor is instrumental in entering into or performing the contract for the third party
  • To the extent that an Actor is negligent in performing his or her duties for the LLC, the Actor will not be liable to a third party for any damage incurred by the third party unless the Actor owed an independent duty to the third party.
  • To the extent a third party sustains economic harm (i.e., harm other than personal injury or injury to the third party’s property) as a result of the negligence or other tort committed by an Actor in the course of negotiating or performing a contract between the LLC and third party, the Actor will not be liable to the third party under the Economic Loss Rule or the Restatement of Torts: Liab. for Econ. Harm.
  • Notwithstanding the rules set forth above, an Actor will be liable to a third party for damages resulting from the Actors actions if: (1) the Actor is a professional in the context of the LLC’s rendition of professional services to the third party or (2) the Actor has made fraudulent misrepresentations (including promissory fraud).

Each of these rules are general statements of principles that are subject to many exceptions, qualifications, and nuances. They do not deal with the liability of the Actor to the LLC or the liability of the LLC to the third party.

Further, there are many other factors that may have an impact on the liability of the Actor to the third party. For example, while as a matter of common law an agent may not have obligations under a contract between the principal and the third party, the agent may agree to become a party to that contract or may be subject to liability under other state statutory or common law.

In addition, as noted above, the Economic Loss Rule varies from the rules with respect to economic harm articulated in the Restatement of Torts: Liab. for Econ. Harm. The rules under the Economic Loss Rule and those under the Restatement differ on the extent to which the Actor is protected in the case of economic harm (under the Restatement, the protection is limited to economic loss caused by negligence in the negotiation or performance of a contract between the parties while the economic loss rule has been read as broadly as to eliminate liability in tort for causing any economic loss to another), and the extent to which the damages that the third party has sustained constitute “economic loss” or “economic harm” (the Restatement attempts to clarify the distinction between “economic loss” and injury to the plaintiff’s person or property in a way that is more rigorous than that employed by the common law of some states). Thus, the liability of the Actor may turn on whether the jurisdiction in which the claim is determined has adopted the Restatement of Torts: Liab. for Econ. Harm or some variation on the “Economic Loss Rule.”

Nonetheless, the important lesson that may be taken from this Sturm und Drang of varying rules is that the liability of a manager or other Actor for actions taken on behalf of the LLC of which he or she acts is neither automatic nor totally precluded. In determining that liability, a court will need to analyze the nature of action (i.e., tort or contract), to duties owed by the Actor and to whom the duties are owed, the nature of the damages sustained by the third party (i.e., whether they are “economic” or not), and the language and intent of the state LLC statute. The cost and uncertainty of this analysis, as well as the clear encouragement that all of the rules provide for the parties to anticipate these problems before they arise, all strongly argue for contractual undertakings involving principals, agents, third parties, and – if appropriate – insurers at the outset of the transaction. As stated in the Restatement of Torts: Liab. for Econ. Harm § 3 Comment b: 

When a party’s negligence in performing or negotiating a contract causes economic loss to the counterparty, remedies are determined by other bodies of law: principally the law of contract, though sometimes also the law of restitution or relevant statutes. The law of contract and the law of restitution have been developed for the specific purpose of allocating economic losses that result from the negotiation and performance of contracts. They provide a more extensive and finely tuned apparatus for the purpose than the law of torts, which has developed primarily to address injuries that occur outside contractual relationships.

Series of Unincorporated Business Entities: the Mobius Strip and Klein Bottle of Business Entity Law

Posted on February 17, 2015 by - Uncategorized

Möbius strip, a one-sided surface that can be constructed by affixing the ends of a rectangular strip after first having given one of the ends a one-half twist. This space exhibits interesting properties, such as having only one side and remaining in one piece when split down the middle.

 

Klein bottle, topological space, named for the German mathematician Felix Klein, . . . not constructible in three-dimensional Euclidean space but [with] interesting properties, such as being one-sided, like the Möbius strip; being closed, yet having no “inside” . . . ; and resulting in two Möbius strips if properly cut in two.

*     *     *

Back in the day – say, 1990 – limited liability companies (LLCs) were the cutting edge of business entity law. Today, LLCs dominate entity formation, and the cutting edge has moved further out – to the notion of a “series,” a quasi-separate, quasi-person existing within an LLC.

Business lawyers are generally familiar with series of stocks and bonds, but those series have nothing to do with the LLC series discussed in this article. To avoid confusion, this article refers to protected series, which, as we will see, are the Mobius strips or Klein bottles of entity law.

The Protected Series Construct

The protected series comprises an identifiable set of assets segregated within a limited liability company (or also, under Delaware law, within a limited partnership), with the following features:

  • Those “associated” assets constitute the series, and a series is empowered to conduct activities in its own right. A series and its associated assets are responsible only to persons asserting claims pertaining to those assets or activities.
  • The associated assets are not responsible to persons asserting claims arising from the assets or activities of the LLC itself or from any other set of assets segregated within the LLC (i.e., from any other series within the LLC).
  • One or more members of the LLC may be, but are not necessarily, associated with the series.
  • The profits of the series inure to the benefit of only the members associated with the series, or if there are none, the LLC itself.

Thus, an LLC that has protected series perforce has “internal shields” – i.e., the partitions confining the assets and liabilities of each series to that series alone. These shields are conceptually and practically quite different from the shield that protects the owners of an entity from automatic liability for the entity’s obligations.

As detailed below, no one knows whether the internal shields will work in bankruptcy. Accordingly, this article is a warning label, not an operator’s manual.

What’s Old and What’s New?

The protected series has long existed in the context of series of investment trusts (particularly Delaware statutory trusts) and in the kindred context of captive insurance companies. However, in those contexts:

  • the construct has the blessing (and supervision) of the relevant regulators; and
  • the internal shields are not at issue, because:
    • involuntary creditors are as plentiful as unicorns; and
    • voluntary creditors will promise not to challenge the internal shields.

In 1996, Delaware amended its LLC and limited partnership statutes to provide for protected series. At that time, the thought seemed to be a combination of “why not?” and “perhaps in some circumstances an LLC or LP might work marginally better than a series within a Delaware statutory trust.” None of the key architects of the series provisions of the Delaware LLC and LP statutes then envisioned, let alone advocated, using series to compartmentalize the activities of operating businesses.

That attitude may well remain “best practices.” For example, the LLC Committee of the ABA Business Law Section has begun drafting a model operating agreement for a multi-member Delaware LLC with protected series. The project assumes that the LLC will be an investment vehicle and not an operating business or holding company.

However, anecdotal evidence suggests that many “series LLCs” are indeed used for operating businesses and holding companies and that many lawyers are recommending (or at least countenancing) such purposes.

Twelve states, the District of Columbia, and Puerto Rico now have series provisions in their respective LLC acts, and on Google the hits for “series LLC” go on almost endlessly. More than 25,000 series now exist under Illinois law alone.

These developments are occurring even though the efficacy of a protected series’ internal shields remains in doubt and many other important question are as yet unanswerable.

The Import of the Series Construct in Other Areas

Outside the realm of investment funds and captive insurance companies, the protected series is one of the most significant developments in the law of business organizations since the advent of the LLC. The series:

  • pushes the conceptual envelope of entity law by providing for a quasi-distinct legal construct existing within an overarching entity; and
  • establishes a new type of liability shield – rather than protecting the owners of an organization from vicarious liability for the organization’s debts, the “internal shields” of a protected series protect the assets of one protected series from the creditors of the overarching entity and any other protected series of that entity.

Enter the Uniform Law Commission

The Uniform Law Commission (“ULC” or “Commission”) (formerly known as the National Conference of Commissioners on Uniform State Laws), is a long-established (est. 1892) non-profit that develops and supports the enactment of uniform state statutes. The Commission’s most famous uniform act is the Uniform Commercial Code. The Commission’s earliest business organizations act was the 1914 Uniform Partnership Act.

In 2011, the ULC established a study committee to consider whether to draft a uniform act providing for protected series. A Drafting Committee began work in 2013 and is expected to finish work in 2015.

The committee’s work has been complicated, because a uniform business entity act must be “self-executing” – that is, the act must (1) take into account that most business entities are formed without legal advice, and (2) provide sufficient “default rules” so as to allow an entity to function without its owners having specified the rules that govern their inter se relationship. As a result, the Drafting Committee is identifying and addressing numerous issues that current series statutes address vaguely or not at all. As explained below, a uniform act can resolve some of those issues but not all.

ULC Drafting Committee Key Issues

Will the Internal Shields Hold?

No series act can directly answer these questions, because they implicate the Supremacy Clause (bankruptcy law) and choice of law doctrine (states without series legislation). The “internal affairs” doctrine does not control the choice of law question, because the internal shields dramatically affect the rights of creditors in a quite novel way.

As for the internal shields under bankruptcy law, no directly relevant case law exists. The safest approach would be to characterize the protected series as a separate entity and provide the series the full spectrum of entity powers. However, most series statutes duck the characterization issue, declining even to define a series as a separate “legal person.” As for entity powers, a series can contract, own property, and sue and be sued, but cannot exist except within the overarching organization (i.e., an LLC, or under some statutes, a limited partnership).

For investment trusts and captive insurance companies, a “non-entity” approach is essential for regulatory reasons. But outside those contexts the aversion to entity status remains unexplained – even though this aversion might conceptually undermine the shields. Moreover, there may be practical problems with saying, “It looks like a duck, quacks like a duck, swims like a duck, but it’s not a duck. Mobius strips and Klein bottles may seem real to mathematicians, but the series as non-entity, non-person may be so counter-intuitive to judges as to encourage piercing, substantive consolidation, and other theories of affiliate liability.

In sum, with regard to the internal shields, the only thing we know for sure is that we know nothing for sure.

  • The Drafting Committee’s current approach: A protected series is a person distinct from the series organization, other series of the organization, and the owners of the organization. A series cannot exist on its own.

Will Other Important Areas of Business Law Accommodate the Series?

The California Franchise Tax Board has decided to treat protected series as separate entities for filing and tax purposes, and the U.S. Treasury Department has formally proposed to treat each protected series as a separate taxpayer. However, it is uncertain how series will interrelate with other important areas of business law.

The two most important examples are bankruptcy law and Article 9 of the Uniform Commercial Code. As noted above, if bankruptcy law does not respect the internal shields, the shields are worthless. Moreover, if a series cannot enter bankruptcy on its own, the situation will be messy at best.

As for Article 9, that law – not series law – determines where to file a financing statement on assets associated with a series. The determination depends on the Article 9’s characterization of the debtor, and for a protected series that characterization involves three questions much at issue under most series statutes: (1) Is a series a distinct entity or at least a juridical person? (2) Does the formation of a series require the filing of a document with the government? (3) Precisely what “interest” does a series have in property associated with the series?

Other examples are perhaps less dramatic, but nonetheless involve serious practical questions. For instance: How does a person make service on a series? How do statutes requiring foreign organizations to register to do business in a state apply to series? For the purposes of establishing personal jurisdiction over a series or an LLC with series, are the activities of the “parts” aggregated in a whole?

  • The Drafting Committee’s current approach: A series is a person whose formation requires the public filing of a document. One serves a protected series by serving the LLC. For purposes of foreign registration and personal jurisdiction, each series is distinct from the LLC and any other series of the LLC.

Who Owns Property “Associated” with a Protected Series?

To indicate that a particular protected series encompasses particular assets, series statutes use “associate” as the term of art. However, these statutes do not describe a series as “owning” associated assets. The statutes refer instead to “assets of a series.”

If “assets of a series” means something less than ownership, the phrase is at best ambiguous. For the internal shields to function as intended, a series must have exclusive rights in its associated assets vis-à-vis the LLC and any other series of the LLC. Only in this way can those assets be made available solely to the series’ creditors, safe from competing claims from creditors of the LLC and other series. To have exclusive rights in property means to own the property.

  • The Drafting Committee’s current approach: “Property associated with a protected series is owned by the protected series.”

How Property is Associated with a Protected Series

Associating property with a protected series is a matter of recordkeeping. Property is associated when the LLC’s records adequately identify the property and the series that owns the property. Series statutes delineate adequacy in various ways, but in all events the standard is objective. No existing statute requires associated property to be titled in the name of a series, even if the property is subject to a public recordation system (e.g., land, motor vehicles).

Inadequate documentation imperils the internal shields, but to what extent? Current statutes appear to take an all or nothing approach. Either a series maintains generally adequate documentation and its internal shield works generally, or not. That is, generally inadequate documentation removes the shield even as to property documented with superlative specificity.

In the alternative, adequacy could be determined asset by asset and the shield applied accordingly.

  • The Drafting Committee’s current approach: Adequate documentation and shield protection are determined asset by asset. No consensus has yet formed around the recordation issue.

Duties of Those Who Manage a Protected Series

Absent a contrary agreement, as a matter of agency law, a person who manages a protected series owes fiduciary duties. But who has standing to enforce those duties: The series itself? The members associated with the series? The LLC?

In entity law generally, standing belongs to the person directly injured, subject to an owner’s right to bring derivative claims. This approach may well be apt for protected series.

  • The Drafting Committee’s current approach: In general, whatever rules of standing apply to the LLC apply as well to each protected series. However, a member not associated with a protective series has no standing to bring a derivative claim pertaining to the series.

Competition Between an LLC and its Protected Series

No current statute addresses this issue; resolving the issue is accordingly the burden of those who draft operating agreements providing for protected series. The “rub” is likely to occur when the LLC manages more than one of its series.

  • The Drafting Committee’s current approach: “A series manager of one protected series of a series organization does not in that capacity owe any fiduciary duties to another protected series of the organization or [to] the owners associated with another protected series.” The Committee has instructed the Reporter to draft around “the Sinven problem.” Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del. 1971) (shareholders of one corporate subsidiary [Sinven] brought derivative claims against the parent in part because the parent had allocated a business opportunity to another subsidiary).

Relationship of an LLC’s Operating Agreement to a Protected Series

Even though their formation requires a public filing, LLCs are very much creatures of contract. The same is true for protected series. Accordingly, once an LLC has established a series with at least one associated member, myriad contract issues arise. They include:

  • novel complexities of contract interpretation;
  • the need for a default rule for amending a provision of the operating agreement specific to one series;
  • the need to address the consequences when an amendment to a generally-applicable provision of an operating agreement disproportionately prejudices a series or its associated members.

No current statute addresses any of these issues.

  • The Drafting Committee’s current approach: The committee is aware of these issues but has not yet reviewed any proposed statutory language.

What Does the Public Need to Know About a Protected Series?

Following Delaware’s lead, almost every current series statute empowers an LLC to establish a protected series through a private document (the operating agreement), so long as the LLC’s articles of formation state that the LLC has the power to establish series. Illinois law takes the opposite approach; an LLC must make a separate public filing to establish each series.

From a transparency perspective, the Illinois approach seems a foregone conclusion. From a political science perspective, the Delaware approach is revolutionary; the sovereign delegates to a private organization the power to equip a private enterprise with a liability shield that abrogates traditional liability rules.

The transparency question informs two issues relating to names. Should the name of a protected series: (1) indicate that the series is a series (a “designator” requirement); and (2) include the name of the LLC as part of the series name?

  • The Drafting Committee’s current approach: To form a protected series requires a publicly filed document, albeit a very simple one. The name of a protected series must include the name of the LLC.

Business Needs Served by the Protected Series Construct

Outside the contexts of investment trusts and captive insurance companies, the special advantages of the protected series remain obscure. For example, an LLC with series can compartmentalize various divisions of an operating company or function as a holding company. But what advantage does the series provide over traditional structures that use separate affiliates to compartmentalize risk?

Though placed last in this article’s list of issues, this question may be the most important facing the ULC Drafting Committee. Absent a persuasive answer, skeptics will analogize the protected series to a shell game played to the prejudice of creditors.

Saving filing fees and paperwork cannot alone justify the protected series construct, especially given the uncertainty as to (1) the efficacy of the internal shields; and (2) how series provisions interrelate with important areas of business law. In fact, paperwork requirements for series may be more demanding than for other affiliate structures, because the requirements for associating assets are quite stringent.

Likewise, saving filing fees seems a rather small tail for a rather large and potentially risky dog. For one thing, state governments have a way of noticing when fee revenue decreases. For example, as mentioned above, the State of California has acted proactively to protect its filing revenues (and franchise taxes as well).

Perhaps the protective series remains attractive because it is novel, appears efficient, and “none of the chickens (open questions) have yet come home to roost.” The directly relevant case law consists of just two cases, neither of which answers any of the important questions.

The ULC Drafting Committee continues to inquire into the question of “series advantages,” not only as a response to “shell game” skeptics, but also because a statute should be shaped in light of its primary purpose.

Going Forward

The Drafting Committee’s next meeting is March 20–21, 2015. The next draft will be publicly available at the beginning of March. Comments are welcomed.

Sustainability Reporting: The Lawyer’s Response

Posted on January 21, 2015 by - Uncategorized

With ever-increasing frequency, clients are seeking advice about reporting and communication on sustainability issues. “What are we legally required to communicate?” “What are we permitted to communicate?” “What can or should we say to stay competitive and protect business relationships, profitability, and our social license to operate?” “What standards should we use?” This article will help lawyers understand and advise clients on their sustainability communications pressures and needs.

Corporate sustainability is a business management practice. When used strategically, it enhances business value. As a practice, it involves assessing and managing risks and opportunities that arise from environmental, social, and economic impacts of the company and its industry. Assessment is done for short-, medium-, and long-term time horizons. This broader and longer-term perspective is essential to realizing value from sustainability management. 

As a practical matter, the concept of sustainability management may conflict with some aspects of current corporate law and behavior. These conflicts can be generalized by the reality that most of corporate America focuses on a market-imposed, short-term, single bottom line. But the marketplace is in flux. Perspectives are changing in response to climate change, population growth, constrained resources, globalization of supply chains, and more transparent and ubiquitous communications. The upshot is growing pressure on businesses to evolve toward a triple bottom line approach: considering social, environmental, and economic impacts over a longer term, and their implications for governance. As lawyers, we will be called upon to help navigate these shifting influences on business management and success. 

What’s Going On? 

Macro Drivers for Sustainability Reporting Pressure 

The drivers that are creating pressure on companies to address and communicate more and more about sustainability issues arise from a number of factors, including from a variety of external and internal stakeholders. There are four primary macro drivers that have had, and will continue to have, wide-ranging social, environmental, and economic impacts with the potential to affect businesses everywhere. Being attuned to, and mitigating the risks of, or adapting to those impacts is a key attribute of a sustainable company. 

Concern about climate change and greenhouse gas emissions: Rising levels of greenhouse gasses in our atmosphere are driving increases in average temperature on the planet. This warming leads to changes in our climate and natural systems, resulting in sea level rise, droughts, floods, severe weather, wildfires, and ocean acidification. Even 2°C of warming will have a significant adverse impact on human health and well-being. 

Population growth and resource constraints: World population is on track to reach 9 billion by 2050 and 10 billion by 2100. The global middle class is expected to triple by 2030. At today’s pace, global energy demand will increase by 57 percent over the next 25 years. Water use is expected to increase by 50 percent in developing countries and 18 percent in developed countries by 2025. Our current level of consumption utilizes 1.5 Earths to provide resources to meet current demand and absorb waste. These factors will drive prices of all commodities up and lead to serious problems without corrective actions and creative solutions. Businesses have significant risks and opportunities in this respect. See, World Business Council on Sustainable Development; Energy Information Agency; Geo-4 – Global Economic Outlook; Global Footprint Network. 

Organizational and global interdependence: Large companies used to have several hundred partners and suppliers; today they have thousands, and they are spread across the globe. Companies of all sizes are outsourcing noncore functions, partnering for some core functions, and building larger business networks in general. The greater the number of outside suppliers and service providers upon which a company relies, the more difficult it is to manage the associated risks across multiple geographies. This is true from both a supply chain and reputation management perspective. 

Social license and accountability to stakeholders: Public demand for transparency and accountability has increased markedly. An instant information society has emerged from widespread access to social media, the Internet, and cable news. A single individual now has the ability to communicate instantaneously and globally to influence public opinion on a topic or a business. Multiplicities of stakeholders are affected by and interested in how a company manages sustainability issues. Consumers and investors are increasingly factoring a company’s ethics, sustainability, and social responsibility into their buying and investment decisions. 

Stakeholder Perspectives 

Sustainability reporting serves the needs and interests of a wide and growing variety of stakeholders, ranging from investors, employees, customers, and suppliers, to governments, regulators, local community groups, and nongovernmental organizations. Stakeholder reasons for seeking information on sustainability issues, the information they seek, and the lens through which they view the reported information varies. The number and variety of information requests about environmental, social, and governance (ESG) activities is a significant burden for many companies. Accordingly, companies must balance how and to whom they respond. 

Investors and customers are the two stakeholder groups that garner the most attention. Companies are influenced by their own investors to pursue sustainability into their supply chains. As a result, understanding what is driving the investment community to care about sustainability activities and reporting is key. 

In many cases, institutional investors care about medium- and long-term value and whether the companies in which they invest are contributing to systemic problems or are conducting their business in a way that helps solve those problems. This is not to say that short-term financial returns are unimportant to institutional investors, but rather, that more and more institutional investors are taking into account a broader range of factors in their investment decisions. Company performance on ESG factors are being included because they are outperformance indicators. Robert G. Eccles, Ioannis Ioannou, and George Serafeim, The Impact of Corporate Sustainability on Organizational Processes and Performance, first published November 01, 2011 (dated 11/23/11). In the words of Thomas P. DiNapoli, New York State Comptroller and Sole Trustee of the New York State Common Retirement Fund: “Our goal is simple: we want long-term sustainable economic growth. And we have found from experience that comprehensively integrating environmental, social and governance considerations into the investment process is essential to achieving that goal.” Peter Ellsworth and Kirsten Snow Spalding, The 21st Century Investor: Ceres Blueprint for Sustainable Investing, 2013, Forward, www.ceres.org.

Pressures to Report; Understanding the Reporting Landscape 

Clients are measuring their reporting against that of their peers and competitors. They are gauging social pressure to demonstrate responsible corporate behavior. There have been significant reporting developments, both in terms of the growth in reporting and the number and quality of reporting requirements, standards, or frameworks. 

The arguments for not reporting are shrinking day after day for companies that have yet begun to report on their sustainability progress. Now that 53% of the S&P 500 and 57% of the Fortune 500 are reporting on their Environmental, Social, and Governance impacts, the non-reporters are now in the minority. We believe this minority will continue to shrink as it has in the past few years. The benefits of sustainability reporting will become increasingly obvious as more time passes and the long term benefits are easier to measure. 

Governance & Accountability Institute, Inc., 2012 Corporate ESG/Sustainability/Responsibility Reporting, Does It Matter? (Dec. 15, 2012).

Making Reporting Decisions 

Once a company decides to report to stakeholders about its sustainability activities, risks, and opportunities, legal questions arise. Public-facing information about sustainability often starts as a marketing initiative in response to customer interest or as a means of demonstrating social responsibility and philanthropy. This type of information can then become the basis of requests to “verify” information gathered by a rating systems that will report with or without company input or corrections. Other reporting systems, like the CDP (formerly the Carbon Disclosure Project), will request formal reporting and publicize a failure to respond or report. As soon as investors or rating systems get involved, or customer pressure takes the form of supply chain requests, the focus rapidly shifts from a marketing effort. Management begins to ask what the company is legally required to report and what the company should report to support reputation, stakeholder relationships, and business development. 

Mandatory Reporting Requirements 

1. SEC Filings. 

Companies subject to the Securities and Exchange Commission (SEC) filing requirements must disclose material information in their SEC filings, such as the Form 10-K. Various rules and regulations, including Regulation S-K, may require the disclosure of material sustainability information in the Form 10-K and other periodic SEC filings, depending on the circumstances. Securities Act Rule 408 and Exchange Act Rule 12b-20 require a registrant to disclose, in addition to the information expressly required by line-item requirements, “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” 

Over the past several years, the SEC has struggled with how best to address evolving concerns with climate change and sustainability in the agency’s disclosure requirements. The SEC attempted to address the issue of climate change by publishing an interpretive release providing specific guidance as to how existing rules may require disclosure of information relevant to climate change. Release No. 33-9106, Commission Guidance Regarding Disclosure Related to Climate Change (February 2, 2010). The interpretive release identifies how climate change disclosures may be required under particular disclosure items in Regulation S-K, depending upon a company’s circumstances. These disclosure items include Description of Business
(Item 101 of Regulation S-K), Legal Proceedings (Item 103 of Regulation S-K), Risk Factors (Item 503(c) of Regulation S-K), and Management’s Discussion and Analysis of Financial Condition and Results of Operations (Item 303 of Regulation S-K). The principles that the SEC articulated in the climate change interpretive release can be applied in other contexts related to sustainability in determining if a public company has any disclosure obligations with respect to such matters. 

The SEC’s interpretive release addresses four topics that companies should consider when evaluating the need for, and appropriate level of, disclosure related to climate change matters:

  • The impact of legislation and regulation regarding climate change, including the potential impact of pending legislation.
  • When material, the impact on their business of treaties or international accords relating to climate change.
  • Whether legal, technological, political, and scientific developments regarding climate change will create new opportunities or risks, including reputational risks.
  • The actual and potential material impacts of the physical effects of climate change on their business, such as the effects of severe weather, sea levels, arability of farmland, and water availability and quality. 

In other sustainability areas, Congress has recently amended the federal securities laws to impose disclosure obligations regarding certain types of human rights and other issues of interest to specific groups. Recent examples include disclosure regarding the sourcing of certain “conflict minerals” (Section 13(p) of the Securities Exchange Act of 1934 (“Exchange Act”), which was implemented by the SEC by rule), payments to governments by resource extraction issuers (Section 13(q) of the Exchange Act, which is in the process of being implemented by SEC rule), and business with certain governments, persons, and entities subject to specific U.S. trade sanctions (Section 13(r) of the Exchange Act, which was effective upon enactment). 

2. State and Local Requirements. 

Other requirements for reporting on sustainability issues may arise at the state or even local level, or come into play by virtue of the geographic scope of a company’s business. For example, the California Transparency in Supply Chains Act requires every retail seller and manufacturer doing business in the State of California and having worldwide annual revenues of $100 million or more to disclose their specific actions to eradicate slavery and human trafficking in their direct supply chains for tangible goods offered for sale. 

For a regulatory example, the insurance commissions in six states (California, Connecticut, Illinois, Minnesota, New York, and Washington) require insurance companies with direct written premiums of $100 million or more in their state to complete an annual climate risk disclosure survey. 

3. International Requirements. 

In spring 2014, the European Parliament passed a law requiring publicly traded companies with more than 500 employees to report on nonfinancial sustainability factors. The law will go into effect in 2017, and will require nearly 7,000 companies to include this new information in their annual financial reports – 4,500 more than are doing so today. The new law requires affected companies to report on ESG factors, including human rights impacts, diversity, and anticorruption policies. Companies will be expected to describe their business model and the outcomes and risks of their policies. Companies will also be required to include their supply chain in reporting. This will likely have a trickle-down impact, forcing smaller and medium-sized private companies and multinational companies upstream in the value chain to report even though the law does not apply them. 

Under Canadian securities laws, public companies must disclose all material information, including material information about environmental and social issues, and there are additional disclosure obligations under the TSX and TSX Venture Exchange timely disclosure policies. 

In October 2010, the Canadian Securities Administrator published Staff Notice 51-333, Environmental Reporting Guidance to provide guidance on continuous disclosure requirements relating to environmental matters under applicable Canadian securities laws and to assist issuers in determining what information about environmental matters needs to be disclosed and about enhancing or supplementing their environmental disclosures. The staff notice was motivated by the impact of environmental matters on reporting issuers, the changing regulatory landscape, and increasing investor interest in environmental matters. 

Quasi-Voluntary and Voluntary Reporting 

There are many stakeholder and other organizations that pressure companies for ESG information. Among the many means used to gather this information are a myriad of investment screening tools, rating organizations, and reporting frameworks that aggregate public information or provide vehicles for sustainability reporting. Below is a brief overview of the most prominent among these organizations, tools, and reporting frameworks. 

Investors use ESG screening to measure or assess how a company manages social and environmental impacts. This screening focuses on whether a company identifies and either mitigates risks or seizes opportunities with respect to ESG indicators. 

Investment screening tools are flourishing:

  • The Bloomberg ESG Valuation Tool and its ESG Score has experienced significant interest. This tool “enables users to apply a financially-based methodology to assess and value the impact of ESG factors on a company’s Earnings Before Interest and Taxes (EBIT) performance and share price.” PWC, Do Investors care About Sustainability? Seven Trends Provide Clues (March 2012).
  • MSCI has several screening tools/indices, including its ESG Impact Monitor.
  • FTSE4Good revamped and expanded its screening process. Companies are required to publicly disclose a broad array of sustainability information to gain and maintain listing on the index.
  • GS SUSTAIN is another index that incorporates ESG into its analysis. Like MSCI and FTSE4Good, GS SUSTAIN submits information it has gathered from the public realm for company review, correction, and supplementation. 

The CDP, a global not-for-profit organization, operates a reporting framework and rating system. The CDP holds the largest and most comprehensive collection of primary climate change, water, and forest-risk information. Investors representing more than a third of the world’s capital request corporate accountability on climate change through the CDP reporting framework. 

Global Reporting Initiative (GRI) is the globally-recognized “gold standard” for sustainability reporting. The framework includes reporting guidelines and sector/industry guidance. It requires a high degree of organizational transparency and accountability. The uniform indexed reporting structure provides stakeholders a capacity for year-over-year analysis and easy comparison of reports from different companies. When investors pressure companies to report, they most often request reporting using the GRI framework. 

On the leading edge of the reporting industry, and in support of an emerging interest in integrating financial and non-financial reporting, the International Integrated Reporting Council (IIRC) has developed the Integrated Reporting Framework. This includes guidance for how publicly traded companies can integrate sustainability into their annual reports so that the public can understand the value of sustainability initiatives and can effectively compare one company to the another. The stated purpose of integrated reporting is to show how a company creates value of the short, medium, and long term. http://www.theiirc.org/resources-2/faqs/. 

Voluntary Standards to Support Mandatory Reporting 

The Sustainability Accounting Standards Board (SASB) is developing voluntary standards, which identify industry-specific, sustainability-related issues that may give rise to material information for companies to disclose. The intent is for companies to reference the standards as a guide when making sustainability disclosure decisions for mandatory filings to the SEC. The complete set of guidelines is scheduled for release in early 2016. See www.sasb.org. The SEC has not acted on incorporating the SASB standards into any disclosure requirements. 

The Lawyer’s Response 

The manner in which sustainability issues are reported or communicated to stakeholders and others must align with the type and purpose of the report or communication. Mandatory reporting should follow SEC or other governing requirements. Voluntary reporting should, on its face, be readily distinguishable from such mandatory reporting. Lawyers should recommend that language be used that reflects the standard and the audience for the reporting venue. Counsel will need to weigh litigation risks that voluntary reporting may carry for reported information that is significant, but not material, and therefore not included in mandatory reporting. 

This is of primary significance because of the ways in which differing concepts of materiality are incorporated into mandatory and voluntary reporting requirements:

  • Under the GRI reporting framework, information is considered material and should be included in a report if it “may reasonably be considered important for reflecting the organization’s economic, environmental and social impacts, or influencing the decisions of stakeholders.”
  • The IIRC deems information to be material if “it is of such relevance and importance that it could substantively influence the assessments of providers of financial capital with regard to the organization’s ability to create value over the short, medium and long term.”
  • For SEC reporting purposes and under the voluntary SASB standards, information is deemed to be material if there is “a substantial likelihood” that a “reasonable investor” would view the information as “significantly alter[ing] the ‘total mix’ of information made available.” TSC Indus. v. Northway, Inc., 426 U.S. 438, 449 (1976).

Disclosures under the U.S. federal securities laws are a mixed question of law and fact. The SEC has noted that the issuer is in the best position to know what is likely to be material to investors. “[A] corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact.” Richman v. Goldman Sachs Group, Inc., et al., 10 Civ 3461 (June 21, 2012, United States District Court for the Southern District of New York).

Companies are required to disclose material informa­tion only where the federal securities laws or other applicable legislation specifically impose such a duty to disclose. The analysis should focus on whether or not the information is material by securities law standards and whether there is a prima facie duty to disclose the information. 

Because a number of recognized standards for sustainability reporting outside of the SEC’s disclosure requirements reference different concepts of “materiality,” counsel must be cognizant of those varying definitions while remaining focused on the specific duties and obligations that are currently contemplated by the U.S. federal securities laws. Understanding these nuances enables lawyers to help clients clearly identify the importance ascribed to information by reference to the standard and audience. For example, a company could use the concept of materiality for investor-related information that is included in required reporting to the SEC. Other information should be identified using words like “significant,” “important,” or “key,” or as being relevant to stakeholders other than investors. The company could add disclaimers or cautions where appropriate. 

All reporting standards require that a company’s sustainability disclosures – even where there is no duty to disclose under the U.S. federal securities laws – be both accurate and complete. To effectively manage sustainability reporting and communication, companies must build appropriate reporting capacity (including disclosure controls and procedures) to identify and vet sustainability issues. The development and implementation of sustainability management systems will serve to provide a company with a process for measuring, monitoring, and improving sustainability reporting and performance. These systems should encompass an internal educational component to ensure awareness of sustainability activities and reporting needs.

Companies ask their lawyers to review mandatory reporting disclosures as a matter of course. Given the complexity of sustainability issues, there is also a role for lawyers in reviewing and advising on voluntary reporting. Counsel should help clients weigh liability risks against reputational, relational, and other benefits of voluntary reporting. Understanding the drivers for that reporting noted above should guide that review and inform giving advice that protects client interests, while enabling them to respond to real and significant social and business pressures.

The Business Case for Environmental Sustainability

Posted on January 21, 2015 by - Uncategorized

A corporation’s main objective, and many would agree, legal obligation, is to make money and maximize profits for its shareholders, but should more be asked or required of today’s successful businesses? For an ever increasing segment of society, the answer without a doubt is “yes.” The concept, commonly referred to as corporate social responsibility (CSR), extends beyond compliance with legal mandates or even charitable donations and good deeds. CSR advocates believe a company has a clear duty of care to all stakeholders connected to or impacted by a company’s operation. 

A number of green issues are emerging as key components in a more global initiative to hold corporations socially, and if possible, financially responsible for their actions and inactions. Sustainable development, as a critical component of CSR, takes into account social, economic, environmental, and natural resource issues potentially affected by business. With growing awareness worldwide of environmental concerns, the CSR component of sustainability is focused on environmental sustainability. Environmental sustainability generally addresses how the needs of the present can be met without compromising the ability of future generations to meet their own needs with emphasis on protection of natural resources and the environment. 

CSR and environmental sustainability at first blush appear newer, more trendy philosophies, but in reality are deeply rooted in the kinds of challenges companies have confronted over the last century such as pollution, corruption, child labor, and poor worker conditions. Similar challenges exist today as companies seek new international markets and expand globally into areas that present not only business opportunities but also more operational risk. This is particularly evident in the environmental arena where critical business needs for water, energy, and raw products must coincide and be balanced with care for stakeholders and the environment. How companies manage these modern-day challenges does matter, as evidenced in a new study by Nielsen. This year’s Nielsen Global Survey on Corporate Social Responsibility polled 30,000 consumers in 60 countries to understand how passionate consumers are about sustainable practices when it comes to purchase considerations; which consumer segments are most supportive of ecological or other socially responsible efforts; and, which social issues/causes are attracting the most concern. One key finding is that 55 percent of global online customers are willing to pay more for products and services provided by companies that are committed to positive social and environmental impact. 

This article will examine environmental sustainability and why it matters for business. The authors will detail key environmental sustainability focus areas and outline a roadmap of essential considerations companies should incorporate into any environmental stewardship initiatives. Lastly, we conclude that there is a business case for environmental sustainability that will improve financial performance. 

What is Environmental Sustainabiltiy?

The terms “environmental sustainability” or “sustainable development” are widely used, but the United Nations World Commission on the Environment and Development is credited with developing these concepts in its 1987 report titled Our Common Future. In that report, the World Commission defined “sustainable development” as development which “meets the needs of the present without compromising the ability of future generations to meet their own needs.” The greening of the U.S. economy has focused increased scrutiny on environmental issues, laws, and policies and focused much more attention and emphasis on environmental sustainability initiatives. In a recent report titled Taking Flight: Environmental Sustainability Proposals Gain More Attention, it is interesting to note that Ernst & Young found the three largest sustainability topics were all environmental issues including climate change/sustainability, energy efficiency/recycling, and energy extraction risks. 

While environmental sustainability appears a new concept, it really has roots in conservation, land management, and protection of natural resources which are age-old mandates in the United States. In 1966, Lyndon B. Johnson commented on environmental conditions and even on the sustainability of the environment: “. . . To sustain an environment suitable for man, we must fight one-thousand battlefields. Despite all of our wealth and knowledge, we cannot create a redwood forest, a wild river or a gleaming seashore. But we can keep these we have.” 

Understanding what environmental sustainability means, its priorities, and how the same are measured remain an ongoing challenge. The Global Reporting Initiative (GRI), a well-known leader in developing a sustainability reporting framework, incorporates key environmental performance indicators into its sustainability guidelines: 

Materials

  • Materials used by weight or volume.
  • Percentage of materials used that are recycled input materials. 

Energy

  • Direct energy consumption by primary energy source.
  • Indirect energy consumption by primary source.
  • Energy saved due to conservation and efficiency improvements.
  • Initiatives to provide energy efficient or renewable energy-based products and services, and reductions in energy requirements as a result of these initiatives.
  • Initiatives to reduce indirect energy consumption and reductions achieved. 

Water

  • Total water withdrawal by source.
  • Water sources significantly affected by withdrawal of water.
  • Percentage and total volume of water recycled and reused.
  • Total weight of waste by type and disposal method.
  • Total number and volume of significant spills.
  • Weight of transported, imported, exported, or treated waste deemed hazardous under the terms of the Basel Convention Annex I, II, III, and VIII, and percentage of transported waste shipped internationally.
  • Identify size, protected status, and biodiversity value of water bodies and related habitats significantly affected by the reporting organization’s discharges of water and runoff. 

Biodiversity

  • Location and size of land owned, leased, managed in, or adjacent to, protected areas and areas of high biodiversity value outside protected areas.
  • Description of significant impacts of activities, products, and services on biodiversity in protected areas and areas of high biodiversity value outside protected areas.
  • Habitats protected or restored.
  • Strategies current actions and future plans for managing impacts on biodiversity.
  • Number of IUCN Red List species and national conservation list species with habitats in areas affected by operations, by level of extinction risk. 

Emissions, Effluents, and Waste

  • Total direct and indirect greenhouse gas emissions by weight.
  • Other relevant indirect greenhouse gas emissions by weight.
  • Initiatives to reduce greenhouse gas emissions and reductions achieved.
  • Emissions of ozone-depleting substances by weight.
  • NO, SO, and other significant air emissions by type and weight.
  • Total water discharge by quality and destination. 

Products and Services

  • Initiatives to mitigate environmental impact of products and services, and extent of impact mitigation.
  • Percentage of products sold and their packaging materials that are reclaimed by category. 

Transport

  • Significant environmental impacts of transporting products and other goods and materials used for the organization’s operations, and transporting members of the workforce. 

Compliance

  • Monetary value of significant fines and total number of nonmonetary sanctions for noncompliance with environmental laws and regulations. 

Overall 

  • Total environmental protection expenditures and investments by type.

These environmental performance indicators serve as an important reference for an interpretation and understanding of environmental sustainability concepts. 

The Importance of Environmental Sustainability

For businesses, being a good corporate citizen certainly is part of the CSR philosophy encouraging companies to give back in the communities where they live and work. CSR and environmental sustainability go beyond the “good corporate citizen” approach, however, and motivate companies to develop environmental and community outreach initiatives and to establish related policies applicable not only to company personnel but downstream suppliers and other vendors. 

Almost three-quarters of the U.S. companies on the S&P 500 publish corporate sustainability reports according to research from the Governance & Accountability Institute. Despite growing pressure from green investor groups and organizations like the GRI, sustainability reporting in any meaningful way remains a largely voluntary effort on the part of American companies. New European Union requirements for sustainability reporting going into effect in 2017 will convert these voluntary efforts into legally mandated ones. These new reporting requirements will apply to 6,000 companies in the EU and will impact a number of U.S. businesses. The GRI sustainability reporting framework has been recommended as a possible platform for the EU reporting obligations. Similar to GRI reporting requirements, the EU directive will seek disclosure on policies, risks, and impacts regarding human rights, diversity, environmental matters, and other social considerations. 

Increased or legally mandated sustainability reporting may actually help promote and enhance performance measures for companies that have made environmental sustainability a core element of their business strategies. A recent GreenBiz blog by Daniel Esty highlights the common disconnect between sustainability-related competitive strengths versus improved shareholder value – a concern that better sustainability reporting might improve. In his blog, Mr. Esty identifies several problems that need to be addressed regarding environmental, social, and governance (ESG) data currently available.

  1. “Value” investors in the past wanted to exclude polluting companies and other bad actors from their portfolios. A wider range of investors today are interested in sustainability-driven growth, productivity gains, and risk reduction. The new “value” investors need a different set of sustainability metrics, including indicators tightly focused on financial results.
  2. The sprawling nature of data available lacks clarity on what is important or possibly material. Mr. Esty notes “. . . What is critical to engaging the broad investor community are metrics that are meaningful from an investor perspective rather than from an environmentalist point of view. Thus, we argue for a ‘value driven model’ that centers on a core set of sustainability metrics cast in language familiar to the Wall Street world.”
  3. Existing ESG data is not action or results oriented in a manner useful to investors.
  4. Concern exists over the quality of data often self-reported by companies. 

Significant research exists supporting the competitive advantage benefits of environmental sustainability. Commonly cited improvements include enhanced corporate reputation, better employee retention and engagement, cost effectiveness, risk avoidance and mitigation, innovation, market expansion and greater access to capital. While these benefits appear impressive, a new language must be developed to translate these impacts into positive financial results if environmental sustainability efforts are to gain marketplace traction. 

Key Environmental Sustainability Areas – What Matters?

The environmental sustainability journey is not one-size-fits-all. Each business needs to be clear on why it is making the effort, what it hopes to accomplish, and the scale of its commitment. Having said that, there are a number of typical focus areas. Comparable to most business initiatives, what we measure gets managed. Key performance indicators (KPIs) should be customized to the business needs. Common environmental sustainability concerns include the following.

Energy/Greenhouse Gases/Climate Change 

Many businesses have chosen energy use as their first “toe in the water” on the environmental sustainability journey. Energy reduction is usually a “win-win” due to the positive impact on overhead, cost, return on investment (ROI), and commensurate reduction of greenhouse gas emissions. Utility, local, and state incentives are often available and can make the ROI even more attractive.

Energy use is frequently considered in terms of direct and indirect energy or energy used or generated on site and energy used or generated offsite. 

Successful energy reduction programs are best started with an energy audit. This can be performed by competent internal facilities personnel, but is more commonly performed by outside consultants or utility representatives. The resulting report should document information on each identified issue including potential cost savings, incentives available, and cost to implement. 

Greenhouse gas reductions go hand-in-hand with most energy-reduction strategies. For many manufacturing operations, releases of greenhouse gases from the manufacturing processes are a significant proportion of the overall footprint. As such, a reduction in the amount of energy used has a direct effect on the amount of greenhouse gases resulting from operations. 

When deciding on how to approach identification, tracking, and goal setting on greenhouse gases, decisions will need to be made on what to count. Some businesses choose to only count those greenhouse gases arising from operations within their four walls. Others look at issues as far reaching as employee travel, fleet emissions, and life cycle product impacts. Numerous vendors provide greenhouse gas tracking software, which assists in the conversions of different types of energy uses into carbon dioxide equivalents. 

Water Use 

Water use is an environmental sustainability concern that has recently taken on increased relevance. Drought conditions and the prospects for increased weather severity has caused communities, industry, and regulators to place additional efforts into conservation strategies. Water resources have become increasingly stressed by population growth, contamination of resources, and depletion of groundwater supplies. 

Conservation strategies have included closed-loop water cooling, low-flow fixtures, onsite treatment and reuse, gray water collection for irrigation, and xeriscaping. 

Water use KPIs include total water used, water used per production unit, water used as a percentage of sales, and percent water reduction. 

Waste Reduction/Product Inputs Reduction/Recycling 

Products and processes require resource inputs. Furthermore, processes are never 100 percent efficient, so there is waste. Some excess can be reused in product, some can be profitably sold to other businesses, some can be given away or sold at a loss, and some will have to be disposed. 

The company on the sustainability journey will seek to improve their resource use to product conversion ratio. A hierarchy of environmental preference can be established to guide the process. It is generally easiest to start with reuse and recycling of materials. Large gains can also be made by working with the supply chain on the reduction of packaging materials being received. Additionally, the types of packaging materials can be specified in order to reduce the volume, improve recyclability, and support reuse for outgoing shipments. 

Common measurements may include percent waste recycled, waste per production unit, and total waste disposed to landfill. 

Toxics Use Reduction or Elimination 

Toxic materials are used to make and are found in many products. There are a host of reasons for reducing the toxicity or minimizing toxic materials, including workers exposure, emissions from our factories, and, ultimately, the health of our customers. This is an area that continues to see traction and has resulted in such things as the organic foods movement and calls for regulating plasticizers in children’s toys. Eliminating toxins can be an admirable goal, may be essential to compete, and may also be challenging. Companies can chose to substitute less toxic materials in both the process and the product. This has also become an area of regulatory exposure as the European Union has implemented regulations such as REACH. 

Emissions and Effluents 

Toxic air emissions and contaminated wastewater are common byproducts of manufacturing. While they may be legal and released under a permit, they still have impact and are increasing the level of pollutants in the environment. Industry is required to do an annual assessment of these releases and submit reports to their environmental regulators. These reports are public information and are often scrutinized by stakeholders as one indication of a company’s environmental performance. Many companies have made a significant effort to reduce emissions to be below reporting thresholds, or at least to be able to show progress on protecting the environment.

Common KPIs are tons released, tons per dollars of sales, and pounds per production unit. 

Reduction strategies include substitution or elimination of toxic materials in process and product and process efficiency improvements.

Normalizing KPIs 

It is key when selecting normalizing factors that they enhance understanding of performance, not obfuscate it. The clearer the correlation with processes or products, the better. An example from the automotive industry would be KPI per auto produced. Other common normalizing factors are employee hours, sales, or earnings. 

Getting Goals Right 

Goals drive performance. Properly designed goals have a positive impact on an organization in that they inform the employees that management has selected priorities, provide a frequent reminder of progress, and flow down in a way that identifies the role of each individual in meeting the objective. Where goals often fail is the lack of a plan to achieve them. The plan needs to define actions, individual responsibilities, and timeframes.

KPIs also need to be well defined so that results across the organization are based on the same data inputs. For example, a water use KPI could include water embedded in the product, used for cooling machinery, sanitary facilities, or growing crops. 

It is important to make sure that goals are contextually meaningful. KPIs and goals for some facility locations may not have the same relevance and importance as at another. Back to the water example again: facilities in the arid regions of the American Southwest and facilities on the shore of a large lake may not warrant the same use reduction objectives. 

A Simplified Road Map to Implementation

Start with a shared vision: Each enterprise needs to start with the development of their environmental sustainability vision. As stated earlier, this requires that top management identify their level of commitment to the sustainability journey. This will be influenced by the business culture (or the culture they are trying to achieve), stakeholder interest, the potential to strengthen brand, personal values of leadership, and considerations of moral or ethical positions.

Communicate the vision: Leadership is responsible for the culture in any business and it is no exception for implementing a sustainability program. A successful sustainability program launch requires commitment to communication. 

Develop an implementation strategy: It’s a project, so manage it with the same rigor you would manage any other important initiative. Identify personnel, resources, objectives, targets, schedule and milestones. 

Decide what is important: Once there is a vision, a materiality inventory will help direct the implementation strategy. A company may find that it has very low reportable air emissions, but produce large amounts of toxic waste. The air emissions may not be material and the toxic waste is likely material. There is no requirement that a company work on all material impacts concurrently. A strategy of focusing on the most material issues can be an effective approach. 

Determine what to measure and how to measure performance: What are your key performance indicators? How will you normalize? What is your reporting frequency and how will you share this information? Data will need to be collected on each of the target areas. This can get challenging for some aspects, but is commonly available for energy, water, wastewater, hazardous waste, and recyclables. Also be aware that this data should be of a quality that could be audited if you will be communicating it externally. 

Develop strategies for each KPI: Affecting the KPIs requires actions. Appropriate teams for each KPI can develop and implement plans to achieve the desired results. 

Spend the money but spend it consistent with your values: Nothing can put the brakes on a sustainability program faster than a lack of appropriate resources. Having said that, many businesses look at ROI for various projects. Hurdle rates are sometimes relaxed for projects that have significant brand, employee morale, or stakeholder importance. 

Start winning: Early success breeds enthusiasm. As one sustainability director at a large corporation said, “Simple wins are gateway drugs.” 

Communicate: There is a theme here – it is pretty hard to overcommunicate when engaged in change. Of course, there is ineffective communication. Do not expect high levels of readership for sustainability e-mails and newsletters. Internal communications are best done at all appropriate levels of management by management. 

Continually improve: Turn your implementation into an annual cycle with a goal of improving each year. 

Communicate: Will you share your environmental sustainability progress outside your organization? Most companies publish a sustainability report or a CSR report. Get familiar with organizations which are involved in reporting on environmental performance. As discussed earlier, the GRI, the Carbon Disclosure Project, and the Dow Jones Sustainability Index are examples from a growing list of organizations that have sustainability reporting standards. 

Conclusion

According to the United Nations Principles for Responsible Investment (UNPRI), over $34 trillion (approximately 15 percent) of the world’s investment assets are managed by signatories to the UNPRI who have committed to adopting policies and procedures that factor ESG issues into investment decisions. While not all investors and financial market analysts are convinced that environmental sustainability delivers shareholders value, there is growing belief that companies that are successful in avoiding environmental risks while taking advantage of ESG opportunities will outperform over the long term. The UNPRI economic marketplace statistics support this investment trend. 

Moving toward environmental sustainability should work for even the most prudent or conservative business leaders, as implementing environmental sustainability practices present few if any risks to business operations. Moreover, early start-up initiatives easily can be managed in house including identification of key environmental sustainability areas important to your business, assessing sustainability reporting opportunities and other means of communicating environmental sustainability efforts to stakeholders, and development of KPIs and financial performance impacts. 

It appears a virtual certainty that environmental sustainability will increasingly move from voluntary to legally mandated initiatives, including sustainability reporting requirements. The critical inquiry for business is no longer if, but how and when to launch a meaningful environmental sustainability program. There is a growing business case for environmental sustainability. It is an added bonus that addressing these business challenges not only will enhance financial performance over time, but is simply the right thing to do as well.

The Important Role for Socially Responsible Businesses in the Fight Against Human Trafficking and Child Labor in Supply Chains

Posted on January 21, 2015 by - Uncategorized

The general view of human trafficking is that it is something only occurring “over there,” in places such as Africa and India. However, this perception is wrong. Trafficking is a problem not just “over there,” but right here, right now. Indeed, trafficking and child labor abuses are part of our lives right here, right now. 

For example, slavery may taint the computer, smartphone, or tablet that you are using right now. A recent NGO study by Verité shows that one in three Malaysian electronics workers toil at forced labor. Slavery may have tainted the shrimp that you enjoyed last week. A recent investigation by The Guardian cited evidence that threats of extreme violence may have forced slaves to toil without pay for years harvesting shrimp in Thailand for sale abroad. The bad news is that these and other similar situations exist. The good news is that as businesspeople, there is something that we can do about it. As an example, The Guardian reports on efforts by businesses to form a task force to address the shrimp issue. 

You might be wondering, is this really an article in Business Law Today? Did I click the wrong link? You’ve got the right link. This article addresses two significant initiatives of the Business Law Section: its Corporate Social Responsibility Law Task Force and its Working Group on Model Business and Supplier Policies on Labor Trafficking and Child Labor. These supply chain and corporate social responsibility initiatives work together. While basic social decency demands elimination of labor trafficking from supply chains, corporate social responsibility supplies the business case for doing so.

The Supply Chain Issue

The International Labor Organization (ILO) estimates that 20.9 million individuals worldwide are victims of human trafficking. Of that number, 14.2 million are victims of forced labor or labor trafficking, and 4.5 million in sex trafficking or forced prostitution. As illustrated above, many of these slaves support the supply chains of products that we all use. As further confirmation, one only need look at the December 2014 version of the U.S. Department of Labor List of Goods Produced by Child Labor or Forced Labor to identify 136 goods in 74 countries produced in this manner (child labor is estimated by the ILO at 168 million). 

Human trafficking and child labor are against the law everywhere. Yet the reality is that in the countries “over there” where trafficking is most prevalent, the rule of law isn’t what it is in this country. The problem is that slaves produce goods that enter the supply chains of goods made here, used here, worn here, and eaten here. True, the Supreme Court took the teeth out of the Alien Tort Claims Act with its Kiobel ruling. Yet Congress still knows how to write laws (like Dodd-Frank’s conflict-minerals provision) having extraterritorial reach. As I counseled students in my LL.M. course on Corporate Professional Responsibility, basing risk management on nonenforcement of existing laws is unduly risky business. 

Responsible businesses already know about the supply chain problem and are trying to do something about it. They include a group that belongs to the Global Business Coalition Against Trafficking (gBCAT). Members include Carlson, Cison, Coca Cola, Delta Airlines, Hilton Worldwide, LexisNexis, Ford Motor Company, Manpower, NXP, and Travelport. The coalition has several worthwhile initiatives that dovetail nicely with the ABA Model Principles (Model Principles) and Polices (Model Policies) discussed below. 

Trafficking’s and child labor’s tainting of supply chains starts here in the United States and in other mature economies with consumer demand for cheap goods and services. Demand drives corporations to exact lower prices from supply bases. Price pressure, exacerbated by globalization, outsourcing, and use of labor brokers lead to exploitation of workers. Foreign workers are easily exploited because so many are extremely poor. Among the laborers my wife and I encountered in India, 20 percent live on one dollar a day, 50 percent are malnourished, 67 percent can’t read, and 33 percent don’t have access to safe drinking water. Consider that the present value of a single slave working in early nineteenth century America would be $40,000, while today, a slave sells in the sex or labor-trafficking market for just $90. Noted slavery expert Kevin Bales understandably titles his book citing these statistics Disposable People. 

Certainly, supply chain exploitation and other forms of trafficking like forced prostitution, which goes on both in the United States and abroad (see U.S. State Department Trafficking in Person Reports) conflict with the concept of human dignity that all major religions and atheists alike recognize. The Declaration of Independence provides “that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.” Similarly, the UN’s Universal Declaration of Human Rights states, “All human beings are born free and equal in dignity and rights. . . . Everyone has the right to life, liberty and security of person. . . . No one shall be held in slavery or servitude.” 

The business question is whether moral considerations like those in the ABA Model Principles are enough to motivate a corporation to act. Maybe so, but maybe not. My experience is that in certain situations the personal moral standards of a CEO or board will lead a corporation to address social issues. Yet a surer way to ensure that responsible action survives leadership change or insensitivity is to base that action on a business case.

The Case for Corporate Social Responsibility

Corporations address social issues under the banner of corporate social responsibility (CSR), also known as corporate citizenship, corporate responsibility, sustainability, social enterprise, triple bottom line, or corporate ethics. A member of the Business Law Section’s CSR Task Force, Stanford Law School Professor Chip Pitts, coauthored the premier law school text on the subject, Corporate Social Responsibility: A Legal Analysis, urging that we view CSR as a set of assessment, strategic-development, and commitment practices. 

The widely recognized Carroll Model defines CSR as “the economic, legal, ethical and philanthropic expectations placed on organizations by society at a given point and time.” The Carroll Model depicts a pyramid with the economic imperative to generate a profit at the base, on top of which lie legal obligations to obey the law, ethical obligations to do what is right and fair, and philanthropic obligations to be a good corporate citizen.

An alternative also puts economic obligations at the base, but then represents legal, ethical, and philanthropic obligations as concentric circles sitting on the base. This representation illustrates that while some CSR obligations fall squarely within one category, others overlap two. 

Supply chain efforts to address trafficking primarily fall into the ethical area, because guides like the ABA Model Principles and Policies and UN Guiding Principles are voluntary. Yet California’s Transparency in Supply Chain Act is one state supply chain law already on the books. This law, like the proposed federal law H.R. 4842 discussed below, requires corporations to disclose actions to clean up the supply chain rather than actually undertaking actions to do so, as Dodd-Frank’s conflict minerals law requires. 

Significant potential criminal penalties and civil liability already attend labor trafficking. Congress enacted the Trafficking Victims Protection Act in 2000. Offenders also violate Title VII, the Fair Labor Standards Act and state equivalents, and the Thirteenth Amendment. Corporations could also consider the social and ethical implications. They already do in the environmental arena, where although laws like the Clean Air Act, Superfund, Resource Conservation and Recovery Act, and Clean Water Act certainly provide heavy regulation, voluntary green initiatives in some instances nonetheless predominate. 

Extensive discussion on the Business Law Section Model Policies Working Group website make more of the moral and social case for addressing trafficking in the supply chain. 

The Business Case

We have yet to consider the business reasons why corporations would voluntarily model their supply chain policies after the ABA Model Principles and take appropriate action. The business risks include unstable supply chains. Worker unrest over trafficking or trafficking-related issues can lead to work stoppages, consumer boycotts, product quality issues, and product recalls. Even without direct economic impact, media reports that a company has slaves in its supply chain can cause huge reputational damage, loss of investor confidence, and enormous stock-value loss. 

You should now clearly see the value to a proactive policy to eliminate trafficking and child labor from the supply chain. One sure way to address the issue is to adopt and implement the ABA Model Principles. By doing so, corporations can increase the supply chain stability and sustainability while increasing reputation for responsibility. Appealing to the growing number of socially conscious consumers can increase sales. Institutional investors are also becoming more socially conscious. Due in large part to the 2012 collapse of Bangladesh’s Rana Plaza, in which 1,100 workers lost their lives, institutional investors controlling $4.2 trillion in investments continue to advocate for worker safety while urging companies to commit to a trust fund established to provide victim and family assistance.

Legal Consequences Affecting the Business Case

Potential financial impacts from legal exposure are also growing. Beyond the Trafficking Victims Protection Act, the House of Representatives’ Business Transparency on Trafficking and Slavery Act bill (H.R. 4842) would, if enacted, require disclosure similar to California’s Transparency Act, although federal disclosure would be to the SEC. Ahem: the SEC. The administration also backs proposed regulations to implement President Obama’s Executive Order on Trafficking in Federal Contracts, which would in some cases require mapping the supply chain. Potential Foreign Corrupt Practices Act liability also exists when a company uses a labor broker. 

State laws are also becoming tougher in this area. With the assistance of University of Michigan Law trafficking expert Bridgette Carr and others, Michigan’s Attorney General Bill Schuette led a group of legislators including State Senator Judy Emmons in securing the adoption of 22 provisions toughening existing laws fighting sex trafficking and protecting its victims. The National Association of Attorneys General remains engaged in fighting trafficking. While the present focus is on sex trafficking, labor trafficking could easily become more of a focus. 

Internationally, law-reform advocates in 2013 approved the Uniform Law Commission Model Human Trafficking Law. Advocates also propose UN treaty negotiations to increase the responsibility of businesses to remedy of human rights violations. The European Union and India are each instituting corporate reporting on CSR issues. 

Litigation on behalf of trafficking victims also increases as the movement identifies more trafficking victims. An EEOC lawsuit involving Henry’s Turkey Service of Texas led to $242 million in damages based on findings involving alleged abuse of 32 mentally disabled turkey plant workers whom employers for decades paid hourly rates as low as 41 cents. A recent class action lawsuit involving 350 Filipino teachers whom corrupt labor recruiters charging exorbitant fees allegedly lured to teach in Louisiana public schools returned $4.5 million in damages for the teachers. A prominent plaintiff’s lawyer noted at a recent conference that damages could easily exceed $150 million even in cases involving as few as 100 employees. The array of potential civil causes of actions includes a private right of action under the Trafficking Victims Protection Act, Thirteenth Amendment, Ku Klux Klan Act, Civil Rights Act of 1866, Alien Tort Claims Act, RICO, Fair Labor Standards Act, Title VII, and state labor codes, plus common law claims for intentional torts, negligence, and breach of contract claims. 

Professional Responses

During the 2012 tenure of Laurel Bellows as ABA president, the American Bar Association formed a Human Trafficking Task Force to attack human trafficking from a professional standpoint. Efforts include training for lawyers and law enforcement officials who are often the first to respond to trafficking reports, strengthening pro bono networks to ensure that all civil legal needs of trafficking victims are addressed, and a media campaign including a video explaining how the legal community can help. See Laurel Bellows, “Breaking the Shackles: More Must Be Done to End Human Trafficking and Help Victims,” ABA Journal, Sept. 1, 2012. 

President Bellows asked the ABA’s Business Law Section to develop business practices for corporations encountering and addressing human trafficking. While certain businesses have adopted and implemented codes of business conduct to address labor trafficking including child labor in their operations, other businesses have not done so. U.S. corporations have not yet widely adopted standard business conduct codes. Even corporations that do have codes in place can benefit from periodic policy review to reflect evolving best practices particularly around trafficking. 

The Business Law Section responded to this request by creating a Working Group made up of over 50 leading business law experts who prepared the ABA Model Business and Supplier Policies on Labor Trafficking and Child Labor. The Model Policies consist of six parts: Part I Introduction, Part II Model Principles, Part III Model Business Policy, Part IV Model Supplier Policy, Part V Model Glossary, and Part VI Endnotes. 

The Model Policies assist both corporations and their suppliers currently having labor trafficking and child labor policies in place, but wishing to update those policies, and also corporations and suppliers lacking any current policy. The Model Policies can stand alone or be adapted for particular industries and be incorporated into existing business codes of conduct. 

The Model Principles form the centerpiece of the Model Policies. The ABA House of Delegates formally adopted the Model Principles as ABA policy, apart from the balance of the Model Policies. In addition to adopting the Model Principles as ABA Policy, the ABA House of Delegates in a second resolution urged businesses to adopt policies consistent with the Model Principles. Four Model Principles address both businesses and suppliers:

  • Principle 1 – The Business/Supplier will Prohibit Labor Trafficking and Child Labor in its Operations.
  • Principle 2 – The Business/Supplier will Conduct a Risk Assessment of the Risk of Labor Trafficking and Child Labor and Continually Monitor Implementation of this Policy.
  • Principle 3 – The Business/Supplier should: (i) Train Relevant Employees, (ii) Engage in Continuous Improvement, and (iii) Maintain Effective Communications Mechanisms with its Suppliers.
  • Principle 4 – The Business/Supplier will Devise a Remediation Policy and Plan that Addresses Remediation for Labor Trafficking or Child Labor in its Operation.

The Model Principles are consistent with the UN Guiding Principles on Business and Human Rights, which are the globally recognized guidelines on the roles of states and business enterprises in addressing human rights issues. The Guiding Principles recognize that: (1) states have existing obligations to respect, protect, and fulfill human rights and fundamental freedoms; (2) business enterprises including suppliers must comply with all applicable laws and respect human rights; and (3) rights and obligations should carry appropriate and effective remedies when breached. 

The Model Policies’ Parts III and IV consist of two main parts. Four Model Business and Supplier Policies each relate to one of the Model Principles. Each Model Policy starts with a statement of the applicable Model Principle. A commentary and guidance section recommends provisions to use in a business enterprise’s policy or code of conduct. These Model Policies are not ABA policy in the same manner as the Model Principles, hence a business enterprise can modify any or all of the provisions to suit its environment. 

The Model Policies’ Parts V Definitions and VI Endnotes are also part of the Model Policies and as such were not adopted by the ABA as policy. 

Companies are undertaking more ethical activities related to trafficking, beyond those related to the ABA Model Policies. The Working Group plans a database of resources to permit companies to post their policies and other relevant materials for sharing with others. For example, Apple’s code of conduct requires suppliers to refund to workers any excessive recruitment fees. Since 2008, this initiative has resulted in $17 million going back to workers, $3.9 million during the last year. 

Philanthropic Consequences

Corporations have demonstrated good corporate citizenship in this area. These efforts include the corporations mentioned earlier that formed the Global Business Coalition Against Trafficking. This initiative can become much more than philanthropic as this coalition develops additional tools. Some of those same corporations are signatories to the Luxor Implementation Guidelines to the Athens Ethical Principles, including the Gap, the Body Shop, Microsoft, and Manpower. Microsoft and Manpower are members of End Human Trafficking Now. Google had donated $11.5 million to Polaris and International Justice Mission to Fight Human Trafficking. Hilton Worldwide, Carlson/Radisson, and Delta Airlines have signed the ECPAT Code.

Conclusion

Lawyers discern the legal, financial, ethical, and moral risks of noncompliance with local, state, and federal laws, and international norms and rules, or the “rule of law.” We do not substitute the public good for shareholder return. CSR starts with a corporation’s economic interests and then moves through the legal, ethical, and philanthropic opportunities and concerns. Lawyers help corporate boards and CEOs recognize the risks of violating laws and the long-term reward of acting within those laws, even when others might pursue short-term rewards carrying unacceptable risks. Model Rule 2.1 permits lawyers to consider social and moral concerns relevant to its client’s situation in rendering legal advice. Yet lawyers should go beyond advocating correction of social or moral wrongs to also articulating a cogent business case. Lawyers can help corporate leaders communicate to shareholders broad and lasting value from eradicating trafficking from the supply chain. Doing so can build and protect equity while appealing to the growing number of customers, shareholders, and investors who care about human rights. Conversely, making a profit off of slavery presents unacceptable social, legal, litigation, and reputational risks that no corporation should accept as it could lead to significant erosion of a company’s business.

Investor Interest in Nonfinancial Information: What Lawyers Need to Know

Posted on January 21, 2015 by - Uncategorized

More than ever before, investors want nonfinancial information from companies in making investment decisions. Examples of nonfinancial information (also referred to environmental, social, and governance or sustainability information) include climate change, water quality and quantity, ethical business practices, cybersecurity, and supply chain management. What environmental, social, and governance (ESG) risks does the company face? How is the company managing these risks? How is the company performing on corporate social responsibility (CSR) and sustainability factors relative to its industry peers? This article addresses the growing interest of investors in nonfinancial information and implications for lawyers in advising their clients.

 

Nonfinancial information has legal and business dimensions. On the legal side, a company may, as appropriate, be required to disclose nonfinancial information regarding climate change, cybersecurity, environmental impacts, and social impacts under state and federal regulations. How the company responds to these requirements can create liability consequences. On the business side, how a company implements and represents its CSR and sustainability practices may affect its operations, financial performance, corporate governance, and reputation. These business aspects of nonfinancial information can also raise questions for lawyers.

 

With this context, this article proceeds as follows. First, the article examines the rise of fiduciary capitalism and investor interest in nonfinancial information. Second, the article discusses the implications for lawyers. Finally, the article provides thoughts on the future of nonfinancial information. 

Institutional Investors and Nonfinancial Information 

The Rise of Fiduciary Capitalism 

In the early 1930s, Adolf Berle and Gardiner Means described the modern corporation as one of dispersed ownership by small shareholders who had little power relative to managers. Before the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, investors had little information about the companies they invested in, or thought about investing in, because companies had to report little about themselves to investors. The Exchange Act gave investors a window into the financial condition and operations of a company by mandating that registered companies periodically report information to the Securities and Exchange Commission. 

Since the passage of the Securities Acts, the capital markets have experienced eras of industrial or managerial capitalism and, more recently, finance capitalism, which was dominated by financial intermediaries such as banks, asset managers, and brokers. Some observers see the financial crisis of 2008 as the beginning of a new age – the age of fiduciary capitalism. Fiduciary capitalism differs from the other ages of capitalism in that long-term focused institutional investors dominate the capital markets. The primary actors in fiduciary capitalism are pension funds, university endowments, foundations, and sovereign wealth funds. John Rogers, “A New Era of Fiduciary Capitalism? Let’s Hope So,” Financial Analysts Journal (May/June 2014), Volume 70, Issue 3. 

In the United States, these asset owners have common law fiduciary duties of care and loyalty. The duty of care, or prudence, requires the fiduciary to invest and manage the investments, diversification, and risks of the fund as a prudent investor would, considering the purposes, terms, and distribution requirements of the fund. 

The duty of loyalty binds the investor to remain impartial between beneficiaries, for example, different generations. This duty may influence how the fiduciary incorporates nonfinancial information into its investment calculus: 

Given the potential for shifting of wealth, environmental remediation costs and climate risks between young and older generations, failures of fiduciaries to adopt a sustainable development investment approach has fiduciary duty implications and raises questions about the ability of fiduciaries to efficiently allocate investment capital to growth opportunities and manage risks to economic growth and future portfolio returns. 

Keith Johnson, “Introduction to Institutional Investor Duties,” Institute for Sustainable Development Report, pg. 8 (February 2014). 

The Employees’ Retirement Income Security Act’s (ERISA) fiduciary standard applies to private pension funds. ERISA fiduciaries may not subordinate the economic interests of the plan to unrelated goals, and may not choose investments on factors other than the economic interests of the plan. Nonfinancial factors can be considered if they do not negatively affect risk and returns and if they are integrated into the financial and risk analysis to help choose an investment portfolio that meets the long-term investment objectives of the beneficiaries. 

Although large, public pension funds are not subject to ERISA, they often follow the fiduciary standards of ERISA. The California Public Employees Retirement System (CalPERS), the largest public pension fund in the United States, explains how its sustainable investment approach supports its fiduciary duties: 

CalPERS’ fiduciary duty is paramount to achieving our mission, which is to provide pension and health benefits to more than 1.6 million CalPERS members and their families. We clearly state that our focus is on the long term?–?which is both a responsibility and an advantage for a fund our size. . . . The Beliefs also elevate our framework for sustainable investment, recognizing that long-term value creation requires the effective management of three forms of capital: financial, physical, and human. This process has evolved our thinking on ESG issues into a core theme across our portfolio. The Beliefs flag important issues such as the multi-faceted nature of risk including climate change and resource availability, and the importance of managing costs. 

CalPERS, Towards Sustainable Investment & Operations: Making Progress, 2014 Report, pg. 7 (2014). 

The California State Teachers Retirement System (CalSTRS) requires its investment managers to assess ESG risks in making investments. CalSTRS explains why this approach is in its best interest: 

Since CalSTRS is a long-term investor and may hold an investment in a corporation or entity for decade after decade, short-term gains at the expense of long-term gains are not in the best interest of the Fund. Sustainable returns over long period are in the economic interest of the Fund. 

CalSTRS, Teachers’ Retirement Board Policy Manual, pg. A-18 (2013). 

Materiality and Investor Interest in Nonfinancial Information: The NRDC Cases 

Materiality is intrinsically tied to the reasonable investor. After all, what is material depends on what the reasonable investor would find important in his or her investment decisions. Yet, courts have not explicitly or clearly defined the reasonable investor. Instead, courts have attributed a number of traits to the reasonable investor, including rationality in investment decision making. (Tom C.W. Lin, “The New Investor,” 60 UCLA L. Rev. 678, 694–695 (2013)). Although the definition of the reasonable investor is not settled, the definition is intended to be objective. (Stephen Padfield, “Is Puffery Material to Investors? Maybe We Should Ask Them,” 10 U. Ap. J. Bus. & Emp. L. 339, 346, 365 (2008). The SEC explains that the reasonable investor has been viewed as a long-term investor going back to the Exchange Act. Regulation NMS, 70 Fed. Reg. 37,496, 37,500 (June 29, 2005). 

Through a series of cases brought by the National Resources Defense Council (NRDC) against the SEC during the 1970s, the SEC provided insight how it thinks about the reasonable investor. The late 1960s and early 1970s saw shareholders and organizations ask companies to disclose more social, environmental, and civil rights information. For example, Campaign GM was a proxy proposal that involved General Motors shareholders asking the company to provide more information on its environmental and civil rights performance and on safety and design issues. In 1971, the NRDC brought a rule-making petition before the SEC, asking the commission to expand civil rights and environmental disclosure under the federal securities laws. NRDC v. SEC, 389 F. Supp. 689, 693–694 (D.D.C. 1974). After a number of investigations and public hearings spanning almost a decade, the SEC decided in administrative proceedings that the requested disclosures were not needed because only a small fraction of investors considered social and environmental information important. Two federal courts upheld the SEC’s rule-making authority and actions. 

The district court ordered the SEC to work on two critical factual issues regarding materiality: first, the prevalence of ethical investor interest in greater environmental and civil rights disclosure, and second, what other avenues ethical investors can use to combat corporate actions that negatively affect the environment or the practice of equal employment. Regarding expanded social disclosure, the SEC found that about 0.0005 percent of the total value of stocks and bonds in the United States in 1974 was invested using ethical investing principles. Likewise, shareholder proposals on environmental and social received, on average, between 2 percent to 3 percent approval during the 1970s. These findings led the SEC to conclude that ethical investing was not an important or significant type of investing. Commission Conclusions and Rule Making Proposals, Securities Act Release No. 5627, Exchange Act Release No. 11773, [1965–1976 Transfer Binder] Fed. Sec. L. Rep (CCH) ¶ 80, 820 at 85,719-720 (Oct. 14, 1975). 

The SEC’s decision turned on a level of interest insufficient to conclude that the reasonable investor was interested in social and environmental information. The commission’s analysis of what is material to the reasonable investor depended, to a large extent, on the portion of investors and assets under management interested in nonfinancial information. This suggests that when a sufficiently large percentage of investors and/or assets under management consider sustainability information to be material, sustainability disclosure would be justified because the reasonable investor views that information as decision-useful. 

Because investors presumably invest primarily for economic gain, the commission decided to adhere to an economic understanding of materiality. Further, the SEC stated that it could not require disclosure solely for the purposes of changing corporate behavior, although it recognized that disclosure might have an indirect effect on such behavior. To require disclosure solely for the goal of changing corporate behavior would go beyond the commission’s authority to require disclosure that is “necessary or appropriate for the protection of investors or the furtherance of fair, orderly and efficient markets or for fair opportunity of corporate suffrage.” (Commission Conclusions, Securities Act Release No. 5627, at 85,713.) This reasoning, however, contradicts the legislative intent of the Securities Acts. Moreover, expanded social and environmental disclosure can provide useful information to investors that directly relates to the goals of investor protection and informed voting. Cynthia A. Williams, “The Securities and Exchange Commission and Corporate Social Transparency,” 112 Harvard L. Rev. 1197, 1272-1273 (1999). 

Increased Investor Interest in Nonfinancial Information Today 

The level of investor interest in nonfinancial information has dramatically increased since the SEC’s market study of the 1970s. One reason is the growth of sustainable, responsible, and impact investing. According to US SIF (The Forum for Sustainable and Responsible Investment), at the beginning of 2014 approximately $6.57 trillion in assets under management was engaged in sustainable, responsible, and impact investing. This amount represents about 18 percent of the $36.8 trillion in total assets under management in the United States. The amount invested in sustainable investing practices increased 76 percent from $3.74 trillion in 2012. Since 1995, when US SIF first began tracking sustainable, responsible, and impact investing, the amount of assets engaged in this investment approach has increased over 900 percent from about $600 billion. Report on US Sustainable, Responsible and Impact Investing Trends 2014, US SIF, pg. 12–16 (2014). 

In response to a 2013 survey conducted by Ernst & Young of more than 160 investors, analysts, and portfolio managers around the globe, nine out of 10 respondents stated that nonfinancial performance had played a pivotal role in their investment decision-making in the past 12 months. The report concluded: “This demonstrates that the analysis of nonfinancial issues can no longer be dismissed as a niche approach to investment.” EY, Tomorrow’s Investment Rules: Global Survey of Institutional Investors on Non-Financial Performance (2014). 

How do investors benefit from nonfinancial information? In response to PwC’s survey in 2014 of institutional investors with $7.6 trillion in assets under management, 73 percent said that risk mitigation is the primary reason they consider sustainability information. Fifty-five percent said that avoiding unethical companies is a reason for their interest, and 52 percent said that financial performance is why they factor sustainability information into their investment decisions. 

Despite investor interest in nonfinancial information, companies are not providing the information that investors want. Sixty-one percent of investors stated that they are dissatisfied with corporate disclosures of social and environmental information by U.S. companies. With respect to sustainability issues, investors expressed broad dissatisfaction with how U.S.-listed companies are disclosing information:

  • 79 percent are dissatisfied with comparability of sustainability reporting between companies in the same industry.
  • 74 percent are dissatisfied with relevance and implications of sustainability risks.
  • 68 percent are dissatisfied with sustainability strategy that is linked to business strategy.
  • 62 percent are dissatisfied with internal governance of sustainability issues.
  • 57 percent are dissatisfied with process used to identify material sustainability issues. 

PwC, Sustainability Goes Mainstream: Insights Into Investor Views (May 2014). 

Another reason for the increased interest in nonfinancial information is the greater presence of long-term oriented institutional investors today. Institutional investors own 70 percent of the largest 1,000 U.S. companies, and pension funds own almost 40 percent of this amount. Institutional investors incorporate sustainable, responsible, and impact principles into investment analysis and portfolio selection of $4.04 trillion, or about 60 percent of the total amount of assets under management investing using these principles. 

At the same time, a growing number of investors has committed to the United Nations Principles for Responsible Investment (PRI). The PRI is a global framework for investors to include ESG information into investment analysis and decisions with the purpose of increasing returns and reducing risk. In 2009, 560 institutional investors with $18 trillion in assets under management had committed to the principles, while in 2014 over 1,200 investors with $34 trillion in assets under management had done so. The principles are based on the idea that ESG issues can affect investment performance and that consideration of these issues can help to produce superior risk-adjusted returns. For these reasons, nonfinancial information can fall squarely within investors’ fiduciary duties. The principles explicitly state they are to be applied only in a manner that is consistent with those duties. 

In incorporating ESG information into fundamental equity analysis, investors use the information in several ways:

  • Economic analysis: To understand industry trends and externalities likely to affect the economic outlook and, therefore, value creation and capital formation.
  • Industry analysis: To understand factors driving competitiveness and the potential for sustained value creation in an industry, as well as externalities from an industry likely to affect other industries (and therefore portfolio risks).
  • Company strategy: To understand management quality and corporate strategy, and evaluate a company’s ability to respond to emerging trends.
  • Valuation: To adjust traditional valuation parameters and assumptions, including cash flow and weighted average cost of capital, to reflect performance on material sustainability issues. 

Robert C. Eccles and Jean Rogers, The SEC and Capital Markets in the 21st Century: Evolving Accounting Infrastructure for Today’s World, Governance Studies at Brookings, pg. 5 (Sept. 2014).

Implications for Lawyers

The trend of increasing investor interest in nonfinancial information has many implications for how lawyers might advise their clients. With respect to disclosing nonfinancial information to investors, lawyers will need to consider how to advise companies on what kind of information to provide, in what level of detail, and in what format. Should the company provide information only on ESG issues that investors specifically ask about? Should the company provide information on the commonly sought types of information (e.g., climate change) for companies in its industry? How much information and at what level of detail (general initiatives or measurable performance) is enough to satisfy investors? Should the information be provided in voluntary sustainability reports or in SEC filings? A company may, under appropriate circumstances, need to disclose information on these issues in a company’s SEC filings under Regulation S-K. In other situations, a company may decide to report the information in voluntary reports, such as its corporate social responsibility, Global Reporting Initiative, or sustainability reports. 

Since nonfinancial information is related to risk mitigation and value creation, the lawyer should consider reviewing the board’s role in overseeing the information. What kind of nonfinancial information, and how much, should management report to the board? Should an existing or dedicated committee be responsible for the oversight of nonfinancial information? Or should the entire board be responsible? Should the compensation of executives be tied to performance on nonfinancial matters? If so, over how long of a time period? 

Finally, lawyers can help clients understand the liability implications of nonfinancial information. Companies that fail to disclose material sustainability information may face a higher risk of shareholder suits alleging that the company made materially misleading or false statements. Companies who consider disclosing nonfinancial information in SEC filings should examine the requirements and potential liabilities associated with signing Section 302 and 906 Sarbanes-Oxley certifications concerning the company’s disclosure controls and procedures. Lawyers can help companies assess the materiality of sustainability information and evaluate the risks of disclosing, or not disclosing, sustainability information. 

Conclusion 

With the growing prominence of fiduciary capitalism, nonfinancial information assumes greater significance for companies and investors. Investors want nonfinancial information that will help them reduce risk, improve returns, and make better informed investment decisions. How can they obtain the information in an effective, efficient manner that allows them to compare companies within industries? Companies need to find a way to address investor demand for nonfinancial information. How can companies collect, organize, and report information to investors in a cost-effective manner?

So long as fiduciary investors manage a substantial portion of assets under management, nonfinancial information is likely to remain important to the efficient operation of the capital markets and the formation of capital. Lawyers can play a critical role in advising companies and investors about the legal and business implications of nonfinancial information.