The Securities and Exchange Commission recently proposed to simplify crucial corporate disclosures regarding legal proceedings and risk factors by moving toward a more principles-based approach; yet, the SEC continues to pursue big-dollar enforcement actions that offer filers little clarity about what precisely constitutes accurate disclosure of their risk factors.
Weighing materiality and the potential for liability are traditionally hazy areas that have tripped up a number of companies, including most recently:
Mylan NV, which agreed to pay $30 million because it calculated as “remote” rather than “reasonably possible” the likelihood that a government investigation would impose a substantial liability on the company
Facebook, which in using of the word “may” rather than “have” in its risk-factor disclosures about customer data likely cost the company $100 million
Altaba Inc. (formerly known as Yahoo!), which reached a $35 million settlement last year with the SEC for its tardy disclosure of a data breach
These settlements all point to a heightened focused on analyses of materiality and probability in SEC risk-factor disclosures, which often hinge on standards that are subject to wide variances of interpretation: Is the risk material? Is the liability probable? Is the fact significant? How is a company supposed to communicate to shareholders about the likelihood of adverse consequences?
Slippery Standards
The SEC offers guidance on disclosure descriptions and best practices in performing analysis, but the way in which courts and the SEC have applied the standards has often confounded filers. It may seem black or white to a class-action plaintiff or the SEC looking in hindsight to determine whether a data breach occurred or whether litigation risk should have been more definitive. However, companies answering these questions in real time must pick through numerous cyber incidents and litigation filings to decide which demand disclosure.
In August, the SEC proposed modernizing risk-factor disclosures with the stated intention of improving information available to investors and simplifying compliance for registrants. If finalized as proposed, the disclosure threshold would change from “most significant” to “material” factors. It is far from certain, though, that the new standard would offer brighter lines to filers assessing whether and how to describe unclear scenarios.
Murky Materiality
The Facebook case is an example of how a materiality analysis can be viewed in one way by the company in real time and another way by a regulator in hindsight. For example, the SEC took issue with a disclosure that read, “our users’ data may be improperly accessed, used or disclosed” (emphasis added). The disclosure continued in the same form even after the company became aware that such a breach had in fact occurred. According to the co-director of the SEC’s enforcement division, that meant the company had “presented the risk of misuse of user data as hypothetical when they knew user data had in fact been misused.” Although the SEC repeatedly emphasized materiality in its announcement of the settlement, the staff did not address the specific data breach considerations that should have resulted in a different materiality call. We also do not know the exact materiality considerations that Facebook went through in determining its disclosures.
Determining whether an “event” is material—and required to be disclosed—typically involves undertaking an analysis under SEC Staff Accounting Bulletin No. 99. This 20-year-old standard requires both quantitative and qualitative considerations. Auditors often use five to ten percent of net income as a rule-of-thumb cutoff for a quantitative materiality threshold. However, even that seemingly straightforward accounting practice is packed with many caveats requiring the consideration of numerous inputs that could potentially nullify the initial conclusion. For example, an initially immaterial netted result could become material when reviewed in isolation, whereas similar reliance on a commonplace accounting precedence or on industry practices could inappropriately mask an otherwise material event.
Qualitative analysis is even more complex. To develop risk factors, public companies must assess a list of considerations that is so extensive that it requires its own chapter in the applicable concept note issued by the Financial Accounting Standards Board. Considerations include a mishmash of terminology: estimate imprecisions, masked trends, analyst expectations, misleading impressions, significant segments, contractual requirements, executive compensation, and lawfulness. Even highly experienced accountants, disclosure counsel, and subject-matter experts struggle to apply theoretical generally accepted accounting principles to practical real-world events.
Despite the imprecision in materiality analysis, companies can put themselves in as defensible a position as possible by ensuring the inclusion of subject-matter experts in drafting and reviewing relevant disclosures. Board members, in-house and outside counsel, and consultants well versed in weighing the appropriate considerations must collaborate with subject matter experts as well, and all participants should be empowered to apply those assessments in an impartial manner.
Probable Probability
The Mylan case is a warning to companies that rely on the uncertainties of litigation and investigation to omit loss disclosures and accruals. In its complaint, the SEC mentioned tolling agreements four times, signaling that in the SEC’s view, entering into a tolling agreement means the company has determined an adverse outcome is no longer just “remote,” but now “reasonably possible and probable.” The SEC’s enforcement division emphasized that it is “critical that public companies accurately disclose material business risks and timely disclose and account for loss contingencies that can materially affect their bottom line.”
Evaluating a loss contingency typically falls under SEC Regulation S-K and its FASB counterpart, Accounting Standards Codification 450 (with roots in FAS 5). This guidance requires that an estimated loss from a contingency be recognized if a liability has been incurred as of the date of the financial statements and the amount can be reasonably estimated. Further complicating matters, companies may still need to disclose loss contingencies that do not meet the recognition criteria.
Public companies often associate this standard with “significant litigation” disclosure obligations. In reality, though, the standard applies more broadly to any loss contingency, including asset impairment, product injury, property damage, asset expropriation, and assessments. A separate test under the same standard applies to less common gain contingencies as well.
Companies then face the daunting task of categorizing pending legal matters, whether litigation or investigations, as remote, reasonably possible, or probable. The harsh reality is that depending on the stage of litigation, none of the descriptions may be completely appropriate. Even during negotiations, the initial gap between settlement offers can range in the tens of millions of dollars, leaving a significant possibility that the matter continues to trial without settling at all. Forcing a disclosure that puts a dollar figure on a specific matter in advance of a settlement also puts the company in a weak negotiating position. In addition, during a government investigation, a company often has an extremely limited view of the outcome the enforcement attorney is seeking, whether it be a settlement, a penalty, or a fine.
To Be Continued . . .
A further word of caution: Disclosure analyses do not end upon arriving at a final materiality or liability disclosure determination. If such evaluations affirm a material risk or reasonably probable liability, simply disclosing it is not always sufficient—the risk must be remediated. In October 2019, the SEC held an administrative proceeding against Northwestern Biotherapeutics for “internal control weaknesses” related to the supervision of accounting operations. The company had concluded that the weaknesses were material and publicly disclosed them in its risk factors, but the SEC found that the company failed to remediate in a timely manner the weaknesses it repeatedly identified in its risk factors.
The SEC’s latest move toward principles-based disclosure notwithstanding, the actual enforcement message to SEC filers on materiality, liability disclosures, and accruals is a fairly ominous one.
As chairs of the ABA’s Private Target Mergers & Acquisitions Deal Points Study (the Private Target Deal Points Study), we are pleased to announce that we published the latest iteration of the study to the ABA’s website in early December 2019.
Congratulations! But Wait. What Exactly Is This Private Target Deal Points Study, Anyway?
The Private Target Deal Points Study is a publication of the Market Trends Subcommittee of the Business Law Section’s M&A Committee. It examines the prevalence of certain provisions in publicly available, private target M&A transactions during a specified time period. The Private Target Deal Points Study is the preeminent study of M&A transactions, widely utilized by practitioners, investment bankers, corporate development teams, and other advisors.
The 2019 iteration of the Private Target Deal Points Study analyzes publicly available definitive acquisition agreements for transactions executed and/or completed either during calendar year 2018 or during the first quarter of calendar year 2019. In each case, the transaction involved a private target acquired by a public buyer, with the acquisition material enough to that public buyer for the Securities and Exchange Commission to require public disclosure of the applicable definitive acquisition agreement.
The final sample examined by the Private Target Deal Points Study is made up of 151 definitive acquisition agreements and excludes agreements for transactions in which the target was in bankruptcy, reverse mergers, divisional sales, and transactions otherwise deemed inappropriate for inclusion.
Although the deals in the Private Target Deal Points Study reflect a broad array of industries, the technology and healthcare sectors together made up approximately 40 percent of the deals. Asset deals comprised 5.3 percent of the study sample, with the remainder either equity purchases or mergers.
Of the Private Target Deal Points Study sample, 34 deals signed and closed simultaneously, whereas the remaining 117 deals had a deferred closing some time after execution of the definitive purchase agreement.
The transactions analyzed in the Private Target Deal Points Study were in the “middle market,” with purchase prices ranging between $30 million and $750 million; purchase prices for most deals in the data pool were below $200 million.
The Private Target Deal Points Study Sounds Great! How Can I Get a Copy?
All members of the M&A Committee of the Business Law Section received an e-mail alert from Jessica Pearlman with a link when the study was published. If you are not currently a member of the M&A Committee but do not want to miss future e-mail alerts, committee membership is free to Business Law Section members, and you can sign up on the M&A Committee’s homepage.
The published 2019 Private Target Deal Points Study is available for download by M&A Committee members from the Market Trends Subcommittee. Also available are the most recently published versions of the other studies published by the Market Trends Subcommittee, including the Canadian Public Target M&A Deal Points Study, Carveout Transactions M&A Deal Points Study, and Strategic Buyer/Public Target M&A Deal Points Study.
How Does the 2019 Private Target Deal Points Study Differ from the Prior Version?
The 2019 version of the Private Target Deal Points Study has a number of features that differentiate it from prior iterations.
Data in the 2019 version of the Private Target Deal Points Study is more current. The 2019 version of the Private Target Deal Points Study includes not only 2018 transactions, but also transactions from the first quarter of 2019.
The 2019 version of the Private Target Deal Points Study contains new data points. The 2019 version of the Private Target Deal Points Study includes new data points throughout, including three new representations on #MeToo, data privacy, and cybersecurity. There are other new data points scattered throughout the study with “new data” flags (like the sample shown below) to make them easy to spot:
The 2019 version of the Private Target Deal Points Study includes more correlations. Representations and warranties insurance (RWI) is changing the M&A game, and we are keeping score. We have added a number of data points to our correlations with deals that reference RWI and deals that do not.
Please join us in extending a hearty thank you to everyone who worked so hard on this study, from leadership to advisors to issue group leaders to the working groups, all of whom are listed in the credits pages.
For more information, register for the In the Know webinar, during which the chairs and issue group leaders will provide analysis and key takeaways from the results of the Private Target M&A Deal Points Study, on April 16, 2020, from 1:00 p.m. to 2:30 p.m. (ET).
The U.S. Supreme Court recently narrowed the circumstances under which a court will defer to an agency’s interpretation of its own regulation. In Kisor v. Wilkie, the Court considered whether to overturn a line of precedent that requires courts to defer to the agency’s interpretation unless it is “plainly erroneous or inconsistent with the regulation.”[1] Although all of the justices agreed to uphold this so-called Auer deference, Kisor may render agencies’ deference “maimed and enfeebled,” at least according to one justice’s concurring opinion. It may also provide banking organizations with new methods to encourage agencies to engage in more open, transparent, and careful decision making.
The Lead-Up to Kisor
History of the Auer Deference
In 1945, the Supreme Court established a fundamental principle of administrative law that, where “the meaning of the words [of an agency’s regulation] is in doubt,” the agency’s interpretation of the regulation “becomes controlling weight unless it is plainly erroneous or inconsistent with the regulation.”[2] The principle came to be applied in a mechanical and highly deferential manner beginning in the 1960s and 1970s with the rise of the administrative state.[3] Although certain Supreme Court justices cast some doubt on its continuing viability in the early 1990s,[4] the Court’s 1997 Auer v. Robbins opinion has generally been seen as reaffirming that an agency’s interpretation should be controlling “unless plainly erroneous or inconsistent with the regulation.”[5]
Significance of Auer Deference through the Years
Auer deference appears to make a difference in outcome. An empirical study of over 1,000 Supreme Court cases found that the Court upheld an agency’s interpretation of its own regulations 91 percent of the time.[6] A similar review of district court and circuit court cases found that the lower courts upheld agency interpretations of agency rules 76 percent of the time.[7] However, the Court in recent years has discussed limits to Auer deference,[8] and more recent empirical analysis has demonstrated a decline in deference to agency interpretations of regulations.[9]
Relevance to Chevron Deference
Auer deference is different and less well-known than “Chevron deference.” In short, application of the doctrines depends on whether the agency interpretation is of a regulation or a statute. Whereas Auer deference may apply to an agency’s interpretation of its own regulations,[10]Chevron deference may apply to an agency’s interpretation of statutes for which it has authority to make rules.[11] Under Chevron, courts will adopt an agency’s interpretation if the statute is ambiguous and the agency’s interpretation is reasonable.[12]Auer and Chevron deference share many similarities; therefore, Kisor could provide insight into the future of Chevron deference. However, Kisor does not purport to directly affect Chevron deference, with two of its concurring opinions explicitly noting that Kisor does not “touch upon” Chevron.[13]
Kisor’s Test
Drawing from the Court’s earlier discussions of the limitations of Auer deference, Kisor sets forth a multifactor test that an agency’s interpretation must pass in order to receive such deference.
Is the regulation “genuinely ambiguous”? Under Kisor, a court should not apply Auer deference unless a regulation is “genuinely ambiguous.”[14] Although ambiguity has always been a requirement for deference, Kisor provides that a court may make this determination only after exhausting “all the traditional tools of construction,” including the “text, structure, history and purpose of the regulation.”[15] The Court noted that “hard interpretive conundrums, even those related to complex rules, can often be solved” and that a court’s independent, careful consideration of the issue will make Auer deference inappropriate for “many seeming ambiguities.”[16]
Is the agency’s interpretation reasonable? The interpretation offered by the agency also must fall within the “zone of ambiguity” the court has identified in considering whether the regulation was genuinely ambiguous. In other words, the court’s analysis in the step above not only determines whether a regulation is ambiguous, but also determines the range of reasonable interpretations. Kisor adjures that there should “be no mistake: That is a requirement an agency can fail.”[17]
Does the “character and context” of the interpretation entitle it to deference? In order to grant Auer deference, the court must also determine that the “character and context” of the interpretation warrants deference. In other words, the court must decide whether is it appropriate to presume that Congress would have wanted the agency to resolve the particular interpretive issue presented.[18] The Court gave “some especially important markers” under this inquiry and noted other considerations could be relevant.[19]
Was the interpretation actually made by the agency?Kisor explains that the interpretation must be the agency’s “authoritative or official position” in order to receive deference.[20] Although this standard encompasses more than just interpretations directly approved by the head of the agency (g., official staff memoranda published in the Federal Register), it does not include every memorandum, speech, or other pronouncement from agency staff.[21] The interpretation “must at the least emanate from those actors, using those vehicles, understood to make authoritative policy.”[22]
Does the interpretation implicate the agency’s substantive expertise? The Court explained that, generally, agencies have a nuanced understanding of the regulations they administer, such as when a regulation is technical or implicates policy expertise.[23] However, deference may not be warranted where an interpretive issue “falls more naturally into the judge’s bailiwick,” such as a common law property term or the award of attorney’s fees.[24]
Does the interpretation reflect the “fair and considered judgment” of the agency? Deference also may not be warranted where the agency interpretation creates “unfair surprise,” such as when the interpretation conflicts with its prior interpretation or imposes retroactive liability for long-standing conduct that the agency had never before addressed.[25] Similarly, agency interpretations that are “post hoc rationalizatio[ns] advanced to defend past agency action” should not be afforded deference.[26]
Kisor’s Potential Implications
Kisor’s effect on banking agencies and banking organizations remains to be seen as few cases have yet applied Kisor’s test to an agency interpretation.[27] It is also unclear whether and to what extent Kisor will affect how agencies interpret their own regulations. On the one hand, the potential additional scrutiny of a court may not deter an agency (or its staff) from making questionable interpretations of regulations simply because of the historically low likelihood of banking organizations challenging these agencies in court.[28] On the other hand, Kisor has the potential to affect the agencies and their interactions with banking organizations in a number of significant ways.
Improve Quality of Agency Interpretations and Regulations
Kisor could improve the quality of agency interpretations of regulations (as well as the regulations themselves) for a number of reasons. First, agencies may be more likely to issue interpretations through the head(s) of the agency or other authoritative or official processes, thereby subjecting them to additional review, so that the interpretation can clearly meet the “authoritative or official position” aspect of the Kisor test. Second, the additional rigor of other aspects of the Kisor test may encourage agencies to more carefully consider their interpretations of regulations. Third, agencies may be more willing to consider banking organizations’ views of the meaning of regulations and their underlying rationale prior to issuing official interpretations (through requests for interpretations or otherwise). Kisor should be seen as giving those outside the agencies a greater role in analyzing interpretive questions; the opinion makes clear that an agency’s views regarding the text, structure, history, and policy of the regulation are not the only ones that matter. Rather, these issues are considered independently—as if there were “no agency to fall back on.”[29] Fourth, an agency may be more reluctant to offer interpretations that are likely to fail the Kisor test, such as those that would “unfair[ly] surprise” banking organizations or for which the agency has no particular expertise. Finally, Kisor also appears to decrease any agency’s incentive to issue open-ended or otherwise ambiguous regulations, as it now should be less likely that the agency would receive Auer deference for its interpretation of such a regulation.[30]
Encouraging Notice and Comment Rulemakings
Kisor also could be seen as further cabining an agency’s ability to create binding requirements outside of the Administrative Procedure Act’s rulemaking process.[31] The banking agencies recently have acknowledged that, although law and regulations have the force and effect of law, “supervisory guidance” does not.[32] In other words, supervisory guidance may not be phrased in terms of binding requirements, and an agency may not treat the guidance as if it were binding.[33] However, agency interpretations, like the regulations they interpret, may be phrased as binding requirements and treated as binding.[34]
Of course, agencies are aware of this distinction and may use it to impose binding requirements on banking organizations, sometimes by characterizing statements that appear to be supervisory guidance as interpretations. For example, in a bank’s appeal of a cease-and-desist order issued by the FDIC, the 9th Circuit disagreed with the bank’s argument that the FFIEC’s BSA/AML Examination Manual[35] could not impose legal obligations on the bank, and found that the manual was an interpretation of the FDIC’s regulations entitled to Auer deference.[36] The Kisor test may have led the 9th Circuit to reach a different outcome because the test would have required the court to engage in a much more careful analysis of this question than the two paragraphs the 9th Circuit afforded it.[37] In other words, Kisor’s additional constraints on deference should make it more difficult for agencies to successfully impose binding requirements by issuing interpretations of regulations or characterizing supervisory guidance as an interpretation of a regulation.
The impact of a new Supreme Court case can be easy to overstate, and Kisor may be no exception to this general rule. However, the Kisor test and the Court’s underlying rationale do at least appear to provide new methods to encourage the banking agencies to engage in more open, transparent, and rigorous consideration of interpretive questions.
[1] Kisor v. Wilkie, 588 U.S. __ (2019); see also Bowles v. Seminole Rock & Sand Co., 325 U.S. 410, 414 (1945).
[2]Seminole Rock, 325 U.S. at 414. Even if the court finds that an agency’s interpretation should not be given controlling weight under Auer (or Chevron, discussed below), a court may nonetheless uphold the agency’s interpretation if it finds the interpretation persuasive. This “power to persuade,” generally referred to as “Skidmore deference,” considers factors such as a thoroughness of the agency’s consideration, the validity of its reasoning, and its consistency with earlier and later pronouncements. See, e.g., Skidmore v. Swift & Co., 323 U.S. 134, 141–42 (1944). Some have argued that this weaker form of deference represents no deference at all. Colin S. Diver, Statutory Interpretation in the Administrative State, 133 U. Pa. L. Rev. 549, 565 (Mar. 1985) (“Of course, the ‘weight’ assigned to any advocate’s position is presumably dependent upon the ‘thoroughness evident in its consideration’ and the ‘validity of its reasoning.’ . . . The argument’s pedigree adds nothing to the persuasive force inherent in its reasoning.”).
[3]See Sanne H. Knudsen & Amy J. Wildermuth, Unearthing the Lost History of Seminole Rock, 65 Emory L.J. 47 (2015).
[4] Thomas Jefferson University v. Shalala, 512 U.S. 504, 525 (Thomas, J., dissenting); Shalala v. Guernsey Memorial Hosp., 514 U.S. 87, 108–09 (1995) (O’Connor, J. dissenting).
[5]See, e.g., Kristen E. Hickman & Richard J. Peirce, Jr., Admin. L. Treatise 353 (6th ed. 2019).
[6] William N. Eskridge, Jr. & Lauren E. Baer, The Continuum of Supreme Court Treatment of Agency Statutory Interpretations from Chevron to Hamdan, 96 Geo. L.J. 1083 (2008).
[7] Richard J. Pierce, Jr. & Joshua Weiss, An Empirical Study of Judicial Review of Agency Interpretations of Agency Rules, 63 Admin. L. Rev. 515 (2011).
[8]See Christopher v. Smithkline Beecham Corp., 567 U.S. 142 (2012); Talk America, Inc. v. Michigan Bell Tel. Co., 564 U.S. 50 (2011).
[9] Cynthia Barmore, Auer in Action: Deference After Talk America, 76 Ohio State L.J. 813 (2015).
[10] Although Auer deference generally does not apply to an agency’s interpretation of another agency’s regulations, the D.C. Circuit has held that Auer deference may apply to one agency’s interpretation of another’s rules if Congress had reassigned responsibility for implementing the statute on which the rule was based from the other agency to the first agency. Amerada Hess Pipeline Corp. v. Fed. Energy Regulatory Comm’n, 117 F.3d 596 (D.C. Cir. 1997).
[11]See, e.g., United States v. Mead Corp., 533 U.S. 218, 231–34 (2001).
[12] Chevron U.S.A. v. Nat. Res. Def. Council, Inc., 468 U.S. 837, 842–43 (1984).
[13]Kisor, slip op. at 2 (Roberts, C.J., concurring in part); id., slip op. at 2 (Kavanaugh. J., concurring in judgment).
[27] At least three lower court cases applying the Kisor test do not defer to the agency interpretation in question whereas at least another two cases do. Wolfington v. Reconstructive Orthopaedic Assocs. II PC, 935 F.3d 187 (3d Cir. 2019); Romero v. Barr, 937 F.3d 282 (4th Cir. 2019), reh’g denied (Oct. 29, 2019); Am. Tunaboat Ass’n v. Ross, 391 F. Supp. 3d 98 (D.D.C. 2019);N. Carolina Div. of Servs. for Blind v. United States Dep’t of Educ., No. 1:17CV1058, 2019 WL 3997009 (M.D.N.C. Aug. 23, 2019), report and recommendation adopted sub nom. State of N. Carolina v. United States Dep’t of Educ., Rehab. Servs. Admin., No. 1:17CV1058, 2019 WL 4773496 (M.D.N.C. Sept. 30, 2019); Belt v. P.F. Chang’s China Bistro, Inc., 401 F. Supp. 3d 512 (E.D. Pa. 2019).Of the three cases that do not defer, the agency interpretations most commonly failed the “genuinely ambiguous” and “unfair surprise” inquiries. Courts’ characterizations of the impact of the Kisor test have also been mixed. See, e.g., Spears v. Liberty Life Assurance Co. of Bos., No. 3:11-CV-1807 (VLB), 2019 WL 4766253 (D. Conn. Sept. 30, 2019) (“Kisor did not change anything about Auer, but merely explained its application”); Devon Energy Prod. Co., L.P. v. Gould, No. 16-CV-00161-ABJ, 2019 WL 6257793 (D. Wyo. Sept. 11, 2019) (“The Court [in Kisor] chose to restrict the Auer doctrine rather than abolish it.”).
[28] Similarly, agencies may choose to cast their interpretations of regulations as interpretations of the underlying statute, which would subject the interpretation to the test for Chevron deference rather than the Kisor test. As one state supreme court justice recently noted, “Not long ago, the distinction [between Chevron deference and Auer deference] might not matter in a case like this one, because Auer was generally understood to give even more deference to agency interpretations of rules than is accorded to agency interpretations of statutes under Chevron. … The upshot of that shift [due to Kisor] is that while courts previously could have been insensitive to whether the implicit agency interpretation of a statute that they were deferring to under Chevron was actually an implicit interpretation of a rule—because even if it were, deference would be required anyway—accepting that uncertainty is no longer an option. Given that Auer and Chevron have different, non-coextensive limits, it cannot be appropriate to defer to an agency’s implicit interpretation under Chevron unless it is either clear that the agency really is interpreting a statute, or, at a minimum, that the agency’s interpretation would be owed deference under Auer and Kisor even if the agency were interpreting a rule.” E. Or. Mining Ass’n v. Dep’t of Envtl. Quality, 445 P.3d 251, 278 (Or. 2019) (Balmer, J. dissenting). The justice clarified that “[n]ow, Auer’s own application having been restricted, we should not use Chevron to avoid Kisor’s limitations.” Id. at 278 fn. 4.
[30] As the Court noted earlier, Auer deference “creates a risk that agencies will promulgate vague and open-ended regulations that they can later interpret as they see fit, thereby frustrat[ing] the notice and predictability purposes of rulemaking.” Christopher, 564 U.S. at 158. In Kisor, Justice Kagan, joined by Justices Ginsburg, Breyer, and Sotomayor, argues that this criticism of Auer has notable empirical and theoretical weaknesses. Kisor, slip op. at 24–25.
[33]See, e.g., U.S. Telephone Ass’n v. Fed. Commc’n Comm’n, 28 F.3d 1232 (D.C. Cir. 1994); Community Nutrition Institute v. Young, 818 F.2d 943 (D.C. Cir. 1987); Pac. Gas & Electric Co. v. Federal Power Commission, 506 F.2d 33 (D.C. Cir. 1974).
[34] The ability to bind courts under Auer deference without notice and comment, Justice Gorsuch argues, “subverts the [Administrative Procedure Act]’s design.” Kisor, slip op. at 18 (Gorsuch, J., concurring in judgment).
[35] As noted by the 9th Circuit, the FDIC itself had characterized the manual as containing the agency’s “supervisory expectations.” FDIC, Financial Institution Letter 17-2010 (Apr. 29, 2010); compareGuidance on Guidance, at 1 (“Unlike a law or regulation, supervisory guidance does not have the force and effect of law, and the agencies do not take enforcement actions based on supervisory guidance. Rather, supervisory guidance outlines the agencies’ supervisory expectations or priorities and articulates the agencies’ general views regarding appropriate practices for a given subject area.”) (emphasis added).
[36] Cal. Pac. Bank v. Fed. Deposit Ins. Co., 885 F.3d 560, 573–75 (9th Cir. 2018).
[37] For example, it is not clear that the 9th Circuit would have concluded, based on its independent analysis of the text, structure, history, and purpose of the FDIC’s regulation, that the FFIEC BSA/AML Examination Manual is within the range of reasonable interpretations that the court identified in its analysis, or that the “character and context” of the Manual warranted deference. See, e.g., Kisor, slip op. at 16 (“So the basis for deference ebbs when the subject matter . . . falls within the scope of another agency’s authority.”) (internal quotations omitted).
In a recent decision, In Re Clovis Oncology, Inc. Derivative Litigation,[1] the Delaware Court of Chancery held that stockholders of Clovis Oncology, Inc. (Clovis), a developmental biopharmaceutical company, adequately pled facts that supported a pleading stage inference that the Clovis board of directors breached its fiduciary duties by failing to oversee the clinical trial of the company’s most promising drug, and then allowing the company to mislead the market regarding the drug’s efficacy. This decision follows the Delaware Supreme Court’s recent reversal in Marchand v. Barnhill,[2] which involved the dismissal of Caremark claims arising from a listeria outbreak at Blue Bell Creameries USA, Inc., resulting in a number of deaths.
Background
Clovis is a biopharmaceutical company that has no products on the market and generates no sales or revenue. In early 2014, the Clovis board was determined to get U.S. Food and Drug Administration (FDA) approval for the company’s then-most promising, cancer-fighting drug, Roci, before AstraZeneca’s competing drug for lung cancer received FDA approval. After clinical trials began in 2014, the Clovis board received data suggesting that management was inaccurately reporting Roci’s efficacy by including unconfirmed responses to corroborate Roci’s cancer-fighting potency. Although the Clovis board allegedly knew that under the protocols for its clinical trial the FDA could base approval of Roci’s new drug application only on confirmed responses, the Clovis board did nothing to address the fundamental departure from protocol. Clovis continued to publicly report inflated numbers in 2014 and early 2015, and used the inflated numbers to obtain additional funding from investors during that timeframe. By November 2015, the FDA informed Clovis that it could report only confirmed responses, and Clovis issued a press release informing the public of Roci’s actual efficacy, which led to a 70-percent drop in the company’s stock price. In April 2016, the FDA voted to delay action on Roci until Clovis could provide concrete evidence that Roci produced meaningful tumor shrinkage in patients treated with the drug, which led to another 17-percent drop in the company’s stock price, and Clovis withdrew its new drug application for Roci.
Analysis
In this action, plaintiffs alleged that the Clovis directors breached their fiduciary duties under Caremark by either failing to institute an oversight system for the Roci clinical trial, or consciously disregarding a series of red flags that the clinical trial was failing. The defendant directors moved to dismiss plaintiffs’ claims for failure to (1) make a pre-suit demand under Court of Chancery Rule 23.1, and (2) state a claim upon which relief could be granted. The court disagreed and found that: (1) pre-suit demand was excused because plaintiffs pled particularized facts to support a reasonable inference that the Clovis directors faced a substantial likelihood of liability under a Caremark theory of liability that excused plaintiffs’ failure to make a pre-suit demand, and (2) plaintiffs stated a Caremark claim by making well-pled allegations that the Clovis board acted in bad faith by consciously disregarding red flags that arose during the course of Roci’s clinical trial that placed FDA approval of the drug in jeopardy. According to plaintiffs, the Clovis board then allowed the company to deceive regulators and the market regarding the drug’s efficacy.
As the court noted, successful Caremark claims require well-pled allegations of bad faith to survive dismissal, i.e., allegations that the directors knew that they were not discharging their fiduciary obligations. Plaintiffs may meet that burden by showing either that the board completely failed to implement any reporting or information system or controls, or that the company implemented an oversight system but the board failed to monitor it as evidenced by red flags which were known, but ignored, by the board. Here, the court found that plaintiffs successfully pled that the Clovis board ignored red flags that revealed a mission-critical failure to comply with drug protocols and associated FDA regulations. The court noted that a board’s oversight obligations are enhanced with respect to mission-critical products while operating in a heavily regulated industry.
Takeaways
As then-Chancellor Allen stated of a Caremark theory of liability: “The theory here advanced is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment”.[3] In order to meet this enhanced pleading burden, the plaintiffs in Clovis and Marchand brought books and records actions under section 220 of the General Corporation Law of the State of Delaware prior to bringing their Caremark complaints. The books and records actions enabled the plaintiffs to gather crucial facts that highlighted potential gaps in compliance systems and board-level ignorance of red flags. Some practical lessons can be drawn from both cases.
In Clovis, the Court of Chancery emphasized the importance of a board’s oversight function when a company is operating in the midst of a mission-critical regulatory compliance risk, suggesting that a board’s oversight of such impactful business risks may be subject to greater scrutiny than the same board’s oversight of less-critical business risks. In Marchand, the Delaware Supreme Court’s decision emphasized the importance for corporations operating in heavily regulated industries to implement a system that ensures that mission-critical risks and compliance issues are brought to the attention of the board whether through a board-level compliance committee or a direct reporting line between the corporation’s top compliance officer and the board. Both cases underscore the importance of board engagement in regular discussion of critical business risks and compliance issues and the evaluation of the effectiveness of existing monitoring and compliance systems.
Prior decisions of the Delaware courts relating to Delaware corporations with vast global operations have emphasized the importance for such an enterprise to: (1) establish compliance standards and procedures that are designed to prevent violations of the law at all levels of the organization, (2) require participation in training programs, and (3) establish whistleblower systems that enable employees to report potential wrongdoing anonymously and without fear of retaliation.
Acme’s cloud storage provider just got hacked. Private information was exposed. Acme’s customers who lost information in the hack are angry and don’t care that it was a third party that failed to secure the information or that some maleficent hacker from across the globe got into their system. Likewise, their customers don’t care how difficult it is for Acme to migrate data, or how they retain and store their records, or what regulations govern each part of Acme’s business. Acme’s customers care only about their information, their data, and whether Acme performs for them.
This story could be any company’s story. The problems afflicting Acme could be one of a number of information-management issues that confound most businesses. In 2020, you should expect that bad actors will seek to break into your information trove and find and exploit any weakness in your information culture. Expect they will try regularly—they are trying right now, in fact. Expect that customers will become ever more aware of “their” private information, and when (not if) that information is exposed, it may impact your relationship with your customers, vendors, and the public. Expect that confidential information may fly across the ether unprotected, and that sensitive information may fall into the wrong hands. Expect that records may be kept for too long or not long enough, and that discovery for a lawsuit may be inexplicably gone, precipitating a claim for spoliation.
If every worst-case scenario is not only possible, but likely at some point, then now what? Take a deep breath and read on because there is a path forward. As you reflect on how to change the course of, or mitigate the fallout from, some future event, you could find help in building a mindful information culture at your company. Building a more mindful information culture has several distinct and critical elements:
Who Is the Organization’s “Champion”? Every major project or initiative requires a champion possessing a combination of institutional knowledge and political savvy to help make the journey more productive and less painful. It is critical that the face of the journey to build a mindful information culture has the right temperament and skill set. In order to establish and properly incubate this shift, your champion must demonstrate three essential qualities: the ability to clearly communicate, a balance of business and technology acumen, and knowledge of the organization. Properly selecting the right champion will enable the new culture to grow and flourish, whereas failing to select the right champion will likely doom it to failure.
Relying on the Right Support to Do the Heavy Hauling and Deliver Guidance. Every programmatic trek also needs the right supporting cast that represents the essential parts of your organization. Without the right supporting team members to haul each segment of the organization forward, the initiative will likely experience headwinds and hurdles (which might happen anyway). For every information project, there must at a minimum be business, IT, and legal executive involvement, and do not minimize the need for excellent project-management skills, too. Getting the right executive’s imprimaturs will be essential in getting the employees’ behind the initiative.
Assessing Where You Are in the Fog. The only way you know where you are is by looking. The only way you know what needs fixing is by assessing “the good, the bad, and the ugly.” Knowing what is “good enough” and what needs fixing is an essential part of the project, and it should happen early in the process. Additionally, when you have several issues that must be addressed, each issue must be evaluated based on risk to the organization. In other words, the issues that create the greatest risk, and the issues that can be addressed fairly easily, should be tackled first. Until you assess, you cannot address, but only after identifying your organization’s problems can you begin to change your information culture.
Building a Plan to Get to Information Nirvana. Having the right remediation path and taking the right action steps to triage and fix any information problem requires a plan. Ensuring your organization provides long-term solutions to address company and employee needs for information similarly requires a plan, and likely new technology to ensure information accessibility.
So, what should your organization’s plan look like? You have done your triage and know that immediate litigation response requirements likely take precedence over longer-term records retention fixes. Likewise, managing private information that is sitting unprotected on a server likely takes precedence over training on information classification. However, the plan must be more than just triaging emergencies. The tyranny of the immediate cannot derail you from your long-term goals. Your organization can implement tactical fixes at the same time that it fleshes out the strategic initiatives. You simply must manage resources to maximize effectiveness and not overwhelm a particular business unit or individual.
Part of the path forward also requires that your plan consider your organization’s existing information culture. What is your work force’s openness to change? Are they technologically sophisticated? Centralized? Are business units autonomous? Does your company vet and buy applications for the entire company? How big is the problem? Who is required to fund and fix it? Are employees going to balk if you change e-mail retention, for example? The bottom line is to be ambitious but take the time to build a plan that includes the needed expertise from across the organization, and be realistic about what can get done given the company information culture, resource constraints, and other projects impacting employee availability.
Messaging as the Information Mantra. Moving your team, department, or organization to change is not easy. It will be effective only if the key leaders properly message the change. Mid-level management typically does not steer the ship; redirection is done by the people at the top.
For example, when moving to a new collaboration environment or migrating to O365, your workforce’s needs and concerns should be anticipated and managed, otherwise the project will likely get derailed. Providing the necessary information to the proper people and giving them the opportunity to ease into change and readjust their way of operating will be necessary for your plan to succeed.
People default to what is simple and what they know. Therefore, the messaging surrounding building an information culture is critical. It must be clear, consistent, and anchored to a “why” that resonates with your employees and makes their life better (not just simpler, but better). This will allow them to move past the “but this is how we have always done it” response toward becoming mindful stewards of your organization’s information. Mindful employees are essential to building a great information culture.
Achieving a Mindful Information Culture Requires Processes and Repetition. Achieving any organizational goal, let alone building a mindful information culture, requires the right processes and directives that can become muscle memory—implementable, repeatable, and followed over time. Diligence must become your organization’s state of being. Persistence must be how the champion and executive team manages any information-related initiative and program. A mature information culture is a state of being, like a never-ending marathon. Culture is not a “sometimes thing,” it is an “all the time thing.” If your company is able to wrangle its information security risks, it is because information security mindfulness was made part of the fabric of your organization. If your organization right-sizes its information footprint annually, it is because minimizing cost and mitigating the risk of keeping unneeded data has also been woven into the fabric of your company. It takes a person doing something correctly 14 times in a row to make it a habit, and achieving information nirvana is no different. Building a mindful information culture can be achieved only by implementing a consistent, persistent, evolving cycle to assess, plan, implement, communicate, monitor, resolve, and repeat. This is the way to truly effectuate cultural change.
Information Mindfulness. All organizations care about profits and costs, yours included. Harvesting and harnessing information can promote both. To be a truly information-mindful organization, your company must use information as a differentiator. Information can promote employee satisfaction and provide a more valuable workplace. Information can advance your customers’ needs and create a deeper customer experience, which translates into a deeper customer connection, which translates into greater sales. Information mindfulness is about using information as the currency that makes business better and the glue that connects people in various ways with your company.
Finding Easy Places to Focus. Your organization should focus its efforts on the most critical gaps first while finding some low-hanging fruit to bolster the credibility of project champion. Once you solve a few of the less complex issues impeding your organization, you can move on to the tougher issues, having acquired wins under your belt and hopefully having banked goodwill and support from management. When employees see the changes to your information culture helping their work day, they will almost certainly climb aboard.
Conclusion
A leader’s obligation is to be constant in principle but flexible in approach—to change just before change is necessary. Specifically, once the pillars are poured, you and your champions must find a new way to look at and think about the enterprise’s information culture, whether a new angle or new focus, a new way forward, or simply to decide to do what you are already doing, just more efficiently. The bad actors never rest and are always reinventing themselves. Without that same dedication to diligence as a way of corporate life, your information culture will stagnate, issues will appear, and you will likely feel the pain that is exacted on the nonvigilant.
In the July issue of BLT I described briefly the consequences of the application of RULLCA’s default rule to members of a limited liability company (LLC) who fail to provide for member death. Readers suggested a follow-up piece that would provide suggestions to avoid those consequences.
The issue arises because, unlike the shares of a corporate shareholder all of whose rights, unless otherwise provided in a shareholders agreement, pass to his or her estate, when an LLC member dies, unless something is provided to the contrary, his or her interest divides, with only economic rights passing to the estate.[1] The management rights devolve upon the remaining members. In a multi-member LLC (MMLLC), where the pick-your-partner principle of partnership law applies, this result is clearly appropriate. In a single member LLC (SMLLC) pick-your-partner protection is oxymoronic.
The consequences for the decedent’s heirs are different in the MMLLC from those in the SMLLC. In the former, the estate is treated as an assignee or transferee of the economic rights.[2] The now former member, dissociated at death, has provided his or her heirs with little or no authority to enforce their inherited economic rights. They are at the mercy of the remaining LLC members who may choose not to make distributions. They have no right to participate in the direction, whether wise or foolhardy, in which the surviving members may take the LLC. [3] Recovery of the decedent’s capital account will not be realized until the LLC dissolves if that event should ever occur. The estate has no right to compel the LLC’s dissolution[4] or even, perhaps, to acquire information as to the LLC’s ability to make distributions.[5]
In the SMLLC, where the economic rights also pass to the estate, the problem is that if the estate does not act within a short statutory period to name a successor member who accepts the role, the memberless LLC dissolves with whatever unintended consequences flow from that event.[6]
Knowledgeable business lawyers will protect against these consequences. When a multi-member LLC is formed, and all the members are on the same side of the table and don’t know who will be the first to die, the lawyers will offer suggestions as to how the members may wish to provide for death in their operating agreement. If admission to membership of one or more successors to a deceased member is not desired, perhaps a buy-out on death can be negotiated, or provision made for the heirs to have certain rights short of participation in management.
In the SMLLC provision should also be made in the operating agreement for the one future event that is certain to occur. Here are a few suggestions.
1. Treat the member’s interest similar to that of a sole shareholder in a corporation. The operating agreement might provide that:
Upon the death of the member (or last surviving member in a multi-member LLC), the member’s estate is admitted to membership in the LLC on the member’s date of death with both economic rights and full management authority.
The time gap between the date of death and the appointment of an executor or administrator for the estate, during which business operations may not be able to be directed, might be addressed by naming an interim manager.
2. The operating agreement might name a successor member admitted to membership immediately upon the death of the member.[7]
3. If the governing statute permits, name a special member who has no capital account or percentage interest in the LLC and thus should not impair its disregarded status for income tax purposes.[8]
4. If the governing statute permits, the concept of a springing member might be utilized.
5. Instead of placing the membership interest in the individual, it may be placed in a revocable trust for the client (a) if a trust may be an LLC member and (b) if the client is willing to incur the complexity and cost of a trust agreement in addition to an operating agreement.
My attention has been called to The Uniform TOD Securities Registration Act, part of the Uniform Non-Probate Transfers on Death Act, promulgated in 1989 when LLCs were in their infancy. Its design is to provide the owner of securities an alternative to the process of probate. Although the statute’s definition of security is broad enough to encompass an interest in an LLC, the statute does not address the dichotomy between economic and management rights. It is doubtful that, in a multi-member LLC, authorization for non-probate transfer overrides the pick-your-partner principle. The statute’s usefulness to a SMLLC, limited by the definition of Registering Entity, may present practical difficulties.
[1]Ott v. Monroe, 2011 WL 5325470 (Va. 2011): An LLC interest, like a partnership interest, is comprised of two separate components. The first is the management right to control or participate in administration. The second is the economic or financial right to participate in the sharing of profits and losses and receipt of distributions. The only interest alienable is the economic interest
[2]Faienza v. T-N-B Marble-N-Granite, LLC, 2018 WL 1882586 (Conn. Sup. Ct. 2018): The deceased member’s estate has only the rights of a transferee, not a member, and cannot sue for dissolution. To the same effect: Estate of Calderwood v. ACE Grp., Int’l, LLC, 61 N.Y.S. 3d 589 (App. Div. 2017); SDC University Circle Developer, L.L.C. v. Estate of Patrick Whitlow, M.D., 2019 WL 92791 (Ct. App. Ohio 2019).
[3] See, Gebroe-Hammer v. West Green Gables, LLC, 2019 WL 3428499 (App. Div. N.J. 2019). Act of sole surviving member bound, LLC.
[5]Succession of McCalmont, 261 So.3d 903 (La. App. 2018): As a mere assignee the deceased member’s estate as could not access the LLC’s books and records to determine if it was getting its fair share of distributions.
[7]Blechman v. Estate of Blechman, 160 So. 3d 152 (Fla. App. 2015): Where supported by adequate consideration, contracts transferring a property interest upon death are neither testamentary nor subject to the Statute of Wills, but are instead evaluated under contract law. See also, in the corporate context, Jimenez v. Carr, 764 S.E.2d 115 (Va. 2014)
[8] Support for this proposition is Historic Boardwalk Hall, LLC v. C.I.R., 694 F.3d 425 (3rd Cir. 2012), where the entity involved was not recognized as a partnership for tax purposes because the purported partner had no meaningful stake in its success or failure.
A key distinction in international transactions has been whether a contract is governed by the law of a civil-law jurisdiction or the law of a common-law jurisdiction. For purposes of contracts, the structural distinctions between civil law and common law have diminished in significance, but use of common-law terminology in contracts governed by the law of a civil-law jurisdiction remains a source of confusion. After considering the historical difference between civil-law and common-law contracting, this article suggests how to avoid that confusion.
Civil Law and Common Law
Civil law is primarily derived from Roman law. In civil-law jurisdictions, codified principles serve as the primary source of law. By contrast, common law is based on medieval English law. In common-law jurisdictions, judicial decisions serve as the primary source of law.
The primary English-speaking jurisdictions—the United States, the United Kingdom, the English-speaking parts of Canada, and Australia—are common-law jurisdictions. Civil-law jurisdictions can be divided into the Romanistic (including Italy, France, and Spain), the Germanic (including Germany, Austria, Switzerland, and Taiwan), and the Nordic (Denmark, Finland, Norway, and Sweden).
Shorter or Longer Contracts
The conventional wisdom is that contracts drafted in common-law jurisdictions are longer than those drafted in civil-law jurisdictions because civil-law drafters are able to rely on codified default rules.
For example, section 121, paragraph 1 of the German civil code defines the word unverzüglich to mean “without culpable delay.” When that word occurs in contracts, it is generally understood to express its statutory meaning, subject to caselaw relating to how it is to be interpreted—it need not be defined in a contract.
And although common-law contracts often spell out what constitutes an event of default for purposes of the transaction and what the resulting consequences are, that’s addressed in the German civil code. Generally, the parties to a contract may deviate from such default rules in their contract.
But this distinction between common-law and civil-law contracts is blurring—English-language drafters used to common-law drafting apply a more exhaustive approach even for purposes of contracts governed by the law of a civil-law jurisdiction. And civil-law drafters exposed to common-law drafting are prone to replicating it. Nevertheless, it would always be prudent to make clear how contract provisions relate to the codified default rules. For example, if the words “without culpable delay” are used in the contract, an explicit reference to section 121, paragraph 1 of the German Commercial Code should be included to indicate that these words are used to convey that meaning.
Whether Interpretation Is Limited to the Wording of the Contract
It’s also the conventional wisdom that common-law judges, in reliance on the parol evidence rule, are likely to interpret a contract based solely on the contract text, whereas civil-law judges also take into account subjective considerations like the parties’ presumed intent, even if that requires departing from the wording of the contract.
For example, in a famous German court case from 1916, the parties intended to conclude a sale contract for whale meat. But their contract referred to håkjerringkjøtt, the Norwegian word for the much cheaper meat of the Greenland shark. The court had no difficulty finding that the contract was for whale meat.
But this distinction is less clear-cut than it seems. For example, courts and commentators in the United States have swung back and forth between an approach that relies exclusively on the text and one that takes context into account. And the parol evidence rule is subject to exceptions.
Law and Equity
Traditionally, common law distinguished between law and equity. Even though in the United States the distinction has been eliminated in federal and most state courts, courts retain many of the differences between legal and equitable principles. In particular, courts have continued—with exceptions—to grant specific performance only when money damages are inadequate. By contrast, the distinction between law and equity doesn’t exist under civil law. The statutory default remedy for breach of contract under civil law is to have the defaulting party perform. For example, if a seller delivers nonconforming goods, by law the buyer’s initial remedy is delivery of conforming goods.
So in a civil-law contract it would still be unnecessary to refer to equitable remedies. In fact, it might be counterproductive: because the word equity, in translation, can be equated with fairness, a judge might take use of the word equity as an invitation to instead apply general considerations of fairness.
Common-Law Terminology
Contracts for international transactions are usually drafted in English even if no party to the transaction is based in a jurisdiction where English is an official language. And the overwhelming majority of standard contracts promulgated by trade groups for international transactions (for example, the FIDIC standard forms) are in English.
Because the primary English-speaking jurisdictions are also common-law jurisdictions, it’s commonplace for English-language contracts governed by the law of a civil-law jurisdiction to incorporate, by a process of cross-contamination, common-law terminology. Some of that terminology is confusing for those with a civil-law background. That risks causing greater annoyance and uncertainty than the broader differences between civil law and common law.
The standard advice is not to use problematic common-law terminology. That’s our advice, too, but with a difference—the problematic common-law terminology is problematic for common-law drafting as well, so you should eliminate it from all your drafting.
We consider below some examples of this problematic terminology.
Referring to Consideration
The Common-Law Feature: The traditional recital of consideration, which appears to say that there is consideration for the transaction. It usually consists of grotesquely archaic language of this sort:
NOW, THEREFORE, in consideration of the premises and the mutual covenants set forth herein and for other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto covenant and agree as follows.
The Problem:Consideration is defined as something bargained for and received in exchange for a contract promise. In common-law jurisdictions, consideration is required for a contract to be enforceable. Consideration is not required in civil-law jurisdictions.
The Fix: Eliminate the traditional recital of consideration, and not just for contracts governed by the law of a civil-law jurisdiction: in common-law jurisdictions, you cannot create consideration where there was none just by saying you have consideration. Say instead, The parties therefore agree as follows.
The Common-Law Feature: Use of the phrase represents and warrants in contracts to introduce statements of fact, and use of the phrase representations and warranties to refer to those statements of fact.
The Problem: Drafters in civil-law jurisdictions might assume that use of the word represents somehow refers to an action for misrepresentation (a tort claim) and that use of the word warrants somehow refers to an action for breach of warranty (a claim under the contract). Unsurprisingly, they are puzzled as to how common-law remedies are meant to be relevant for purposes of a contract governed by the law of a civil-law jurisdiction.
The Fix: The phrase represents and warrants is pointless and confusing. Attempts by commentators (and, in England, by a couple of courts) to justify use of the phrase in common-law contracts fail utterly. It follows that no one should have any reservations about deleting it from civil-law contracts. For any contracts, whether civil-law or common-law, if you have sufficient negotiating leverage and are not working in a hidebound practice area like mergers-and-acquisitions, consider using states instead. If you continue to use represents and warrants, don’t use it to list not only statements of fact but also obligations—that just makes things worse.
The Common-Law Feature: Use of the verb warrants and the noun warranty in contracts for the sale of goods.
The Problem: Under common law, an express warranty is a seller’s affirmation of fact to the buyer, as an inducement to sale, regarding the quality or quantity of goods. When the verb warrants and the noun warranty appear in civil-law contracts, drafters in civil-law jurisdictions are understandably puzzled as to how common-law concepts are meant to be relevant for purposes of a contract governed by the law of a civil-law jurisdiction.
The Fix: It’s a simple matter to avoid using this terminology. To introduce a statement of fact, use states, as described above. Instead of using warrants to introduce a statement of future fact, use a conditional clause followed by the remedy. For example, don’t say this:
The Vendor warrants that during the six months after the date of this agreement, the Equipment will conform to the Specifications. In the event of breach of the foregoing warranty, the Vendor shall modify or replace the Equipment.
Instead, say this:
If during the six months after the date of this agreement the Equipment fails to conform to the Specifications, the Vendor shall modify or replace the Equipment.
Even common-law drafters should be willing to make these changes: under the Uniform Commercial Code, enacted in U.S. jurisdictions, a statement does not need to be called a warranty to be a warranty. But because in common-law jurisdictions the notion of a warranty for goods is widely recognized, it might be convenient to use the word warranties as a heading in a common-law contract.
Resource: Kenneth A. Adams, A Manual of Style for Contract Drafting 437–39 (4th ed. 2017).
Using a Variety of Efforts Provisions
The Common-Law Feature: Use of the phrases reasonable efforts, best efforts, good-faith efforts, and other efforts variants.
The Problem: In common-law jurisdictions, many who work with contracts accept the idea of a hierarchy of efforts standards, with, for example, an obligation to use best efforts being more onerous than an obligation to use reasonable efforts. And courts in England and Canada have accepted this notion. Drafters in civil-law jurisdictions wonder whether the gloss given to these phrases in common-law jurisdictions is relevant for purposes of civil-law contracts.
The Fix: A hierarchy of efforts provisions is unworkable for three reasons. First, imposing an obligation to act more than reasonably is unreasonable. Second, requiring that a contract party act more than reasonably creates too much uncertainty as to what level of effort is required. And third, legalistic meanings attributed to efforts standards conflict with colloquial English. Furthermore, rationales offered to validate the idea of a hierarchy of efforts standards fall short. Drafters, whether in civil-law or common-law jurisdictions, should use only reasonable efforts and should structure efforts provisions to minimize the vagueness.
Although anyone involved in international transactions should be aware of the historical distinctions between civil-law contracting and common-law contracting, those distinctions have become less significant. But a cause of annoyance remains: the tendency for drafters to insert irrelevant common-law concepts into contracts governed by the law of a civil-law jurisdiction. Because the primary examples of such terminology are also suboptimal for purposes of common-law drafting, the simplest fix is to express the intended meaning more clearly, without relying on obscurantist terms of art.
As discussed in part one of this two-part article, there is a general premise in bankruptcy law that waiving or contracting away the right to file for relief under the Bankruptcy Code[2] is contrary to public policy. Thus, contractual waivers of such rights are generally deemed invalid. Nevertheless, as the case law has developed over the years, a number of courts have held that operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable. In recent years, lenders have become more creative in seeking to reduce or eliminate their bankruptcy risk. In this regard, a common approach is to create a bankruptcy-remote limited liability company by obtaining, either directly or through a nominee, a so-called golden share in their borrower. Contemporaneously, the lender insists that its borrower incorporate various blocking provisions into their operating agreement such that it can utilize a bankruptcy approval requirement to effectively preclude a bankruptcy filing. When a bankruptcy is filed notwithstanding the inclusion of such provisions, challenging issues are raised. Part two of this article will discuss how courts have dealt with such issues.
Blocking Provisions in Favor of Creditors Are Unenforceable on Public Policy Grounds
Although the law in this area remains in the early stages of development, the cases discussed below suggest that a blocking provision contained in a limited liability company operating agreement in favor of a lender who also holds an equity interest will likely be deemed invalid as contrary to federal public policy.
In re Bay Club Partners-472, LLC. In In re Bay Club Partners-472,[3] the debtor was formed to renovate and operate an apartment complex in Arizona and borrowed $24 million from the lender to finance such efforts. Years later, after multiple defaults by the debtor, the debtor commenced a chapter 11 bankruptcy case. The petition was signed by the debtor’s manager and was accompanied by a written consent prepared to document authorization of the chapter 11 filing that was signed by three of the debtor’s four members, representing 80 percent of the debtor’s equity. The fourth member opposed the bankruptcy filing.
The operating agreement contained a bankruptcy waiver provision that provided that the debtor “intends to borrow money with which to acquire the Property, and to pledge the Property and related assets as security therefor.”[4] The operating agreement went on to provide that the debtor “shall not institute proceedings to be adjudicated bankrupt or insolvent” until “the indebtedness secured by that pledge is paid in full.”[5] The operating agreement was executed by all of the debtor’s members at the time of the original loan.
The lender and the dissenting member filed motions to dismiss the bankruptcy case. The court began its analysis by acknowledging that much of the parties’ arguments focused on state law. However, the court concluded, disposition of the motions to dismiss was governed by federal law. The court noted: “The Ninth Circuit has been very clear that a debtor’s prepetition waiver of the right to file a bankruptcy case is unenforceable because it is a violation of public policy.”
Acknowledging that the lender had not requested any bankruptcy waiver language in the loan documents, the court observed that: “What the evidence established in this case is more cleverly insidious.”[7] The court found that the lender had requested that the bankruptcy waiver be included with its requests for other restrictive covenants in the operating agreement, and that such provision was included in the operating agreement without any discussion among the members. The court deemed the provision unenforceable, reasoning:
The purpose of the bankruptcy waiver provision to prevent a bankruptcy filing while any amount was owed on the Loan debt is clear from the provision of . . . the Operating Agreement that the restrictive covenants of Article XI would only be effective “[u]ntil such time as the [Loan] indebtedness secured by that pledge is paid in full.” That the members of Bay Club signed the Operating Agreement among themselves rather than acquiescing in the bankruptcy waiver provision in a Loan agreement with [lender] is a distinction without a meaningful difference. The bankruptcy waiver in . . . the Operating Agreement is no less the maneuver of an “astute creditor” to preclude [the debtor] from availing itself of the protections of the Bankruptcy Code prepetition, and it is unenforceable as such, as a matter of public policy.[8]
The court held that the bankruptcy waiver provisions were unenforceable and allowed the case to proceed.
Lake Michigan Beach Pottawattamie Resort, LLC. In In re Lake Michigan Beach Pottawattamie Resort,[9] a lender financed the purchase of a vacation resort. Six months later, the debtor defaulted on the loan. After the lender commenced a mortgage foreclosure action, the parties entered into a forbearance agreement under which the debtor’s operating agreement was modified to make the lender a “special member” with the right to approve or disapprove any “material” action, including the right to file for bankruptcy relief. Notwithstanding its “special member” status, the lender had no rights in profits or losses, distributions, or tax consequences, and expressly would not owe any fiduciary duties to the debtor or the other members.
Thereafter, the debtor filed a chapter 11 petition without the lender’s consent. The lender moved to dismiss the bankruptcy case, arguing among other points, that the bankruptcy was filed without the requisite corporate authority. The Bankruptcy Court for the Northern District of Illinois rejected this argument. The court observed that, in general, absolute prohibitions against filing for bankruptcy are void against public policy,[10] but suggested that restrictions in corporate control documents may be treated differently from those in contracts. Nevertheless, the court determined:
common wisdom dictates that the corporate control documents should not include an absolute prohibition against bankruptcy filing. Even though the blocking director structure described above impairs or in operation denies a bankruptcy right, it adheres to that wisdom. It has built into it a saving grace: the blocking director must always adhere to his or her general fiduciary duties to the debtor in fulfilling the role. That means that, at least theoretically, there will be situations where the blocking director will vote in favor of a bankruptcy filing, even if in so doing he or she acts contrary to purpose of the secured creditor for whom he or she serves.[11]
The court found that the amendment to the operating agreement was void under Michigan law because the special member expressly owed no fiduciary duties and was not required to consider the debtor’s interests.[12] The court colorfully summarized its view of the law as follows:
The essential playbook for a successful blocking director structure is this: the director must be subject to normal director fiduciary duties and therefore in some circumstances vote in favor of a bankruptcy filing, even if it is not in the best interests of the creditors that they were shoes be. [The lender’s] playbook was, unfortunately, missing this page.[13]
Turning to Michigan law, the court found that as a member of a Michigan limited liability company, the special member was required to consider the interests of the debtor.[14] The court found that the blocking provision was void because it allowed the special member to consider only its own interests, in violation of Michigan law. “By excluding the Debtor’s interests from consideration” by the lender when acting as the special member of the debtor, the operating agreement “expressly eliminates the only redeeming factor that permits the blocking director/member construct.”[15] Thus, the court found, the provision was unenforceable both as a matter of Michigan corporate governance law and bankruptcy law.
In re Intervention Energy Holdings. In In re Intervention Energy Holdings, LLC,[16] the debtor was an oil and gas exploration and production company mainly doing business in North Dakota. The debtor, a Delaware limited liability company, entered into an agreement through which the lender agreed to loan up to $200 million. The debtor defaulted on the loan, and the parties entered into a forbearance agreement. In exchange for the lender waiving all defaults, the debtor agreed to give the lender one share in order to make the lender a common member of the limited liability company. The debtor also amended its operating agreement to require unanimous consent of all common members in order to file bankruptcy.
The debtor and certain affiliates ultimately sought chapter 11 protection with the consent of all members except the lender in the Bankruptcy Court for the District of Delaware. The lender filed a motion to dismiss, arguing that the debtor lacked authority to file bankruptcy because it had not consented to the filing. Noting that Delaware state law authorizes members of a limited liability company to eliminate fiduciary duties, the lender argued that a limited liability company that has done so may contract away its rights to file bankruptcy at will.[17] The lender also cited to cases in which courts have upheld consent provisions among members.[18] It warned that if the bankruptcy court declared the agreement void, it would cause confusion concerning the breadth of a limited liability company’s right to contract.[19]
Conversely, the debtor relied upon Lake Michigan Beach to argue that the blocking member could not abrogate its fiduciary duties and “must retain a duty to vote in the best interest of the potential debtor to comport with federal bankruptcy policy.”[20] The debtor also argued that if the provision were enforced, debtor/creditor relationships would dramatically change, and future lenders would demand similar provisions in future transactions.
Declining to address the parties’ state law arguments, the court decided the case on federal public-policy grounds. The court found that the amendment was an absolute waiver of the limited liability company’s right to file for bankruptcy, which was unenforceable as a matter of federal law. The court explained:
It has been said many times and many ways. “[P]repetition agreements purporting to interfere with a debtor’s rights under the Bankruptcy Code are not enforceable.” “If any terms in the Consent Agreement . . . exist that restrict the right of the debtor parties to file bankruptcy, such terms are not enforceable.” “[A]ny attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor’s future bankruptcy filing is generally unenforceable. The Bankruptcy Code pre-empts the private right to contract around its essential provisions.” “[I]t would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.” “It is a well settled principal that an advance agreement to waive the benefits conferred by the bankruptcy laws is wholly void as against public policy.”[21]
This rule is not new, the court noted while citing various cases that date back to the early 1900s.[22] Nevertheless, “[t]oday’s resourceful attorneys have continued th[e] tradition” of trying to contract around bankruptcy.[23]
The court acknowledged that other courts have upheld provisions in limited liability company agreements requiring unanimous consent or supermajority approval to file for bankruptcy. However, such cases were distinguishable because the Intervention Energy operating agreement was amended pursuant to a forbearance agreement with a lender, as opposed to included by the members when the limited liability company was organized. The court concluded by explaining:
The federal public policy to be guarded here is to assure access to the right of a person, including a business entity, to seek federal bankruptcy relief as authorized by the Constitution and enacted by Congress. It is beyond cavil that a state cannot deny to an individual such a right. I agree with those courts that hold the same applies to a “corporate” or business entity, in this case an LLC.
A provision in a limited liability company governing document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor—not equity holder—and which owes no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.[24]
In a footnote, the court distinguished the lender from the lender in Global Ship Systems (discussed in part one of this two-part article). The court noted that the creditor in Global Ship Systems had a 20-percent equity interest, whereas the creditor in Intervention Energy had only one share that was provided as part of a forbearance agreement.[25] The court also referenced, and expressly disagreed with, the conclusion of the DB Capital Holdings’ courtthat contractual waivers of the right to file a bankruptcy case may be enforceable absent coercion by a lender.
In re Lexington Hospitality Group, LLC. In In re Lexington Hospitality Group, LLC,[26] the debtor was a Kentucky limited liability company and owned and operated a hotel. The lender had provided the financing to purchase the hotel. Contemporaneously with the execution of the loan documents, an amended operating agreement was executed admitting 5332 Athens, an entity wholly owned by the lender, as a member of the debtor with a 30-percent membership interest. The amended operating agreement also included several provisions that limited the debtor’s ability to file bankruptcy and required a 75-percent vote of the members. The debtor defaulted on the loan and filed a bankruptcy petition. The lender filed a motion to dismiss the bankruptcy case, arguing that the debtor did not have the corporate authority to file the bankruptcy petition.
The court acknowledged that the authority to file for bankruptcy is governed by state law, but that the validity of the restriction on filing bankruptcy is controlled by federal law. Relying on the cases discussed above, the court held that a contract term imposed by a creditor that prohibits a bankruptcy filing is void as contrary to federal public policy. The same was true where, as here, the so-called independent director was really a nominee of the lender. The court determined:
A requirement that an independent person consent to bankruptcy relief, properly drafted, is not necessarily a concept that offends federal public policy. The appointment of an independent person to help decide the need for a bankruptcy filing may suggest fairness on all sides. The input of a truly independent decision maker avoids the fear and risk that a member of manager will act in its own self-interest. But [the operating agreement] shows that the Independent Manager is not a truly independent decision maker.[27]
The court found that the lender’s complete control over 5532 Athens gave it total control to block any bankruptcy filing. “Unlike a member or manager, [5532 Athens] has no restrictions and no fiduciary duties to [the debtor] that might limit self-interested decisions that ignore the best interests of the [debtor].”[28] In any event, the grant to the lender’s nominee of 30 percent of the equity in the debtor itself gave the lender the ability to block a bankruptcy filing. “Such provisions, alone or working in tandem, serve only one purpose: to frustrate [the debtor’s] ability to file bankruptcy.”[29] As a result, the court found, they were unenforceable. Consequently, the court denied the lender’s motion to dismiss the case.
In re Franchise Services of North America. In In re Franchise Services of North America,[30] the Fifth Circuit Court of Appeals became the first appellate court to weigh in on these issues, holding that federal law does not prevent a bona fide shareholder from exercising its right in the company’s governing documents to prevent the filing of a bankruptcy petition by the company merely because it is also a creditor. The court was careful to limit the scope of its holding to the facts before it, and avoided ruling broadly on the validity of “golden share” or blocking provisions.
An investment bank made an investment of $15 million in the debtor pre-petition. In exchange, the bank received 100 percent of the debtor’s preferred stock. At the same time, the debtor reincorporated in Delaware and amended its certificate of incorporation. As a prerequisite to filing a voluntary bankruptcy petition, the amended certificate required the consent of a majority of each class of the debtor’s common and preferred shareholders.
Following some ill-fated business decisions, the debtor filed for bankruptcy. Fearing that its shareholders might nix the filing, the debtor never put the matter to a vote. The preferred shareholder filed a motion to dismiss the bankruptcy petition as unauthorized. The debtor argued that the shareholder, who was also a sizable creditor, had no right to prevent the filing, relying on the aforementioned cases. The bankruptcy court sided with the shareholder and dismissed the petition.
Given the frequency with which this issue has arisen in chapter 11 cases in recent years, direct appeal to the Fifth Circuit was authorized. Three questions, which broadly asked the appellate court to address the legality of “blocking provisions” or “golden shares,” were certified. Instead of addressing the certified questions, which the Fifth Circuit found would have required it to give an advisory opinion, the court narrowed the issue to the specific facts before it: “when a debtor’s certificate of incorporation requires the consent of a majority of the holders of each class of stock, does the sole preferred shareholder lose its right to vote against (and therefore avert) a voluntary bankruptcy petition if it is also a creditor of the corporation?”[31]
The Fifth Circuit began its analysis by noting that state law determines who has the authority to file a voluntary bankruptcy petition for a company. Where, as here, the petitioners lack authorization under state law, the court noted, the bankruptcy court “has no alternative but to dismiss the petition.” Acknowledging that numerous bankruptcy courts have invalidated, on federal public-policy grounds, agreements whereby a lender extracts an amendment to the organization’s governing documents granting the lender a right to veto a bankruptcy filing, the court held that simply being a creditor does not prevent a bona fide equity holder from exercising its right under a charter to block a bankruptcy filing. Under the facts of the case before it, the court found that the shareholder was a bona fide equity holder. There was no evidence to show that the shareholder’s equity interest was “merely a ruse” to ensure that it would be paid on its claims against the debtor.[33]
Finally, the court rejected the debtor’s argument that the shareholder’s fiduciary obligations as a controlling shareholder prevented it from blocking the debtor from filing for bankruptcy. The court found that the record did not establish that the shareholder was, in fact, a controlling shareholder exercising actual control over the debtor, such that it would owe fiduciary duties under Delaware law. Even if the shareholder were a controlling shareholder, the court concluded, “[t]he proper remedy for a breach of fiduciary duty claim is not to allow a corporation to disregard its charter and declare bankruptcy without shareholder consent.”[34] Rather, the debtor’s remedy was under state law. Accordingly, dismissal of the debtor’s bankruptcy case was affirmed.
Conclusion
All of the cases discussed herein and in part one of this article begin with the general premise that waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy. Although the law in this area remains in the early stages of development, the cases suggest that a blocking provision contained in a limited liability company operating agreement in favor of a lender (as opposed to a bona fide shareholder) will likewise be deemed invalid. This is particularly true if: (1) the provision was added at the lender’s behest and during a period of financial distress, (2) the provision eliminates any fiduciary duties to the debtor, (3) the “golden share” was acquired for little or no consideration, and/or (4) the “golden share” is a de minimis percentage of the equity of the debtor.
Regarding the fiduciary duty part of the analysis, applicable state law may also be influential because some states (including Delaware) expressly permit members and managers of limited liability companies to eliminate fiduciary duties in their operating agreement.[35] If a debtor is permitted to, and in fact does, expressly eliminate fiduciary duties, then it is harder to argue that a blocking provision in favor of a lender is contrary to public policy. Conversely, no such authorization exists in many states, including Michigan, the law of which governed in Lake Michigan Beach. Thus, lenders seeking to render their borrowers bankruptcy-remote should ensure that the borrowers are formed as a Delaware limited liability company (or another state that permits waiver) and should eliminate fiduciary duties.[36]
[2] The Bankruptcy Code is set forth in 11 U.S.C. § 101 et seq. Specific sections of the Bankruptcy Code are identified as “section __.” Similarly, specific sections of the Federal Rules of Bankruptcy Procedure are identified as “Bankruptcy Rule __.”
[3]In re Bay Club Partners-472 LLC, 2014 WL 1796688 (Bankr. D. Ore. May 6, 2014).
[6]Id. at *4 (citing In re Cole, 226 B.R. at 651–54; In re Huang, 275 F.3d at 1177; In re Thorpe Insulation Co., 671 F.3d at 1026; Wank v. Gordon (In re Wank), 505 B.R. 878, 887–88 (9th Cir. BAP 2014)).
[9]In re Lake Mich. Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).
[10]Id. at 912 (citing Klingman v. Levinson, 831 F.2d at 1296; In re Shady Grove Tech Ctr. Ltd. P’ship, 216 B.R. 386, 390 (Bankr. D. Md. 1998)).
[11]Id. (citing In re Trans World Airlines, Inc., 261 B.R. at 114 (“Bankruptcy courts are loathe to enforce any waiver of rights granted under the Bankruptcy Code because such a waiver ‘violates public policy in that it purports to bind the debtor-in-possession to a course of action without regard to the impact on the bankruptcy estate, other parties with a legitimate interest in the process or the debtor-in-possession’s fiduciary duty to the estate.’”)).
[12]Id. at 912–13 (citing In re Gen Growth Props., 409 B.R. at 64; In re Kingston Square Assocs., 214 B.R. 713, 736 (Bankr. S.D.N.Y. 1997); In re Spanish Cay Co. Ltd., 161 B.R. 715, 723 (Bankr. S.D. Fla. 1993)).
[14]Id. at 914 (citing MCL § 450.4404(1) which requires a “manager” to discharge managerial duties “in good faith . . . and in a manner the manager reasonably believes to be in the best interest of the limited liability company.”).
[22]Id. (citing In re Weitzen, 3 F.Supp. at 698–99; Nat’l Bank of Newport v. Nat’l Herkimer Cnty. Bank, 225 U.S. 178, 184 (1912)).
[23]Id. (citing NHL v. Moyes, 2015 WL 7008213 at *8 (D. Ariz. Nov. 12, 2015) (“If a contractual term denying the debtor parties the right to file bankruptcy is unenforceable, then a contractual term prohibiting the non-debtor party that controls the debtors from causing the debtors to file bankruptcy is equally unenforceable. Parties cannot accomplish through ‘circuity of arrangement’ that which would otherwise violate the Bankruptcy Code.”).
[36] Perhaps the most surefire way to preclude a borrower from filing bankruptcy is to require that the members of the borrower personally guarantee the borrower’s indebtedness upon a default or bankruptcy filing by the borrower, through a so-called bad boy guarantee. Such guarantees are usually enforced and, for obvious reasons, dramatically decrease the likelihood that a borrower’s members and managers will elect bankruptcy as a remedy. See, e.g., F.D.I.C. v. Prince George Corp., 58 F.3d 1041, 1046 (4th Cir. 1995).
Innovation in internet and related communication technology has spawned new ways for firms to tap into the marketplace. Business models built on digital platforms can generate significant income from remote markets through network connections without a significant physical presence in the form of facilities or personnel. The sharing economy, cloud computing, streaming services, electronic marketplaces, advertising, and software services provide examples of activities that can target remote markets from operational bases that could be anywhere. Moreover, these activities are now common components in many business models.
The permanent establishment (PE) concept, which is based on physical presence within the taxing jurisdiction, is no longer considered an effective tool for allocating taxing authority by some countries. As the value chain for providing goods and services continues to expand across jurisdictional boundaries, governments have struggled to address their ability to capture taxes on an appropriate share of economic income from firms tapping their markets without a PE within their borders.
Legal techniques designed to shift income from high-tax to low-tax jurisdictions have also presented tax administration challenges. Anti-avoidance rules designed to prevent shifting profits through contracts and legal relationships have long been part of the international tax regime. Transfer pricing rules based on arm’s-length principles have emerged as effective tools to address income allocation for transactions involving traditional goods and services. However, as technological change has shifted more value into intangibles and information, some claim those rules have been strained to appropriately measure and assess value creation and the locus of economic benefits.
Government Responses: Sovereignty Versus Coordination
The Organization for Economic Cooperation and Development (OECD) has become the leading international organization devoting efforts toward study and policy development for a coordinated response to the changing tax environment. Although sovereign states maintain their own power to impose taxes, coordinated approaches offer advantages, including more efficient compliance and the avoidance of double-taxing or double-nontaxing income.
Beginning with a 2013 report on base erosion and profit shifting (BEPS), the OECD identified the jurisdiction to tax digital goods and services as one part of a multipronged action plan to address the changing tax environment. However, the complexities of the digital landscape and differences in policy commitments among state participants have contributed to disagreements based on sovereign interests of member states. For example, if rules change to allow market states to tax more of the income generated by the digital economy, states that previously taxed that income—including those where intellectual property, capital, and management skills are located—stand to lose portions of their current tax base.
The OECD continues to work on a coordinated solution, targeting early 2020 as the date for achieving high-level political agreement. In the meantime, sovereign governments are working independently on solutions that will address their own desires for revenue. The EU launched a coordinated digital tax proposal of its own in 2015, which targeted large businesses utilizing digital platforms. However, EU countries have also failed to reach an agreement on a coordinated approach for member nations. Some EU countries (and in some cases, states within those countries) have resolved to forge ahead with digital tax proposals of their own, including the United Kingdom, Spain, France, and Italy. Outside the EU, other countries are modifying their tax laws to address their conception of the value proposition inherent in the digital environment, including the role of their consumers in generating income. Tax claims based on providing support for markets, rather than support for firms based on physical presence, are expanding.
So far, these country-specific approaches have taken four primary forms: (1) changing the PE threshold; (2) withholding taxes involving payments for digital goods and services; (3) so-called turnover taxes on gross receipts from firms offering digital goods and services; and (4) specific taxes targeting large multinational enterprises with digital activities.
The OECD will be taking these approaches into account in its quest to find a coordinated approach, with a targeted completion date scheduled for mid-2020. OECD leadership has professed a goal of developing a neutral system that does not significantly change the current allocation of taxes, but one wonders how that goal can be reconciled to the desire of sovereign states to assert their independent interests.
Implications for Business Advisors
Modifying the PE concept will likely have the most far-reaching effects on (even small) firms conducting business abroad. If the PE concept is modified to permit a significant digital or online presence, income tax possibilities become magnified. India, the Slovak Republic, and Israel have all started down this path. Still unresolved is the manner of solving competing claims for allocating income among different states.
Most firms engaged in cross-border businesses have experience with withholding taxes; however, if the withholding tax base is potentially expanded beyond traditional categories of interest, dividends, and royalties to include certain kinds of digital and technical services, there will not only be new compliance challenges, but also changes to the economics of delivering those services. Although business customers in a market state may bear some of the compliance burdens, firms dealing directly with consumers may face special compliance challenges as rules emerge to shift the locus of collection and payment responsibilities.
When tax obligations are based on reaching minimum thresholds (such as gross receipts or the number of transactions within a jurisdiction), business planners and tax policymakers must both carefully think through the significance of legal structures for delivering products and services to foreign markets. Can the tax be mitigated by changing the locus for providing goods or services? Does that structural change make good business sense? How will those tax implications affect pricing policies?
Concerns about double taxation in this regime are well-founded, particularly when states use different approaches. These tax changes are likely to enhance the possibilities of conflict with taxing authorities of multiple states. Such problems are akin to those experienced on a subnational level in the United States, where U.S. states adopt different income allocation approaches. Bilateral tax treaties and the foreign tax credit regime both are designed to address the double-taxation concern. Treaty protections will require new scrutiny, and some of these taxes will also present U.S. taxpayers with challenges in obtaining a foreign tax credit to offset taxes imposed elsewhere. A creditable tax must have a predominant character as an income tax in the United States; gross receipts taxes may not be able to satisfy these requirements.
Finally, IT departments must become more involved with their counterparts in the tax department. These new tax regimes will require information that current accounting and information systems may not be designed to produce. Geolocation technologies may prove increasingly important in determining how and where digital goods and services are delivered. Moreover, the collection and retention of this information for tax compliance will also implicate cross-border responsibilities involving privacy and security, which present their own legal and economic challenges.
In short, business lawyers must pay attention to developments in this area if they are to effectively identify and manage the risks that accompany participation in international markets.
Connect with a global network of over 30,000 business law professionals
