When the parties to a contract agree to alter the contract’s terms, the common law sometimes needs to classify the change as either an amendment or a novation, and this classification depends heavily on the intent of the parties. In this case, a trustee in bankruptcy convinced an appellate panel to indulge in unwarranted speculation about the parties’ possible intent to novate, thereby forcing a lender through a trial on the merits on whether its security interest should be avoided.
Textron Financial Corp. was the lender to Fair Finance Company, which turned out to be the operator of a Ponzi scheme. The lending transaction involved two sequential sets of loan documents: the first was executed in 2002, and the second—describing itself as an amendment and restatement of the first—was executed in 2004. During the interim, Textron had become aware of at least some of Fair Finance’s misdeeds, and after 2004 Textron was paid off in full. Later, as part of an involuntary bankruptcy proceeding, the trustee argued that the security interest provided by the 2004 loan documents was an actual fraudulent transfer. (The statute of limitations for a constructive fraudulent transfer cause of action had already passed, held the court, in a departure from other recent rulings.) To prevent the collateral from being held excluded from the UFTA’s definition of an “asset” that is subject to “transfer,” the trustee argued that the 2004 documents were a novation of the 2002 documents, rather than a mere amendment thereof, meaning that the collateral was not already encumbered by the lien of the 2002 documents. Textron moved to dismiss the trustee’s claim, and the district court (acting on a withdrawal of the reference) granted Textron’s motion, holding that the 2004 documents were an amendment rather than a novation as a matter of law. The Sixth Circuit reversed, finding a triable issue of fact on the parties’ intent to novate.
The grounds upon which the Sixth Circuit found this a triable issue of fact were weak. First, the 2004 documents provided that they constituted “the entire agreement of [the parties] relative to subject matter hereof.” This clause is a routine measure to prevent the undermining of the agreements by parol evidence, and accordingly should not be considered evidence of a terminating of the 2002 documents. Next, the 2004 documents included their own promissory note and personal guarantees rather than relying on the ones from 2002. But this appears to have been an instance of careful although duplicative documentation, engaged in to avoid interpretive questions that otherwise might have arisen about the continued efficacy of the 2002 note and guarantees. And third, and relatedly, the court found it potentially probative of novation that the 2004 documents were entered into on the very date that the 2002 documents expired. Yet this fact more readily supports – if anything – an intent to amend rather than an intent to novate: after all, with the 2002 documents coming to an end under their own terms, the parties had no need to terminate them.
The Sixth Circuit also faulted Textron’s lawyers for, in effect, not using both a belt and suspenders. The district court, in its opinion below, had found some support in a Florida case, In re TOUSA, Inc., 2011 WL 1627129 (S.D. Fla. March 4, 2011), in which a second set of documents had explicitly recited the parties’ intent that the lien of a first set would remain in full force and effect. By contrast, noted the Sixth Circuit here, the 2004 documents in this case had no such clause. It is troubling that the court found fault with the documentation for omitting this single clause (which concededly would have been a helpful inclusion), while at the same time misunderstanding the clauses that the documentation did carefully include. More fundamentally, avoidance-of-doubt clauses like the one in TOUSA are called “belt and suspenders” for a good reason: the extra clause, like the extra clothing device, is there to make sure that even if one or the other somehow doesn’t do its job, the pants will still stay up.
The point of a novation is typically to substitute one party for another. (For example, an obligee may agree to a novation in which an original obligor is discharged and a delegate commits to perform instead.) In this two-party setting there is no apparent reason why Textron, which clearly benefited from good legal advice and would have appreciated the importance of a continuing security interest, would have actually intended to novate rather than amend. Moreover, as a matter of sound jurisprudence, the distinction between novation and amendment should probably be ignored altogether on facts like these, for even if it is possible to conceptualize an instant of time elapsing between the discharge of one security interest and the attachment of the second, a technicality such as that is not a reason for judicially triggering momentous substantive consequences. Of course, the Sixth Circuit might have wanted to keep an arguably tainted lender from propping up a Ponzi scheme and then walking away from all of the losses; but other viable causes of action in this case, including civil conspiracy and equitable subordination, would have been much more appropriate vehicles for imposing losses on Textron. Perhaps, on remand, the district court would stick with its initial finding that the parties intended to amend rather than novate; but even in that event, this Sixth Circuit precedent will cast an unnecessary shadow over future perfectly sound transactions.
Laws in the United States have evolved to be technologically neutral, so that laws won’t dictate what technology to use, but rather mandate the attainment of a legal “end state.” In other words, laws will make clear that chain of custody, authenticity, completeness, immutability, veracity, privacy, and security are vital to compliance, but they won’t dictate how to attain it. That way, companies and individuals are free to buy or build whatever technology makes business sense and aren’t trapped into using a technology as it becomes obsolete. For example, the Health Insurance Portability and Accountability Act (HIPAA) Security Rule’s major goal “is to protect the privacy of individuals’ health information while allowing covered entities to adopt innovative technologies to improve the quality and efficiency of patient care.”
While laws won’t tell organizations what to buy, there are technologies that are worth exploring by lawyers because it helps attain authenticity, integrity, completeness, transparency, etc. One such technology is blockchain. Before I tell you why it holds so much promise for lawyers and others as well, it’s worth revisiting what it is and what it isn’t.
What is Blockchain?
For starters, blockchain is a technically complex system based on math, algorithms, and encryption. “The blockchain uses public key cryptography to create an append-only, immutable, timestamped chain of content.” (IEEE. A Case Study for Blockchain in Healthcare: “MedRec” prototype for electronic health records and medical research data. August 2016.) In contrast, the explanation that follows is simple and will likely make you want to learn more and at a deeper level. If you have heard about blockchain, it may be in the context of Bitcoin, but they are not synonymous. While blockchain is the technology behind many cryptocurrencies, like Bitcoin, blockchain technology holds promise for many other applications including real estate deals, portable secure health records, and financial transactions.
According to Gartner, technology analyst firm, “Blockchain is a type of distributed ledger in which value exchange transactions (in bitcoin or other token) are sequentially grouped into blocks. Each block is chained to the previous block and immutably recorded across a peer-to-peer network, using cryptographic trust and assurance mechanisms.”
How Does Blockchain Technology Work?
Unlike a traditional clearinghouse, a blockchain implementation does not depend on just one entity to maintain the ledger of transactions. Blockchain depends on many independent third parties—miners—who compete to both verify each transaction and be the first to solve a math problem in exchange for payment. It is each miner’s responsibility to maintain an independent, often public memorialization of the transaction on the ledger of the chain (“block”) of transactions. The verified chain of transactions is derived when a majority of the thousands of anonymous, independent ledgers match. The use of distributed, anonymous, self-interested arrays of verifiers helps make bitcoin very hard to subvert. It would require collusion between 51 percent of miners, who likely don’t know each other, to perpetrate a fraud.
Transactions are executed within the blockchain environment and thereafter are aggregated in blocks, which are retained forever and are constantly revalidated with new transactions memorialized in new blocks. Similarly, there is a third-party retention of salient evidence of transactions, and validation of transactions. The chain of blocks, all verified, connected with hashes, and time-stamped accordingly, show the exact time the transaction took place, as well as the time of each subsequent verification. All this adds integrity to the blockchain process.
Like any technology, however, blockchain is not without its technical limitations. First, the database for “public” blockchain transactions, in which all transactions are stored, is public and not “owned” by an individual to the transaction. Private blockchains do exist but have limited personal use. When using a public blockchain, only the individuals involved in a transaction have access to all the information, including certain private information about the transaction, but the transaction and select information related to it is available to the public. Another issue is the need to rely on a third-party computer and entities to document transactions. Normally, business between two parties is limited to the systems controlled and used by the parties to the transaction. These uninterested, anonymous third parties have no stake in altering or hacking information; in fact, it is in their best interest to validate only real transactions in order to receive the transaction fee. Errors in effectuating and validating transactions will happen, though given the algorithmic nature of the process, they should be very limited.
Future Use That Should Matter to Lawyers
Blockchain is a transformative technology that is possibly revolutionizing various industries and business processes. Beyond its potential for securely transacting business and transferring money, there are many other business activities that would benefit from its use.
For example, “[t]he Pentagon and U.S. NATO allies have been moving discreetly but aggressively in recent months to develop military-related apps exploiting the capabilities of blockchain. NATO is considering the technology to improve efficiencies across such traditional processes as logistics, procurement and finance . . . if ‘significant portions of the [Defense Department] back-office infrastructure can be decentralized,’ DARPA wrote, “‘smart documents and contracts’ can be instantly and securely sent and received, thereby reducing exposure to hackers and reducing needless delays in DoD back-office correspondence” (Washington Times, 2017). The reason lawyers care is that the various uses of blockchain make better business evidence, promote the discovery process, and provide a risk-mitigated way to execute various types of business.
Help with Ownership
Blockchain can be useful for transactions involving proof and chain of title, ownership of property, or identity of a person. Because the ledger is an ongoing, validated, and secure log of all things that have happened, perhaps going all the way back, ownership can be known with exactitude.
Help with Secure Life-long Medical Records
Blockchain records similarly hold promise for the medical industry as Personal Identifiable Information that could be properly encrypted and securely stored in the Cloud for long-term access by authorized medical professionals and the patient alike. According to Brian Forde, editor of MIT Media Lab Digital Currency Initiative, “By putting your health records into a blockchain-managed system, you and your doctor should not only be able to update and review your medical information in real time, but also know it has been held securely.
A novel design feature of MedRec is the way records are validated and added to the blockchain. The miners for MedRec are medical researchers who are rewarded with access to census-level data of the medical records.”
Perhaps most intriguing is that Blockchain records can be securely stored, accessed, and shared over the lifetime of the patient with multiple providers. That allows medical records to have portability, longevity, and security that promotes care and treatment over the life of the patient.
Help with Disaster Recovery Backup
Blockchain could also be useful as a means to back up important information from an organization’s servers in much the same way as using a Cloud provider today, with differences related to its public facing and distributed technology design. With encryption, the content could be scrambled and securely stored in a third-party location that could be made available in the unlikely event of a disaster that requires information to be restored. In today’s information security environment, such protections may be more and more essential.
Help with Litigation Discovery
The litigation process could be greatly enhanced if ESI were blockchain records in that they would be “self-authenticating”; stored publicly, which would add to their integrity; and would be complete as they are captured real-time in total and validated as part of the blockchain process. Further, if managed in the blockchain environment overtime, chain of custody would be known and easier to demonstrate if challenged.
Help with Transactions Between Devices in the Internet of Things
With the exponential growth of transactions between smart devices, called the Internet of Things (IoT), traditional intermediaries like banks won’t be able to handle the volume of transactions. Here, too, Blockchain can execute and track such transactions. Many companies are testing out the utility of blockchain and IoT, from security to storage management.
Conclusion
Whether it’s secure real estate transactions, chain of custody, smart contract, multi-party agreements, or UCC filings, blockchain may be a gamechanger. According to the Harvard Business Review, “It can validate—and secure—almost anything. From voter authentication to government processes, health information, and proof of intellectual property, Blockchain can serve as a secure process to validate almost anything of value, and to keep it safe.”
While Bitcoin and other cryptocurrencies may wither away, blockchain is here to stay. U.S. law will likely never dictate that Blockchain be used, but, depending on the business being transacted, there are lots of reasons to see if it can make electronic business happen “faster, better and cheaper,” while being legally compliant.
Generally, public policy prohibits attempts to contract away the right to file bankruptcy, and a string of recent decisions confirms this principle in the context of limited liability company (LLC) operating agreements. In September, the U.S. Bankruptcy Court for the Eastern District of Kentucky held that provisions of an LLC operating agreement that were added incidental to the closing of a commercial loan served no purpose other than to frustrate the LLC’s ability to commence a bankruptcy case, and were thus unenforceable. In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017). In short, the applicable provisions gave the lender the ability to block a filing. Notwithstanding state law policy of freedom of contract in LLC agreements, the bankruptcy court observed that enforceability of bankruptcy restrictions is a matter of federal law. The court’s holding follows two other recent decisions similarly voiding restrictions on bankruptcy rights. SeeIn re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).
In Lexington Hospitality, the LLC’s original operating agreement contained no limitations on its manager’s and/or members’ ability to file bankruptcy on the LLC’s behalf. The LLC later executed an amended operating agreement (the Agreement) in connection with its acquisition of a hotel which granted the lender a 30 percent equity stake until the loan was fully repaid. The Agreement also provided for the appointment of an “Independent Manager” and vested the sole discretion to file bankruptcy on behalf of the LLC in that person: (i) “The Company may declare bankruptcy only so long as the Independent Manager authorizes such action” and (ii) “In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” 2017 WL 4118117 at *3. The Agreement set forth a list of nine requirements that attempted to preserve the Independent Manager’s independence. It then limited the Independent Manager’s ability to act, vote, or otherwise participate in any LLC matters other than to consent to file bankruptcy. The Independent Manager was instructed to consider the interests of the LLC in acting or otherwise voting, as well as the interests of creditors and the economic interests of a minority member that was controlled by the lender. The Agreement also eliminated any fiduciary duty or liability that the Independent Manager might have to other members or managers. And, the Independent Manager’s role terminated upon repayment of the loan.
An addendum to the Agreement contained a further restriction on the LLC’s right to file a bankruptcy petition: “[The LLC shall not file bankruptcy] without the advance, written affirmative vote of the Lender and all members of the Company.” That provision directly conflicted with the Independent Manager provisions, which required only a 75 percent vote of the members.
The LLC filed a petition for Chapter 11 relief signed by its manager pursuant to a corporate resolution authorizing such action. The resolution disclaimed any knowledge as to the contact information or whereabouts of the Independent Manager and did not indicate a member vote was taken. Three days later, the lender filed a motion to dismiss the bankruptcy case, arguing that the Agreement’s bankruptcy restrictions were not followed.
In analyzing the Agreement’s enforceability, the bankruptcy court first noted that “state law governs whether a business entity is authorized to file a bankruptcy petition.” Kentucky law permitted the LLC’s member to do so, absent the Agreement’s restrictions in favor of the lender. The court then turned to federal law and public policy to determine whether the restrictions were enforceable.
Federal Public Policy Against Bankruptcy Restrictions
Parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law. But there is a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy. Thus, cases discussing bankruptcy restrictions in LLC operating agreements usually begin with the uncontested premise that entities, like individuals, cannot contract away access to bankruptcy relief. See, e.g., In re Squire Court Partners Ltd. P’ship, 2017 U.S. Dist. LEXIS 105032, at *9 (E.D. Ark. July 7, 2017); Lake Michigan Beach, 547 B.R. 899; Intervention Energy, 553 B.R. 258; In re Bay Club Partners 472, LLC, 2014 WL 1796688, at *1 (Bankr. D. Or. May 6, 2014); Continental Ins. Co. v. Thorpe Insulation Co., 671 F.3d 1011, 1026 (9th Cir. 2012) (“This prohibition of prepetition waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive.” (quotation and citation omitted)). As the Lexington Hosp. court noted, “[i]ndeed, since bankruptcy is designed to produce a system of reorganization and distribution different from what [sic] would obtain under nonbankruptcy law, it would defeat the purpose of the Code to allow parties to provide by contract that the provisions of the Code should not apply.” Lexington Hosp., 2017 WL 4118117 at *5 (citing In re 203 N. LaSalle St. P’ship, 246 B.R. 325, 331 (Bankr. N.D. Ill. 2000)). Based on those policy considerations, contractual provisions in operating agreements that effectively block the entity’s ability to file bankruptcy without a creditor’s consent have been held void. Id. (citing Intervention Energy Holdings, 553 B.R. at 263–64; Lake Michigan Beach, 547 B.R. at 913).
In Lake Michigan Beach, the LLC debtor defaulted on a debt and agreed to give the creditor “special member” status in exchange for a promise not to pursue the default. 547 B.R. at 903–04. The amended operating agreement made the creditor a member with the right to approve or disapprove a bankruptcy filing by the debtor. The creditor had no interest in the LLC’s profits or losses, no right to distributions, no tax consequences, and no obligation to make capital contributions to the LLC. The creditor “was kept separate and apart from the Debtor in all ways but for its authority to block the Debtor from petitioning for bankruptcy relief.”.
In Intervention Energy, the LLC debtor defaulted on its debt and agreed to make the creditor a common member in exchange for waiver of all defaults. The amended operating agreement required unanimous consent from members to file for bankruptcy. The effect of the amendment was to grant the creditor, holder of one membership unit out of 22 million, full veto power over a bankruptcy filing.
In Bay Club, the LLC debtor received a real estate purchase money loan secured by the property and the LLC’s related assets. 2014 Bankr. LEXIS 2051 at *1–3. The lender asked the debtor to add a bankruptcy waiver provision and other restrictive covenants to its operating agreement. The amended agreement provided that the debtor “shall not institute proceedings to be adjudicated bankrupt or insolvent” until “the indebtedness secured by that pledge is paid in full.”
The form that a contractual bankruptcy waiver may take is limited only by the resourcefulness of attorneys. Squire Court Partners, 2017 U.S. Dist. LEXIS 105032 at *11 (citing Intervention Energy 553 B.R. at 264). The bottom line, however, is that in all of the recent decisions, the provision amounted to a debtor agreeing to a prepetition waiver. Moreover, each case involved a creditor limiting a debtor’s right to seek bankruptcy relief as a condition of supplying credit. Each of these “blocking provisions” violated federal public policy.
In Lexington Hospitality Group, the court invalidated the bankruptcy restrictions in the amended LLC Agreement. First, the court found that the Independent Manager was “not a truly independent decision maker,” despite the existence of provisions that appeared to require independence. 2017 WL 4118117 at *6. The Independent Manager’s fiduciary duties to the company were abrogated by her contractual duties to creditors and the minority member controlled by the lender. The Independent Manager’s existence was also terminated upon payment of the debt; “this connection with the financing highlights the concern that the Independent Manager is not actually independent from the creditor who negotiated for her participation in a bankruptcy decision.”
In any event, even if those provisions were not enough to invalidate the restrictions, the court determined that the following provision “confirms that the Independent Manager is merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted”—“In order for the Company to declare Bankruptcy or dissolve and liquidate its assets, the Independent Manager must provide authorization, and then only upon a 75% vote of the Members.” The 75 percent requirement, while purporting to reserve the LLC members’ bankruptcy rights, actually disguised the true impact of the restriction because, as part of the loan transaction, the LLC’s majority owner diluted its 100 percent ownership interest to give a 30 percent interest to an entity controlled by the lender. Thus, it was impossible for the LLC to achieve 75 percent without the lender’s consent.
Finally, the lender’s power to prohibit a bankruptcy filing was even more direct in the addendum to the Agreement, which gave the lender express veto power regardless of the members’ consent to a bankruptcy filing. For all of those reasons, the bankruptcy restrictions were deemed unenforceable.
“Acceptable” Bankruptcy Restrictions
Not all bankruptcy restrictions are unenforceable, however. Members of a business entity, even a non-fiduciary member or manager, may freely agree among themselves not to file bankruptcy. See, e.g., Lexington Hosp., 2017 WL 4118117 at *6. Thus, the issue is whether bankruptcy restrictions are imposed by a creditor to create an absolute waiver of the LLC debtor’s right to file bankruptcy. 2017 WL 4118117 at *6. With respect to such restrictions in favor of outside parties to an LLC—such as the appointment of an “independent director” with veto power over a bankruptcy filing—the rule is that “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 creditor that they were chosen by.” Lake Michigan Beach, 547 B.R. at 913. Absent normal fiduciary duties, “allowing a creditor to contract for control of a debtor’s decision whether to file a bankruptcy petition would undermine the most fundamental purposes of the bankruptcy laws.” Squire Court Partners, 2017 U.S. Dist. LEXIS 105032 at *12 (citing Lake Michigan Beach, 547 B.R. at 914).
Conclusion
The key takeaway for parties considering restrictions on an LLC’s bankruptcy rights is that an independent decision maker installed by an outside creditor cannot exist simply to vote “no” to a bankruptcy filing, but must also have normal fiduciary duties. See Lexington Hosp., 2017 Bankr. LEXIS 3129, at *16 (citing Lake Michigan Beach, 547 B.R. at 911–13). This is consistent with the rule that upon insolvency (and in some states in the so-called “zone of insolvency”), fiduciary duties shift from equity holders to all creditors. Contractual provisions cannot alter existing common law and/or statutory fiduciary duties for the sole benefit of one creditor. Further, as the discussion in Lexington Hospitality makes clear, the purpose of a contractual restriction on bankruptcy and the factual circumstances surrounding its adoption may affect enforceability as much as the contract language itself.
Two years ago this past December, substantive amendments to the Federal Rules of Civil Procedure took effect. The most significant of these changes were to address the behemoth that is e-discovery. This included the new Rule 26 “proportionality” standard designed to balance ever increasingly complex e-discovery with the needs of each particular case. Another key revision was to require discovery objections to be made “with specificity,” thus effectively killing off boilerplate objections.
Another significant change was the retooling of Rule 37(e) to define the affirmative duty to preserve electronically store information (ESI) and to establish a framework for when it is appropriate to impose sanctions for the spoliation of ESI. This article explores the amended Rule 37(e) and its application since its introduction two years ago.
Background of the Rule 37(e) Amendment
The duty to preserve relevant documents and information is not new but arises from a long-recognized, common-law duty to preserve potentially relevant information for trial, subject to the court’s inherent sanction power. In adapting this common-law duty to the rising influx of ESI, some courts, however, had imposed rather harsh sanctions for even negligent conduct that resulted in lost ESI. Because a party could potentially “lose” vast amounts of ESI with surprising ease due to the nature of ESI, practitioners were rightfully terrified of being hit with spoliation sanctions.
In response to these decisions, the Advisory Committee on Civil Rules crafted Rule 37(e) in an effort to create a uniform framework for courts to evaluate the duty to preserve ESI and determine whether and what sanctions might be appropriate. But, as the Advisory Committees recognizes, Rule 37(e) is not intended to supplant the inherent powers of the court to sanction bad behavior.
When Does the Rule 37(e) Duty to Preserve Apply?
Rule 37(e) codifies the affirmative duty to preserve ESI that “should have been preserved in the anticipation or conduct of litigation.” Thus, Rule 37(e)’s duty to preserve ESI requires several “trigger” elements before a court can consider spoliation sanctions:
the relevant ESI that “should have been preserved” must have been “lost”;
the loss must have occurred after the duty to preserve arose (i.e., when litigation was “reasonably foreseeable”);
the loss must have occurred because the party failed to take “reasonable steps” to preserve the ESI; and
the ESI cannot be “replaced or restored” through additional discovery such that the loss prejudices the party seeking the ESI.
Each of these individual triggers deserves a little more discussion.
The ESI Must Be “Lost”
ESI may often exist in multiple forms in multiple places. Thus, ESI that can be restored or replaced is not “lost” under Rule 37(e). A question that is still open is whether “lost” ESI can be supplanted by other forms of discovery. Some courts have declined to allow this, but others have permitted narrowed additional discovery to allow parties to pursue additional discovery to uncover “lost” ESI.
Another potential question is what does “lost” mean? In Hsueh v. N.Y. State Dep’t of Fin. Servs., 2017 WL 1194706 (S.D.N.Y., Mar. 31, 2017), the court agreed with the defendant’s argument that Rule 37(e) does not apply when ESI is intentionally deleted, rather than “lost.” Although the court found that the language of Rule 37(e) did not cover intentional deletion, the court still imposed sanctions under its inherent authority. Arguably, intentional deletion still falls under Rule 37(e)—especially considering the “intent to deprive” factor discussed below—but in cases of evident bad faith, regardless of whether Rule 37(e) applies, the court has the power to sanction such egregious conduct and most likely will.
The Duty to Preserve Must Have Been “Reasonably Foreseeable”
Typically, the initiation of litigation—whether formally by a lawsuit or informally by a preceding demand letter—will be the obvious trigger of a party’s duty to preserve ESI. Other events, however, such as governmental investigations or industry events or knowledge, may make such litigation “reasonably foreseeable” such that a court will consider the duty to preserve to have been triggered. Obviously, these situations are case-specific, but practitioners must proceed with caution when disputes begin to arise. The second case discussed below provides a good example.
A Party Must Take “Reasonable Steps” to Preserve ESI
Once the duty to preserve has been triggered, Rule 37(e) requires the party to take “reasonable steps” to preserve ESI. A sound litigation hold practice and procedure that identifies all the relevant custodians and document storage systems will generally be sufficient to qualify. Courts and the Advisory Committee understand that “reasonable steps” does not mean perfection, and ESI may get lost. However, failure to turn off auto-deletion systems is generally not going to be easily forgiven.
The Lost ESI Must Be “Relevant”
Relevance, of course, is a touchstone for all the triggers. The courts will evaluate the relevance of the lost ESI in applying the Rule 37(e) triggers. The moving party bears the burden to show relevancy, but a party requesting extensive relief under the Rule should be prepared to answer questions as to how relevant it believes the lost ESI is. This will also go toward proving prejudice, as discussed below, and when looking at the prejudice suffered from the lost ESI, courts may sometimes shift the burden to the nonmoving party to prove that the ESI was not relevant.
Steps for Imposing Sanctions for Failure to Preserve ESI
If a party can establish the elements above, Rule 37(e) then separates possible sanctions for spoliation into two categories. Both categories require an initial finding that the loss of the ESI prejudices the other party. As noted above, proving prejudice will often require evaluating the relevance of the lost ESI. This will, of course, be factually intensive. Generally, however, if the lost ESI would have made a difference in the pursuit of claims or defenses, its loss will be considered prejudicial.
Once prejudice is proven, the court looks to whether there was an “intent to deprive” the other party of the lost ESI.
If there were no “intent to deprive,” then the court may “order measures no greater than necessary to cure the prejudice.” This will generally constitute, but is not limited to, monetary fines or, more likely, the award of the other side’s attorney’s fees. However, a court may also order, for instance, a forensic examination of a hard drive at the nonmoving party’s expense to attempt to lessen the burden of the spoliation, or other similar measures.
Harsher sanctions are only applicable upon a finding of an “intent to deprive.” These sanctions include a jury instruction (or court presumption) that the lost information was likely unfavorable to the party and, for egregious cases, “death penalty” sanctions of dismissal or a default judgment.
Recent Decisions
Courts continue to apply and interpret Rule 37(e). The following decisions are illustrative of some of the principles behind the Rule and its mechanical application.
In Mueller v. Swift, 2017 U.S. Dist. LEXIS 112276 (D. Colo., July 19, 2017), a radio DJ claimed pop star Taylor Swift falsely accused him of sexual misconduct, resulting in his firing. At the time of his termination, he recorded his calls with his employer. Swift requested them in discovery. The DJ turned over the files to his attorney, but not before editing them to delete everything that was “not important.” He also claimed the original files were lost due to a spilled-coffee incident.
Consequently, Swift claimed spoliation under Rule 37(e) and requested an adverse inference against the DJ that the missing information was favorable to her. Applying Tenth Circuit precedent and Rule 37(e), the court held that such an inference is only warranted if there is sufficient proof the evidence was lost or deleted in bad faith. The court was unable “to draw conclusions about disputed facts bearing on the merits of an action as the result of spilled coffee.” The court thus denied Swift’s request for an adverse inference, but allowed her to cross-examine plaintiff about the record of spoliation in front of the jury.
In ILWU-PMA Welfare Plan Bd. of Trs. v. Connecticut Gen. Life. Ins. Co., 2017 WL 345988 (N.D. Cal., Jan. 24, 2017), an ERISA plaintiff sought spoliation sanctions against the defendant, stemming in part from a tolling agreement the parties signed in 2011 due to previous litigation. In 2012, defendant’s parent company sold one of its three subsidiaries to a third party. Included in the transferred assets were e-mail accounts and other ESI belonging to defendant. Importantly, the purchase agreement obligated the buyer to “provide [the seller] reasonable access to business information of both parties as reasonably required for, among other things, litigation purposes.” The agreement also stipulated that each party would preserve defendant’s information, and that for the first six years, neither party would destroy any of the subsidiary’s information without first providing the other party an opportunity to obtain a copy.
In February 2016, as part of the present dispute, plaintiff requested ESI that included records included in the sale. Despite the purchase agreement’s terms, the third party was unable to produce any of defendant’s records dated before 2009. Defendant argued that sanctions were not warranted, as it could not have reasonably foreseen this action. Further, defendant argued that even if it could have foreseen litigation, the purchase agreement established that defendant took reasonable steps to preserve the ESI.
Turning to FRCP 37(e), the court found that defendant was on notice of potential litigation in 2011 based upon the tolling agreement’s terms and the fact that the issues in the present suit related to the 2011 litigation. Additionally, the purchase agreement expressly stated that defendant would have access to the transferred records “for litigation purposes.” The court was also troubled that the subsidiary sold by the parent company had records of a completely separate subsidiary, and that the company did not bother to make copies of the records before transfer. The court held that even though the discovery process was still ongoing, “at least some prejudice” occurred, and that sanctions against the defendant were appropriate. The court ordered discovery reopened and required defendant to pay the reasonable costs for discovery, as well as plaintiff’s costs for bringing its sanctions motion.
Spoliation Sanctions for Failing to Preserve ESI Are Scary but Manageable
As fitting with the overarching theme of the 2015 Amendments, the preservation duty imposed by Rule 37(e) and its related threat of spoliation sanctions encourage early cooperation with opposing counsel to define the scope of discovery for the case. If parties can do so—or at least understand how each side views proportionality in the context of the case, especially as to ESI—then they can greatly reduce the risk that the other side will claim spoliation of ESI so long as they are taking other reasonable steps to preserve ESI. Parties should not take the duty to preserve ESI lightly, given that courts have not hesitated to dole out spoliation sanctions under Rule 37(e) and their inherent power where appropriate.
It’s been a long wait. More than two years have passed since Ottawa amended Canada’s federal private-sector privacy law, the Personal Information Protection and Electronic Documents Act (PIPEDA, or the Act) by enacting Bill S-4, the Digital Privacy Act, to establish mandatory data-breach reporting requirements. Yet, sections 10.1 through 10.3, the provisions outlining the obligations for breach reporting and notification, still are not yet in force pending the creation of necessary regulations. On September 2, 2017, Innovation, Science and Economic Development Canada finally revealed the proposed Breach of Security Safeguards Regulations (Regulations), along with a Regulatory Impact Analysis Statement (RIAS) which can be found in the Canada Gazette. The proposed Regulations will come into force at the same time as section 10 of the Digital Privacy Act and are open for comments from interested parties for a period of 30 days.
By way of refresher, following the implementation of the new data-breach sections of PIPEDA, organizations that experience a data breach (referred to in PIPEDA as a “breach of security safeguards”) must determine whether the breach poses a “real risk of significant harm” (which may include bodily harm, humiliation, damage to reputation or relationships, loss of employment, business or professional opportunities, financial loss, identity theft, negative effects on the credit record, and damage to or loss of property) to any individual whose information was involved in the breach by conducting a risk assessment. When conducting this risk assessment, organizations must consider the sensitivity of the information involved and the likelihood of whether it will be misused. If the answer is “yes,” the organization is required to notify affected individuals and the Privacy Commissioner of Canada (the Commissioner) as soon as “feasible.”
Additionally, because the primary objective of the new data-breach reporting and notification framework in PIPEDA is to prevent or mitigate the potential harm to individuals resulting from a breach, the updated Act requires organizations that notify individuals of breaches to notify other third-party organizations and government institutions (or part of government institution) of a potentially harmful data breach if the organization making the notification concludes that such notification may reduce the risk of harm that could result from the breach or mitigate the potential harm.
Data-Breach Report to the Commissioner
The proposed Regulations provide a list of requirements that must be covered in any notice to the Commissioner. The RIAS further notes that this list is not intended to be exhaustive, and there is nothing in the Regulations that precludes an organization from providing additional information to the Commissioner should the organization believe that the information is pertinent to the Commissioner’s understanding of the incident.
At a minimum, the data-breach report to the Commissioner must be in writing and must contain the following information:
(a) a description of the circumstances of the breach and, if known, the cause;
(b) the day on which, or the period during which, the breach occurred;
(c) a description of the personal information that is the subject of the breach;
(d) an estimate of the number of individuals in respect of whom the breach creates a real risk of significant harm;
(e) a description of the steps that the organization has taken to reduce the risk of harm to each affected individual resulting from the breach or to mitigate that harm;
(f) a description of the steps that the organization has taken or intends to take to notify each affected individual of the breach in accordance with subsection 10.1(3) of the Act; and
(g) the name and contact information of a person who can answer, on behalf of the organization, the Commissioner’s questions about the breach.
Notifying the Affected Individual
Similarly, although the proposed Regulations also list the requirements that must be contained in any notification to affected individuals, the RIAS provides that companies can provide additional information and/or design the notice to suit the intended audience. Minimally, the following information is required in any notice to an affected individual:
(a) a description of the circumstances of the breach;
(b) the day on which, or period during which, the breach occurred;
(c) a description of the personal information that is the subject of the breach;
(d) a description of the steps that the organization has taken to reduce the risk of harm to the affected individual resulting from the breach or to mitigate that harm;
(e) a description of the steps that the affected individual could take to reduce the risk of harm resulting from the breach or to mitigate that harm;
(f) a toll-free number or e-mail address that the affected individual can use to obtain further information about the breach; and
(g) information about the organization’s internal complaint process and about the affected individual’s right, under the Act, to file a complaint with the Commissioner.
Direct Notification/Indirect Notification
The Regulations confirm that organizations can communicate with affected individuals through a variety of channels, including: (a) by e-mail or any other secure form of communication if the affected individual has consented to receiving information from the organization in that manner; (b) by letter delivered to the last known home address of the affected individual; (c) by telephone; or (d) in person.
However, the Regulations also recognize that there might be circumstances when “indirect” notification of affected individuals is acceptable. Examples include when: (a) the giving of direct notification would cause further harm to the affected individual; (b) the cost of giving of direct notification is prohibitive for the organization; or even when (c) the organization does not have contact information for the affected individual or the information that it has is out of date. In these circumstances, the proposed Regulations suggest that a public announcement, i.e., a “conspicuous message” posted on the organization’s website for at least 90 days or the use of an advertisement that is “likely to reach the affected individuals” would be acceptable. However, one may question whether this carve-out, which clearly puts the onus on the aggrieved party to take active steps to find out about the breach, is actually reasonable in most circumstances, as it may prove tempting to organizations that would rather avoid the considerable cost of individual notification and instead rely on digital publication.
Data-Breach Recordkeeping
Significantly, companies that experience data breaches will no longer have the ability to hide them. Under the draft Regulations, organizations must maintain a “record” (the word is undefined and may arguably be broadly interpreted) of every breach of security safeguards for a minimum of 24 months after the day on which the organization determines that the breach has occurred. Ouch. Even worse, the record must be sufficiently detailed and must contain any information pertaining to the breach that enables the Commissioner to verify compliance with subsections 10.1(1) and (3) of the Act. The Regulations do confirm that the data-breach report provided to the Commissioner as described above can also be considered a record of the breach of security safeguards.
Next Steps
What does this all mean for Canadian and U.S. businesses?
Certainly, U.S. organizations that have a real and substantial connection to Canada and that collect, use, and disclose the personal information of Canadians in the course of their commercial activities should dust off and revisit their existing corporate data-breach/breach of security safeguards policies to ensure that they at least minimally dovetail with the proposed Regulations, which are expected to come into force in 2018. It is important to know that Canadian courts have held that PIPEDA has extraterritorial application to foreign organizations involved in the collection, use or disclosure of personal information in Canada including through the offer and provision of services to Canadians (see Lawson v. Accusearch Inc. (c.o.b. Akiba.com) [2007] F.C.J. No. 164 and more recently, T.(A.) v. Globe24h.com [2017] F.C.J. No. 96).
If an organization does not yet have a data-breach/breach of security safeguards policy, then it’s high time to consider putting one in place. As the recent Equifax and other data breaches have reminded us, no company is immune to the threat of hackers, and the loss of personal information and organizations that are subject to PIPEDA will be obliged, under Canadian law, to report such incidents. Once the mandatory provisions of PIPEDA dealing with breach reporting, notification, and recordkeeping come into force, any affected U.S. organization that knowingly fails to report to the OPC or notify affected individuals of a breach that poses a real risk of significant harm, or knowingly fails to maintain a record of all such breaches, could face fines of up to $100,000 per violation. Therefore, there is no time like the present for smart companies to review their current practices and establish those critical safeguards/methodologies to avoid these penalties.
As chair of the ABA’s Private Target Mergers & Acquisitions Deal Points Study (the Private Target Deal Points Study), I am pleased to announce that we published the latest iteration of the study to the ABA’s website in December 2017.
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 mergers and acquisitions 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 2017 iteration of the Private Target Deal Points Study analyzes publicly available definitive acquisition agreements for transactions executed and/or completed either during calendar year 2016 or during the first half of calendar year 2017. 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 2017 Private Target Deal Points Study is made up of 139 definitive acquisition agreements and excludes agreements for transactions in which the target was in bankruptcy, reverse mergers, divisional sales (for divisional sales, see the Carveout Study also published by the Market Trends Subcommittee in December 2017), and transactions otherwise deemed inappropriate for inclusion.
Although the deals in the 2017 Private Target Deal Points Study reflect a broad swath of industries, the technology and health-care sectors together made up nearly half of the deals. Asset deals comprised 13.7 percent of the sample, with the remainder either equity purchases or mergers.
Of the 2017 Private Target Deal Points Study sample, 21 deals signed and closed simultaneously, whereas the remaining 118 deals had a deferred closing some time after execution of the definitive purchase agreement.
The transactions analyzed in the 2017 Private Target Deal Points Study were in the “middle market,” with purchase prices ranging between $30 million and $500 million; purchase prices for most deals in the data pool were below $300 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 me with a link when the study was published. If you are not currently a member of the M&A Committee but don’t 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 2017 Private Target Deal Points Study is available for download by M&A Committee members from the Market Trends Subcommittee’s page on the ABA’s website. Also available at that link are the other studies published by the Market Trends Subcommittee, including the recently released Canadian Public Target M&A Deal Points Study (chaired by Cameron Rusaw), Carveout Transactions M&A Deal Points Study (chaired by Rita-Anne O’Neill), and Strategic Buyer/Public Target M&A Deal Points Study (chaired by Claudia Simon).
How Does the 2017 Private Target Deal Points Study Differ from the Prior Version?
The 2017 version of the Private Target Deal Points Study has a number of features that differentiate it from prior iterations.
Data in the 2017 version of the Private Target Deal Points Study is more current:
The 2017 version of the Private Target Deal Points Study includes not only 2016 transactions, but also transactions from the first half of 2017.
The 2017 version of the Private Target Deal Points Study includes deals signed during those periods, not just deals that closed during those periods.
The 2017 version of the Private Target Deal Points Study excludes divisional sales:
The Market Trends Subcommittee of the M&A Committee has also published a special study of carveout sales; thus, by excluding them from the 2017 version of the Private Target Deal Points Study, we can better compare results for given data points between the two studies.
The 2017 version of the Private Target Deal Points Study contains new data points:
There is an entire new section in the 2017 version of the Private Target Deal Points Study regarding representations and warranties insurance, along with correlations to certain data points relating to indemnification.
There are other new data points scattered throughout the 2017 Private Target Deal Points Study with “new data” flags (like the sample shown below) to make them easy to spot:
The 2017 version of the Private Target Deal Points Study provides multiyear comparisons:
We have been collecting many of the data points for over a decade now, allowing us to display data—and trend lines—over a number of years in the 2017 version of the Private Target Deal Points Study.
Please join me 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, there will be an In the Know webinar covering the Private Target M&A Deal Points Study on March 8, 2018, from 1:00 p.m. to 2:30 p.m. (ET).
The Tax Cuts and Jobs Act (the Act) provides seven tax brackets (10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent) for individuals paying taxes on their ordinary income, such as wages. The Act repeals the Affordable Care Act’s individual mandate penalty. The Act did not repeal, however, the 3.8 percent net investment income tax, nor did it remove the additional payroll and Medicare taxes, resulting in a possible top marginal rate of 40.8 percent for individuals. These new individual tax rates will sunset on December 31, 2025.
Generally, fewer individuals will itemize their deductions for tax year 2018 because although the Act eliminated personal exemptions, it doubled the current standard deduction. In addition, although charitable deductions were left untouched, the mortgage interest deduction will be based on a new $750,000 limit instead of the prior $1,000,000 limit for home acquisition debt. State and local taxes for individuals can also still be itemized and deducted, but only up to $10,000. There was previously no limit on the amount of state and local taxes that could be deducted on personal income tax returns.
Taxation of Pass-through Income
The Act provides a 20-percent deduction for pass-through entities, such as partnerships, S corporations, and sole proprietorships. Business income from specified services (including health, law, accounting, consulting, athletics, financial services, brokerage services, and certain other services) is ineligible for the deduction, except for taxpayers with income below certain thresholds. Taxpayers with taxable income not exceeding $157,500 (or $315,000 in the case of a joint return) are exempt from the prohibition on specified services. As with other individual income tax provisions in the Act, the 20-percent deduction for pass-through entities will sunset on December 31, 2025.
Corporate Taxation
Corporate tax rates are reduced from a maximum rate of 35 percent to a flat rate of 21 percent under the Act. The corporate alternative minimum tax is also eliminated, unlike the individual alternative minimum tax which was retained. Although the Act has eliminated most corporate deductions and credits, it provides for the immediate write-off of the cost of business investments under bonus depreciation.
Estate and Gift Taxes
The Act increases the federal estate and gift tax unified credit basic exclusion amount to $10 million (adjusted for inflation from the same 2010 base year), effective for decedents dying and gifts made after 2017 and before 2026. The Act increases the federal GST exemption amount to $10 million (adjusted for inflation from the same 2010 base year), effective for generation-skipping transfers made after 2017 and before 2026.
Employee Tax Benefits
Generally, a deduction for compensation paid or accrued with respect to a “covered employee” of a publicly traded corporation is capped at $1 million per year. Covered employees include the CEO, CFO, and the three highest-paid employees. Pre-reform, the deduction limitation did not apply to commissions or performance-based remuneration (including stock options). The Act repeals the commission and performance-based compensation exceptions.
Section 83(i) of the Internal Revenue Code will provide new tax benefits to employees of certain startup companies. Here, a qualified employee may make an election to defer income with respect to qualified stock so that no amount is included in income for up to five years or until a specified event occurs, such as the company going public. The company must have a written plan that provides RSUs or stock options to at least 80 percent of the employees of the company. Employers must provide notice that the employee may be eligible to elect to defer income. Certain highly compensated employees are explicitly excluded.
International Taxation
Subtitle D of the Act contains the international tax provisions. Here, the Act creates a new territorial system of taxation by exempting certain foreign income of U.S. corporations from U.S. taxation.
Conclusion
Although President Trump signed the Act into law, Americans can expect further legislation to clarify and modify the new rules. Outside of budget reconciliation, any subsequent bills are going to require 60 votes to pass in the Senate, which means some Democrats will also have to be on board. In the interim, we will have to rely on further IRS guidance to fill in the gaps of this tax reform legislation.
Analysis of trends in U.S. capital markets reveals “an undeniable fact that the number of U.S. public companies has declined considerably from the peak of 20 years ago.” Ernst & Young LLP, Foreword, Looking Behind the Declining Number of Public Companies, an Analysis of Trends in US Capital Markets, May 2017 (E&Y Analysis). Listings of public companies in the United States “fell by roughly 50 percent . . . from 1996 through 2016.” Credit Suisse, The Incredible Shrinking Universe of Stocks, the Causes and Consequences of Fewer U.S. Equities, Mar. 22, 2017, at 1 (Credit Suisse Report). The reality is that more companies are choosing to stay private longer, and some public companies voluntarily “go dark” (i.e., deregister their stock from the Securities and Exchange Commission) or are acquired.
In his July 12, 2017 remarks at the Economic Club of New York, SEC Chairman Jay Clayton unequivocally stated that “the reduction in the number of U.S.-listed public companies is a serious issue for our markets and the country more generally,” and that “we need to increase the attractiveness of our public capital markets without adversely affecting the availability of capital from our private markets.”
In August 2017, the Council of Institutional Investors (CII) and the U.S. Chamber of Commerce, along with representatives of different segments of the U.S. economy, wrote letters to the Department of Treasury in connection with its upcoming report on regulations impacting the capital markets. See Council of Institutional Investors, Letter to the U.S. Department of Treasury on Capital Markets Report, (Aug. 23, 2017) (CII Letter); Joint Letter to Treasury Regarding the Decline in Public Companies (Aug. 22, 2017) (Joint Letter). (The Joint Letter was submitted by the U.S. Chamber of Commerce, as well as the Intercontinental Exchange; Nasdaq; Biotechnology Innovation Organization; Equity Dealers of America; Steven Bochner, Partner, Wilson Sonsini Goodrich & Rosati; Joseph D. Culley, Jr., Janney Montgomery Scott LLC; Kate Mitchell, Co-Founder and Partner, Scale Venture Partners; Jeffrey M. Solomon, President, Cowen Inc.; and Joel H. Trotter, Partner, Latham & Watkins.) Both the CII Letter and the Joint Letter identify the problem of shrinking public company markets but approach it differently.
CII, as the voice of institutional shareholders, including employee benefit plans, foundations, and endowments, believes that the SEC must “improve the delivery and access of the information required to be provided to investors,” but should not significantly alter “the total mix of information provided to investors.” The Joint Letter, representing views of businesses, expresses concern that “the decline in U.S. public companies inhibits economic growth, job creation, and the ability of households to create sustainable wealth” and suggests the following reforms to help reinvigorate the U.S. IPO market:
extend the “on-ramp” accommodations of the JOBS Act from five years to ten years for all emerging growth companies (EGCs), and revise the EGC definition to eliminate the premature phase-out of those accommodations;
make the JOBS Act on-ramp available for all companies seeking an IPO for five years, regardless of whether they meet the definition of an EGC;
modernize the regulatory regime for internal control reporting requirements under the Sarbanes-Oxley Act;
modernize the disclosure regime administered by the SEC, including elimination of outdated or duplicative disclosures, repeal of immaterial social and politically motivated disclosure mandates, as well as further scaled disclosure requirements for EGCs;
reform the outdated rules governing shareholder proposals under Rule 14a-8, including modernizing the thresholds for shareholder proposal resubmissions by increasing the shareholder support thresholds;
enhance regulatory oversight of the proxy advisory firm industry;
promote an equity market structure that enhances liquidity for EGCs and other small capitalization companies; and
incentivize both pre-IPO and post-IPO research of companies.
In his speech, Chairman Clayton praised the U.S. public company disclosure and trading system as “an incredibly powerful, efficient, and reliable means of making investment opportunities available to the general public,” but he also acknowledged that the SEC, lawmakers, and other regulators “have slowly but significantly expanded the scope of required disclosures beyond the core concept of materiality.”
The SEC’s Regulatory Flexibility Agenda (see 82 Fed. Reg. 163 (Aug. 24, 2017)) published for public comment, delays (arguably indefinitely) the adoption of rules that many companies view as burdensome and pushes forward rules that are designed to lead to a more balanced disclosure regime. For example, the proposed agenda places the adoption of final rules implementing the following Dodd-Frank mandates on hold, with the timetable for the SEC action identified as “to be determined”:
disclosure of hedging by employees, officers, and directors;
clawback of erroneously awarded compensation; and
pay-versus-performance disclosure.
The adoption of the following final rules, among certain other actions, is targeted for April 2018:
amendments to the definition of a “smaller reporting company” to expand the number of registrants that qualify as smaller reporting companies in order to promote capital formation and reduce compliance costs for smaller registrants; and
updates to certain disclosure requirements in Regulations S–X and S–K that may have become redundant, duplicative, overlapping, outdated, or superseded.
The adoption of these rules, albeit important, is unlikely to be a game-changer in a company’s decision whether to go public. The implementation of significant reforms that will spur public company activity may involve a lengthy SEC rulemaking process and will not happen overnight; however, it is important that the issue of declining interest in becoming a U.S. public company is recognized, discussed, and put at the forefront of the SEC agenda.
Sometimes, uncontrollable financial circumstances precipitate a company’s decision to seek the protection of the Bankruptcy Code. Other times, a bankruptcy filing results, at least in part, from poor decisions made by the company’s management. A bankruptcy trustee is duty-bound to scrutinize the decisions of management and determine whether certain errors were made that caused harm to the debtor or its creditors and, if appropriate, commence litigation against the relevant decision makers for the benefit of the bankruptcy estate and its creditors. These suits often involve allegations that directors and officers have breached their fiduciary duties.
This type of litigation is all the more likely in cases where the debtor has or had a director and officer liability policy (D&O policy) in place to cover such claims, but most D&O policies contain an “insured vs. insured” exclusion, which excludes claims made by an insured against another insured under the policy.
Although not all courts have agreed, in a majority of jurisdictions, court-appointed trustees (Chapter 7 and Chapter 11) have circumvented insured vs. insured exclusions by arguing that there is no risk of collusion when the suit is brought by an independent, court-appointed fiduciary, and that the debtor company and the debtor’s estate—on whose behalf a trustee is bringing suit—are distinct legal entities.
But what about bankruptcy fiduciaries who are not court-appointed Chapter 7 or Chapter 11 trustees? A debtor-in-possession often will include in its Chapter 11 plan of reorganization the appointment of a litigation trustee, liquidating trustee, or other fiduciary to oversee litigation and make distributions for the benefit of creditors. Just like a court-appointed trustee, these fiduciaries will see a D&O policy as a source of potential recovery.
But a recent decision of the Sixth Circuit Court of Appeals may have far-reaching ramifications for fiduciaries who are not court-appointed, and may even erode at the general success Chapter 7 and Chapter 11 trustees have had in pursuing claims against debtors’ D&O policies.
In Indian Harbor Ins. Co. v. Zucker for Liquidation Tr. of Capitol Bancorp Ltd., 860 F.3d 373 (6th Cir. 2017), the debtor, Capitol Bancorp, confirmed a liquidating plan that created a liquidating trust to pursue litigation claims on behalf of the estate. The liquidation trustee sued Capitol Bancorp’s officers, alleging that they breached their fiduciary duties to the company. Indian Harbor Insurance—the company’s D&O insurer—filed a separate action seeking a declaration that the trustee’s claims fell within the policy’s insured vs. insured exclusion. The district court found the exclusion applied, and the liquidation trustee appealed.
The Sixth Circuit began its analysis with the language of the insured vs. insured exclusions, which excluded coverage for “any claim made against an Insured Person . . . by, on behalf of, or in the name or right of, the Company or any Insured Person.” This is fairly standard language, some variant of which is found in most D&O policies. Notably, there was no mention of the existence in the policy at issue of an exclusion to the insured versus insured exclusion which relates to insolvency and/or bankruptcy proceedings
The court went on to discuss the purpose of insured vs. insured exclusions, analogized well by the Zucker majority:
Not unlike a homeowner’s insurance policy that excludes coverage for a fire that the policyholder intentionally sets, these exclusions limit the management-liability insurance to claims by outsiders, prohibiting coverage for claims by people within the insured company. A company thus cannot hope to push the costs of mismanagement onto an insurance company just by suing (and perhaps collusively settling with) past officers who made bad business decisions.
(citing Biltmore Assocs., LLC v. Twin City Fire Ins. Co., 572 F.3d 663, 670 (9th Cir. 2009)). Although one would generally consider a liquidating trustee to be similarly disinterested as a court-appointed trustee so as to dissuade any fears of collusive behavior, the Zucker majority was not so convinced. It admitted that court approval of the debtor’s plan was a procedural safeguard, but stated that that alone did not “eliminate the practical and legal difference between an assignee [the liquidating trustee who was assigned causes of action under the plan] and a court-appointed trustee that receives the right to sue on the estate’s behalf by statute.” The majority concluded that “[t]he risk of collusion is surely higher when the insured individuals—the management of the debtor in possession—can negotiate and put conditions on a trustee’s right to sue them.” In other words, the mere fact that the debtor’s former managers can propose to name the individual who will serve as trustee and condition his or her authority is enough to raise the red flag of collusion beyond an acceptable threshold.
This is troubling for two reasons. First, if anything, management typically attempts to restrict the ability of a trustee to bring causes of action against them—a negotiating tactic that, if successful, would reduce overall the types of claims the trustee could bring; it would not elevate the risk of the trustee bringing collusive claims to the insurer’s detriment. Second, even if management sought to restrict or steer the trustee’s recovery efforts, those provisions would be subject to objection by creditors and interested parties and, if unacceptable, may result in a failure to garner sufficient votes to confirm the plan. As the dissent points out, “[f]unctionally, however, there is no distinction between an assigned trustee that a bankruptcy court has determined is independent and does not pose a risk of collusion, and one that is appointed by a bankruptcy court and is by nature of that appointment independent.”
With respect to the distinct-legal-entity argument, the liquidation trustee argued that a debtor-in-possession is legally distinct from the prebankruptcy “Company” defined in the insurance policy, making the insured vs. insured exclusion inapplicable to the trustee, who is the debtor-in-possession’s assignee. In response, the Zucker majority provides another analogy:
[T]his new-entity argument surely would not work before bankruptcy. Capitol could not have dodged the exclusion by transferring a mismanagement claim to a new company—call it Capitol II—for the purpose of filing a mismanagement claim against [Capitol’s management]. No matter how legally distinct Capitol II might be, the claim would still be ‘by, on behalf of, or in the name or right of’ Capitol. The same conclusion applies to a claim filed after bankruptcy. Here too the voluntarily transferred claim would be filed “on behalf of” or “in . . . the right of” Capitol. The exclusion remains applicable by its terms.
The majority interpreted its own precedent discussing the legal distinction between a prebankruptcy debtor and a debtor-in-possession narrowly, stating that the two are “one and the same person, although ‘wearing two hats’” (quoting Cle-Ware Indus., Inc. v. Sokolsky, 493 F.2d 863, 871 (6th Cir. 1974)). The majority concluded that Capitol, as a debtor-in-possession, was the same “Company” that entered into the insurance contract; therefore, the liquidation trustee, as assignee of the debtor-in-possession, stand’s in the “Company’s” shoes and is subject to the same defenses. “Just as the exclusion would bar a suit ‘by’ or ‘on behalf of” Capitol, it bars a suit by or on behalf of the Trust” (citing Biltmore, 572 F.3d at 671).
The majority then went a step further, putting even court-appointed trustees on shaky ground. The court stated, “[i]n truth, because the exclusion also applies to claims ‘in the . . . right of’ Capitol, it’s not even clear that a court-appointed trustee or creditor’s committee could collect on the policy.” But the court stopped short of deciding that issue, and held merely that “a voluntary assignee like the Trust, which stands in Capitol’s shoes, brings a breach-of-fiduciary-duty suit ‘by, on behalf of, or in the name or right of’ the debtor in possession” and, therefore, the claim was excluded from coverage under Capitol’s D&O policy.
The Zucker holding could have a dramatic and unintended impact on bankruptcy cases, the assertion of breach of fiduciary duty claims, and the availability of coverage for those claims. As the dissent notes:
If the majority’s decision becomes settled precedent, this Court will send a clear message to creditors in chapter 11 proceedings that if claims against directors and officers are deemed to be of significant value and the plan proposes to put those claims into a trust, the creditors must not agree to a plan proposed or even agreed to by the debtor-in-possession. Instead creditors will be required to seek the appointment of a bankruptcy trustee, where appropriate, or they will have to defeat the debtor-in-possession’s plan and propose their own disclosure statement and plan.
We will have to wait and see the true effect of Zucker, but all debtors, creditors, fiduciaries, and directors and officers are now on notice that the ability to recover against or receive coverage under a D&O policy may, depending upon the terms of the policy and the exact circumstances of the case, be compromised when such claims are pursued by a fiduciary who has not been appointed pursuant to statute or court order.
Over the past decade, several legislative proposals have been made for the establishment of a national infrastructure bank by both Democrats and Republicans. Although President Trump spoke against such a bank during his campaign, more recent indications are that he is inclined to support one. An infrastructure bank will, in fact, be a means to achieve, at least in part, his campaign promise to make major improvements in needed areas of U.S. infrastructure. It will also potentially provide a bi-partisan means of making these improvements.
A number of articles have been written on the subject of creating a U.S. infrastructure bank (see, e.g., Brookings, Setting Priorities, Meeting Needs: The Case for a National Infrastructure Bank). Although this article borrows some of what was written in such articles, it is focused on providing a roadmap for the creation of a U.S. infrastructure bank. It draws both on elements from three successful models of development banks—the European Investment Bank (EIB), the International Finance Corp. (IFC), a constituent member of the World Bank Group, and Kreditanstalt fur Wiederaufbau (KFW), the German promotional bank—and on prior legislative proposals for the creation of a U.S. infrastructure bank.
A reasonable goal for the initial operation of the new bank is to provide it with $20 billion of capital so that it can, in its first few years of operation, fund $200 billion of projects and quickly grow from that base. The initial capital can readily come from an earmarked portion of the tax proceeds derived from taxing the offshore profits of U.S. multinationals, a proposal that is part of the tax bills now before Congress.
This article recommends that the infrastructure bank be operated on an independent basis as a for-profit, government-owned corporation. It should be professionally managed with a long-term perspective on the type of projects it funds. The article concludes with suggestions about how a U.S. infrastructure bank might be established, funded, and operated.
Models of Development/Infrastructure Banks
EIB. The EIB was created in 1957 under the treaty establishing the European Economic Community. It is owned by the member states of the EU. Its capital is provided by the member states, and it is funded in the international capital markets. Management states that its purpose is “lending, blending and advising”—it lends to projects principally in the EU but also in the broader world, it blends its funds with those provided by other EU institutions, and it advises on project selection and project design (Governance of EIB).
The EIB holds itself out as following best practices in decision-making, management, and internal controls. Most observers agree that the EIB is an effectively managed institution. Given that it is an “international institution” by virtue of its joint ownership by the EU member states, it is not regulated as a commercial bank. The bank has generated a surplus of funds in each year of its operations (under IFRS it reported a financial loss in 2016 largely because of marking its funding liabilities to market). It issues fully audited financial statements under IFRS principles.
The key take-away from the EIB is that strength of management is critically important. A development institution must be run on a sound basis and should not be dependent on a continuing stream of government handouts.
KFW. KFW was founded in 1948 after World War II as part of the Marshall Plan. It is 80-percent owned by the Federal Republic of Germany and 20 percent by the German states. Its capital is provided by its shareholders, but it funds its operations from the capital markets. Although not formally regulated as a commercial bank, the German bank supervisory laws are “analogously applicable” to KFW (Application of German Banking Act to KFW). It has been operated on a continuous basis in a profitable manner and issues annual audited financial statements under IFRS principles.
KFW operates in areas where no banks are active due to unfavorable risk-return ratios in the market. Specifically, it lends monies in areas identified by the state, including, among others, providing financing for infrastructure, small- and medium-sized enterprises, environmental protection, and the housing sector. It seeks to focus on areas of the German economy that will promote growth (see “Management” discussion in KFW’s 2016 Annual Report).
The key take-away from KFW is its focus on areas of market failure, its regulation under essentially the same laws applicable to commercial banks, and its ownership structure being a partnership between the federal government and the German state governments.
IFC. The IFC was created in 1956 as the private-sector arm of the World Bank Group. It is a separately incorporated member of the group and is owned and governed by the member countries of the group. Like the EIB and KFW, its shareholders have provided the equity for its operations, but it funds itself in the international capital markets. As with the other two institutions, it annually issues fully audited financial statements, but in its case under GAAP.
The IFC was founded to further economic development by encouraging the growth of productive private enterprises largely in less-developed countries. It does so by providing debt funding singly or together with other lenders to development projects. It also provides equity funding to some projects and has established several equity funds for this purpose (IFC Products and Services). It generally has operated on a profitable basis.
The key take-away form the IFC is its partnership with private enterprise. By forging public-private partnership investing in worthwhile projects, it has been able to further development in less-developed countries.
Overall, these three institutions show the importance of high-quality management, a well-defined purpose charting the institution’s operational goals, and the ability to sustain themselves by conducting their business in profitable manner. KFW is a model for cooperation between a federal government and state governments and for operating under the regulatory standards of a commercial bank. The IFC brings to the fore the importance of a development bank joining with private enterprises in significant projects. All the institutions operate in a fully transparent fashion with audited financial statements available for public scrutiny.
History of National Legislative Proposals
Legislative proposals for infrastructure banks in the United States go back to 1983 when legislation was introduced to authorize state infrastructure banks (A History of Infrastructure Bank Proposals). In subsequent years, many of these banks were created, but they never became of significant size. Not until 2007 did a proposal for a national infrastructure bank emerge. In that year, Senator Dodd (D-CT) and Senator Hagel (R-NE) introduced the Infrastructure Bank Act of 2007. This legislation was never enacted, but the idea for a national infrastructure bank was picked up by President Obama in his 2008 campaign. This idea was carried forward and became part of President Obama’s legislative preproposal to Congress in 2009 and was repeated in subsequent years. Several proposed bills were also introduced in Congress. None came to fruition.
More recently, proposals for national infrastructure banks were made in the 114th Congress (2015 and 2016) and the 115th Congress (2017 and 2018). Four of these proposals (HR 413 by Rep. Delaney (D-ND), HR 3337 by Rep. DeLauro (D-CT), S 1296 by Sen. Fischer (R-NE), and S 1289 by Sen. Warner (D-VA)) deserve a brief appraisal (summarized in How a National Infrastructure Bank Might Work). S 1589 and HR 413 received broad, bi-partisan support. None of the bills in the 114th Congress were enacted.
All the bills call for the bank to be a wholly owned government corporation. Three of them call for a board of trustees/directors to be appointed by the President, while one (S 1296) somewhat unusually calls for the directors to be appointed by the majority and minority leaders of the Senate and House. As for eligible infrastructure projects, all cover transportation, two add energy and water projects, and one adds environmental measures and telecommunications. All authorize the bank to make loans. Several expand the nature of assistance from loans to include loan guarantees, grants, and equity investments. A mix of measures is suggested for the means to capitalize and fund the new entities. Of interest, two suggest that some of the capital could come from repatriated foreign earnings, a suggestion picked up later in this article.
Infrastructure Bank Proposal
The basic features for a new, national infrastructure bank are suggested below.
Type of company. The new bank should be incorporated as an independent, government-owned corporation (GOC). Congress establishes GOCs to provided market-oriented services on a self-sustaining basis. They span a wide spectrum of businesses from the Tennessee Valley Authority to the Federal Home Loan Banks (CRS, Federal Government Corporations: An Overview). The legislative proposals previously examined unanimously suggested this form of corporation. An idea to consider is to follow the precedent set by KFW and have the corporation jointly owned by the federal government and the various states; however, given the 50 U.S. states, this might create a cumbersome ownership structure. A state advisory council may be a more effective means of involving the states in the new bank.
The new bank should not be created as a government-sponsored enterprise (GSE). Because of the bailout of Fannie Mae and Freddie Mac (both GSEs) in the financial crisis of 2008, a stigma now surrounds GSEs. It would be wise to avoid this stigma with the new bank. For the same reason, it should not be in the business of building up a massive position of off-balance sheet liabilities as Fannie and Freddie did by providing a large number of loan guarantees.
Governance. To insulate the institution from overly partisan oversight, the bank should be independent and not subject to direct supervision by an executive agency or a Congressional committee. Thus, the most effective governance structure is for the bank to have a Board of Directors seven in number, six appointed by the President and confirmed by the Senate, and the seventh from a state advisory council.
Although independently managed, the infrastructure bank should be subject to the provisions of the Government Corporate Control Act and to the Chief Financial Officers Act (as discussed in the CRS article cited above). Under the former, the infrastructure bank must prepare and submit to the President annually a business-type budget for the coming year; under the latter, it must submit to Congress an annual management report, including, among other things, financial statements and a statement of accounting and administrative controls. Although GOCs are given some options on the type of annual financial audit they must undergo, the option most appropriate to the new infrastructure bank is that of an independent external auditor from a firm well versed in auditing financial institutions.
As an additional feature, the new bank should create an advisory council consisting of members appointed by the 50 state governors. The council would create an executive committee to meet periodically with the bank’s management. In addition, the executive committee would appoint one member to the board of directors.
Scope of infrastructure projects authorized. In its 2017 Infrastructure Report Card, the American Society of Civil Engineers estimated that the infrastructure needs of the United States from 2016 through 2025 would be about $4.590 trillion, and the estimated amount of funding available to satisfy that need under current projections would be about $2.526 trillion. The resulting funding gap is approximately $2.064 trillion. The need for infrastructure spending was divided into 11 different categories, including surface transportation and water and electricity projects, among others. During the most recent presidential campaign, both candidates recognized the importance of infrastructure improvements and made promises to dramatically increase the amount of infrastructure spending.
Given the foregoing, a compelling case can be made for a large-sized national infrastructure bank. With the diversity of where spending is needed, a broad definition of the scope of infrastructure projects that can be funded by the infrastructure bank is desirable. An expansive definition for “infrastructure” suitable for the new bank can be taken from the definition found in the proposed National Infrastructure Development Act of 2007:
a road, highway, bridge, tunnel, airport, mass transportation vehicle or system, passenger or freight rail vehicle or system, intermodal transportation facility, waterway, commercial port, drinking or waste water treatment facility, solid waste disposal facility, pollution control system, hazardous waste facility, federally designated national information highway facility, school, and any ancillary facility which forms a part of any such facility or is reasonably related to such facility, whether owned, leased or operated by a public entity or a private entity or by a combination of such entities . . .
A necessary caveat to this proposed definition is that funding for any targeted project should not be readily available in existing credit markets. The national infrastructure bank should not enter markets adequately served by the private financial institutions and the credit markets in which they operate. That said, the role of the IFC in encouraging private investment by investing side by side with private investors can be adopted for many projects. The creation of public-private partnerships for many projects should be encouraged.
Operation of the bank. The new infrastructure bank should be operated on a quasi-independent basis. It should not be simply another department in the executive branch of the government. Furthermore, it should not be forced to seek funds from Congress on an annual basis. If it is established in this fashion, it can be focused on long-term projects needing funding. Given that it should be operated in an independent manner, it must be operated as a profit-making bank. This will be akin to how EIB, KFW, and IFC all operate today.
If it is to be a profitable, successful bank, it must have capable, long-term management. Like the EIB, it should seek to follow best practices in decision-making, management, and controls. In short, it should have a cadre of highly qualified professional managers.
Drawing from the fashion in which KFW is operated, appropriate banking regulations should be issued regarding the infrastructure bank. The regulations should stipulate that the key provisions of the federal banking regulations will be applied analogously to the bank. The most suitable body to be tasked with creating and implementing these regulations is the Federal Reserve Bank.
Form of funding for financed projects. The infrastructure bank should fund projects through individual loans or as the lead manager of loan syndications where it has invited other public and private institutions to join it in making a loan or a package of loans. It may also raise money by establishing debt funds designed for specific types of projects or for specific geographic areas.
It addition, the new bank may make equity investments. These investments typically would provide a base for raising added debt financing for suitable projects. As with debt funds, equity investment funds could also be established.
In every instance, the investments made by the infrastructure bank should be made with a view toward making a profit in the long-term. The new bank should not be in the business of making outright grants for projects. If it gets into the grant-making business, it will need to quickly obtain annual funding from Congress and would not be able to operate independently with a long-term horizon.
Capital for the bank. In order to have a material impact, the new infrastructure bank should be adequately capitalized at the outset. A reasonable goal is to have the bank supply funds for $100 billion of projects in its first two years of operations and to quickly build its balance sheet from that point. To give the bank a solid base of capital, it should be provided with initial Tier 1 equity capital of $20 billion. Under the capital standards set for U.S. banks following the Basel accords, this should permit the bank to grow its balance sheet in its first years of operation to over $200 billion and still have the bank well capitalized. Further growth should come from the bank’s retained earnings.
A good source of the capital for the new bank is from an earmarked portion of the tax proceeds derived from the new tax to be imposed on the overseas retained earnings of U.S. multinationals, as currently contemplated in the tax bills before Congress. In 2016, the Joint Committee on Taxation estimated that the previously untaxed foreign earnings of U.S. corporations at the end of 2015 to be approximately $2.6 trillion (Letter of Joint Committee on Taxation to Congressman Brady). The pending tax bills would tax these earnings at a rate of somewhere between 5 percent and 14 percent, depending on how the earnings were invested and on the version of the tax legislation to be considered. The Joint Committee has estimated that the tax raised by this provision would be approximately $200 billion (Joint Committee Revenue Estimate of Senate Bill). Hence, a capital base for the new bank of $20 billion would only amount to earmarking 10 percent of this tax. This may seem like a novel suggestion, but it is one that was proposed in several of the infrastructure bank legislative proposals previously examined. Although it may not be possible to have this type of provision included in the pending tax legislation, the legislation needed to create an infrastructure bank could contain such a provision, particularly given that the current proposals allow for the tax on untaxed foreign earnings to be paid over eight years.
The balance of the funds needed to grow the infrastructure bank’s portfolio of loans and investments should be raised in the form of debt from the capital markets. The bank should be able to tap these markets for the needed funds. EIB, KFW, and IFC all raise needed funds in this fashion.
Conclusion
The suggestions in this article can be summarized as follows:
Enabling environment. The infrastructure bank should be established under appropriate legislation with a clear mandate for the scope of its operation. In addition, it should be subject to banking supervision under the equivalent of established U.S. regulatory guidelines for banking institutions. These measures will ensure that the bank is appropriately incorporated with a clear focus on the nature of its business. It should prevent operational creep into areas not intended for its operations.
Well managed. The infrastructure bank should have a core of professional bankers leading it with a clear view toward making it a successful bank. Although profitability should not be its sole goal, it is a necessary condition to satisfying the next recommendation below.
Operates on a continuing and sustainable basis. The infrastructure bank should not need to rely on continuing government support for its operations. It should be able to engage in meeting long-term goals for the funding of infrastructure projects. It should not be subject to the immediacy of political pressures.
Insulated from political interference and undue pressure. One of the causes of failures of national development banks in other countries is the engagement in some form of crony capitalism. This corrupted the bank’s credit intermediation function. By making the proposed new bank independent from political interference, this fate should be avoided.
Provides funding not otherwise available in private credit markets. The infrastructure bank should not compete with private financial institutions in the credit intermediation function. Private institutions can efficiently allocate capital in areas where they can generate an adequate long-term return on their capital. The infrastructure bank should operate in areas where private institutions are not providing needed capital. These are areas of so-called market failures. This may be a murky concept to apply in practice. Nevertheless, it is an important one, and one where appropriate banking supervision should be of assistance in realizing this goal.
Connect with a global network of over 30,000 business law professionals
