The American Bar Association’s Derivatives and Futures Law Committee published a first-of-its-kind comprehensive legal guide for practitioners and their clients involved with the fast-developing markets for “crypto” or “virtual” currencies, and the many other types of digital and digitized assets that exist or are recorded on blockchain platforms. The committee’s over 300-page White Paper, “Digital and Digitized Assets: Federal and State Jurisdictional Issues,” reviews the complex web of federal and state statutes and precedents that have been applied to transactions in such digital assets.

The paper was prepared by the Jurisdiction Working Group of the committee’s Innovative Digitized Products and Processes Subcommittee, with contributions from 34 lawyers with expertise in derivatives, securities, FinTech, and related areas of law. The paper summarizes the current interpretations and applications of the federal securities, commodities, and derivatives trading laws, the federal anti-money-laundering statutes, and the state statutes governing money services businesses. It also reviews some of the principal international statutory approaches to regulating crypto assets. Recognizing the complexity and uncertainty of the law in this area, the subcommittee prepared the paper as a service to and resource for practitioners and policy makers. The Commodity Futures Trading Commission (CFTC) included a presentation on the paper at the meeting of its Technology Advisory Committee on March 27th.

Regulators face interpretative obstacles in determining the scope and application of laws that do not envision financial products with the novel, varied, and unique characteristics of digital assets. Recognizing these challenges, the CFTC, the Securities and Exchange Commission (SEC), the Treasury Department’s Financial Crimes Enforcement Network (FinCEN), the Internal Revenue Service (IRS), and state regulators such as New York’s Department of Financial Services (New York DFS) have issued guidance or interpretations concerning application of their rules to digital asset products and market participants. Foreign regulators have done the same. In applying its laws and rules to digital assets, each regulator and standard-setting body must consider the potentially overlapping jurisdiction of other regulators, including cross-border issues.

The paper addresses these themes in eight sections: (1) a factual background describing the various types of digital or crypto assets and blockchain systems; (2) CFTC jurisdiction over digital assets, with an emphasis on virtual currencies; (3) SEC regulation of digital assets under the Securities Act of 1933 and Securities Exchange Act of 1934; (4) regulatory implications under other federal securities laws, specifically the Investment Company Act and the Investment Advisers Act; (5) issues created by jurisdictional uncertainty between the CFTC and SEC, an analytic framework for considering those issues, and potential tools for resolving jurisdictional issues; (6) FinCEN’s regulation of digital assets; (7) international regulation of digital assets and blockchain technology; and (8) state regulation of digital assets. These sections lay out the varying and diverse approaches taken by federal, international, and state regulators with respect to digital asset uses and markets as well as interpretative issues associated with each approach, given that digital asset markets are still in the early stages of development.

Section 1 is a high-level primer on blockchain technology and the different categories of digital and digitized assets and how they function within a blockchain or other electronic ledger. It explains that the absence of uniform definitions for digital assets creates obstacles for regulators in establishing what obligations should apply to these products.

Section 2 provides an overview of the Commodity Exchange Act (CEA) and how the CFTC has applied it to digital assets—with a focus on virtual currencies—and derivatives based on them. It analyzes the potentially broad reach of the CEA’s definition of “commodity” (which covers items one would not expect under a common understanding of the term, such as securities) and the interpretative questions it raises since the CFTC first formally asserted in 2015 that virtual currencies are commodities within its oversight. It analyzes the CFTC’s authority to regulate derivatives on digital assets listed on registered exchanges, swaps on digital assets, and off-exchange leveraged or financed transactions involving digital assets with retail persons, as well as the agency’s anti-fraud and anti-manipulation enforcement authority over digital asset markets. This section also summarizes the current jurisdictional boundaries between the CFTC and the SEC over the various types of financial derivative instruments.

Section 3 explains the application of the Securities Act, the Exchange Act, and SEC regulations to digital assets. It explains the SEC’s treatment of digital assets as securities if they are deemed to be “investment contracts” pursuant to the Supreme Court’s four-part test set out in SEC v. Howey, and the regulatory obligations that apply to issuers and market intermediaries with respect to digital assets that are securities, such as securities registration, reporting requirements and disclosures for issuers, and broker-dealer registration and capital requirements for intermediaries.

Section 4 covers the application of the Investment Company Act and the Investment Advisers Act to investment management activities involving digital assets. Among other things, it summarizes registration requirements for investment companies and for their shares, and explains how the definition of “security” for purposes of determining whether investments trigger investment company status can be broader than the definition in the Securities Act and Securities Exchange Act. With respect to the Investment Advisers Act, the paper explains what constitutes investment advice and summarizes registration requirements and exemptions from registration, and how they can arise in connection with digital assets.

Section 5 analyzes the overlapping and potentially conflicting jurisdiction of the CFTC and SEC and the need for agency guidance to provide a clear and commercially compatible regulatory regime. Recognizing that digital assets can diverge greatly in their characteristics and uses, defying easy “one size fits all” classification, section 5 suggests a framework for applying a jurisdictional analysis to such assets. The discussion includes an explanation of how CFTC and SEC jurisdiction has intersected in the past, and a set of questions for evaluating whether a particular digital asset is within the purview of one agency alone, both agencies together, or neither agency. Section 5 also discusses past instances of jurisdictional debates between the two agencies and how they were resolved. It describes the formal inter-agency process for cooperation mandated as part of the Dodd-Frank Act for clarification of each agency’s jurisdiction over novel products. The paper examines other potential methods to resolve jurisdictional issues without new legislation, including utilizing each agency’s exemptive authority.

Section 5 is particularly timely. SEC FinHub recently issued a “Framework for ‘Investment Contract’ Analysis of Digital Assets” that provides color on how to apply the Howey investment contract analysis to digital assets, and identifies additional considerations for reevaluating whether a digital asset initially sold as a security remains a security in the future. The framework does not address the jurisdictional issues raised in section 5, but may help further illuminate how the SEC and CFTC can jointly address them.

Section 6 explains FinCEN’s regulation of virtual currency issuers and sellers through its authority to regulate “financial institutions” under the Bank Secrecy Act (BSA). These regulations focus on combating money laundering and terrorism financing. This section discusses the scope of FinCEN’s regulatory authority under the BSA and how FinCEN has interpreted the BSA’s term “financial institution” to extend its authority to certain virtual currency businesses deemed to be money services businesses. Those businesses are required to register with FinCEN, submit to examinations by the IRS, and establish an anti-money-laundering program. This section also describes FinCEN’s enforcement actions against virtual currency market participants.

Section 7 provides an overview of international regulations, directives, and guidance regarding virtual currency and other digital asset markets. It discusses European efforts initiated at both the EU level, through EU legislation and European Securities and Markets Authority guidance and statements, and the individual country level. These efforts include compliance obligations under the Markets in Financial Instruments Directive II, the European Market Infrastructure Regulation mitigation requirements, and European Parliament and EU Council amendments to anti-money-laundering legislation to specifically cover cryptocurrency exchanges and custodial wallet providers. Section 7 also summarizes approaches to virtual currency taken by regulators in the United Kingdom, Switzerland, France, Germany, Austria, Slovenia, Malta, Japan, South Korea, Singapore, China, and Australia, and addresses guidance by international bodies such as the International Organization of Securities Commissions, the Financial Services Board, the Financial Action Task Force, and the Bank for International Settlements.

Section 8 discusses key state regulators that also have asserted authority over virtual currency businesses. It focuses on the New York DFS regulations of virtual currency businesses and the requirement that those businesses register for a “BitLicense.” It explains the exemption from BitLicense regulations for virtual currency businesses that are chartered under New York banking law. Section 8 also summarizes the efforts of other states in regulating the issuance of virtual currencies or tokens through initial coin offerings, and an appendix provides a 50-state survey of the state laws and regulations that govern money transmitters and virtual currency regulations (as of January 23, 2019).

The subcommittee is undertaking other projects through its working groups. In addition to the efforts of the Jurisdiction Working Group, the Blockchain Modality Working Group is considering commercial and regulatory issues relating to application of blockchain technology in the financial markets and financial services industry, and the Self-Regulatory Organization Working Group is considering issues for potential implementation of self-regulation with respect to markets for digital assets.

On March 29, 2019, Section members and guests enjoyed a most interesting presentation by guest speaker Chris Gear, the vice-president of team operations and general counsel for Canucks Sports and Entertainment, which owns the Vancouver Canucks Hockey Club and Vancouver Warriors Lacrosse Club.

Chris reminded the audience of the fact that sport has become big business, and referring to the applicable laws as “sports law” is something of a misnomer; more accurately it involves the application of business law discipline to the sport context. Sport franchises are valued in the billions of dollars, and players are paid millions, sometimes hundreds of millions. Sport activities and the collateral aspects of those activities are often focal points in building cities and communities. Their activities are complex businesses that operate within the existing social and legal orders.

Sport, like all of society, continually evolves, as does its footprint. Chris gave the example of the rise of e-sport, which like it or not is now a factor. His company has already invested in the sector, particularly the competitive gaming aspects. In respect of the phenomenon, like any responsible business investment in something new, he sought “expert” advice. Although he could understand why individuals might have an interest in playing e-sports, why would people would pay to watch (often in specially constructed facilities) other people play e-sports, from which the players earn considerable income? The 12-year old expert’s perspective on this was simply, “Dad, you watch other people playing hockey for a living.” There will be much more of this to come.

The seminal events that brought Chris to sports occurred in 1984, when the Edmonton Oilers won the first of five Stanley Cup championships, led by the Great One, Wayne Gretzky, and when Los Angeles hosted the Olympic Games. This led to business school, followed by law school and subsequent professional experience in M&A, corporate finance, and related fields. His insertion in the sports field came from volunteer involvement in an annual PGA golf tournament sponsored by Air Canada, which helped him to understand the needs of sponsors and broadcasters. When Vancouver decided to bid for the 2010 Winter Olympic and Paralympic Games, Chris volunteered to work on the bid as an investment in the community at large.

After Vancouver won the bid, the chief legal officer of the organizing committee offered him a job on the legal team for the ensuing five to six years. It was a whirlwind experience, with long, difficult, but inspiring, work and some 5,000 contracts, for which there were precious few useful precedents (given that the preceding Olympic Games were held nin China, Italy, and Greece). They encountered the usual range of problems, from a lack of snow, interference with the torch relay, and initial bad weather that, fortunately, cleared up by the fourth day of the games.

During his time with the Canucks, there have been several legal issues to face, which have included legal proceedings arising from the career-ending injury of an NHL hockey player that took forever to resolve, including jurisdictional issues (whether the case should be resolved in civil court or within the NHL structure, and whether the injury was a personal or club responsibility) and a quantum of applicable damages. Other legal proceedings arose in the context of a trademark of the Vancouver Millionaires, a hockey club that had won the Stanley Cup in 1915, before the NHL was formed. The trademark had been acquired by a squatter, who sold t-shirts with a registered mark. The owner, a hard-rock performer named Thor (but off-stage a reasonable, mild-mannered Clark Kent), agreed to sell it, and the Vancouver team wore the jerseys in an NHL game commemorating the 1915 Stanley Cup winners.

The matter of trademarks is one of the most valuable assets for any professional team, which must be able to protect the rights it has granted to marketing partners and sponsors. A local Honda dealership jumped on the Canucks playoff bandwagon and portrayed itself as (in effect) a Canucks partner, painting the dealership in Canucks colours and generally occupying a great deal of Canucks “space.” This, of course, was not appreciated by the official Canucks sponsor in the automotive category, General Motors. The team sent a cease-and-desist letter to the dealership, which then took it to a local radio station and had it read over the air, painting the Canucks in a bad light. The learning experience for the team was that it had not explained in advance to the public how important it was to the Canucks that the rights granted be respected by the community at large.

An emerging set of rights relates to players. To what extent does a player retain the rights to her or his image, and to what extent does the club or organization own those rights? One solution to the dilemma was to create a group licence, under which the clubs could use four or more players in a club promotion, whereas in promotions involving three players or less, the individual players retained their personal rights, and their consent would be required. A local professional hockey team had a promotion for Canucks Water, using the portraits of four players on water bottles, under the group licence agreement. The agent for one of the four complained that the players union had no right to use his client’s image. The club immediately removed his image and found another player, who then trumpeted around town that they had had to change the complaining player’s bottles because those bottles tasted like piss. What comes around, goes around!

In his current role with the Canucks Management Team, Chris deals on a daily basis with risk management, governance, venue, and other agreements; player compensation; dealerships; sponsorships; the evolving e-sports; and concessions. He considers that sports are good for society and the local community. As he says, “We are all Canucks.”

During the Q & A following his initial remarks, Chris was asked what innovations were being adopted to make the game of hockey more interesting for spectators. Chief among these were the use of chips in the pucks and players’ uniforms to enable better tracking of the movements of both the players and the puck and better replays to demonstrate how plays developed, all as supplementary information for the fan base. There is also the possible use of biometric data and statistics (such as heartbeat, speeds, etc.) if such data is not used improperly, such as a club refusing to pay a large (or long-term) salary to a player who was shown by the biometric data to have an irregular heartbeat.

As we enter the 2019 proxy season, we want to bring your attention to a few topics that are likely to play a prominent role in the coming months.[1] In this article, we discuss some of the significant policy changes adopted by ISS and Glass Lewis applicable to the 2019 proxy season and the SEC’s continued focus on non-GAAP measures.

1. ISS PROXY VOTING POLICY UPDATES

ISS has updated its proxy voting policies for shareholder meetings held after February 1, 2019. The following is a summary of the significant policy changes:

A. Board Composition—Gender Diversity

For the 2019 proxy season, ISS will not issue an adverse vote recommendation due to lack of gender diversity. It will, however, highlight the lack of gender diversity in its report. For companies in the Russell 3000 or S&P 1500 indices, effective for meetings on or after February 1, 2020, ISS intends to recommend a vote against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis) at companies with no women on the company’s board.

B. Board Accountability—Management Proposals (New)

ISS took note of the use of board-sponsored proposals to ratify existing charter or bylaw provisions during the 2018 proxy season. In particular, ISS noted that several companies “obtained no-action relief to exclude shareholder proposals to adopt or amend the right of shareholders to call a special meeting by seeking ratification of their current provision. Notably, none of these ratification proposals made material changes to the provisions that enhanced shareholders’ rights to call special meetings.”

In response, ISS has adopted a new policy to recommend a vote against/withhold from individual directors, members of the governance committee, or the full board where boards ask shareholders to ratify existing charter or bylaw provisions considering certain enumerated factors.

C. Shareholder Rights—Management Proposals to Ratify Existing Charter or Bylaw Provisions (New)

Under this new policy, ISS will generally recommend a vote against management proposals to ratify provisions of the company’s existing charter or bylaws, unless these governance provisions align with best practice. In addition, in certain instances, ISS could also recommend a vote against/withhold from individual directors, members of the governance committee, or the full board, in certain instances.

Action Items:

• In light of the new gender diversity emphasis, companies without any female board members may wish to include a firm commitment, as stated in the proxy statement, to appoint at least one female to the board in the near term.
• For a company that has included a shareholder proposal or management proposal in its proxy statement, consider expanding disclosure in its next proxy statement regarding the outreach efforts by the board to shareholders in the wake of the vote and the level of implementation of that proposal.

2. GLASS LEWIS

In late October 2018, Glass Lewis published its updated U.S. policy guidelines and 2019 shareholder initiatives policy guidelines. The following is a summary of some significant changes to the guidelines that are in effect for annual meetings held after February 1, 2019, except as noted below.

A. Board Gender Diversity

For meetings held after January 1, 2019, Glass Lewis will generally recommend voting against the nominating committee chair of a board that has no female members. Glass Lewis may extend this recommendation to vote against other nominating committee members depending upon several factors, including the size of the company, the industry in which the company operates, and the governance profile of the company. This policy does not necessarily apply to companies outside the Russell 3000 index or those that have provided a robust explanation for not having any female board members.

B. Conflicting and Excluded Proposals

Glass Lewis has updated its policy related to “conflicting” management proposals, and in those instances where a special meeting shareholder proposal is excluded as a result of “conflicting” management proposals, it will take a case-by-case approach, taking into account the following issues: (1) the threshold proposed by the shareholder resolution; (2) the threshold proposed or established by management and the attendant rationale for the threshold; (3) whether management’s proposal is seeking to ratify an existing special meeting right or adopt a bylaw that would establish a special meeting right; and (4) the company’s overall governance profile, including its overall responsiveness to and engagement with shareholders. Glass Lewis noted that it generally favors a 10–15 percent special meeting right and will generally recommend voting for management or shareholder proposals that fall within this range.

With respect to conflicting proposals, Glass Lewis will generally recommend in favor of the lower special meeting right and will recommend voting against the proposal with the higher threshold. In addition, where there are conflicting management and shareholder proposals, and a company has not established a special meeting right, Glass Lewis may recommend that shareholders vote in favor of the shareholder proposal and that they abstain from a management-proposed bylaw amendment seeking to establish a special meeting right.

Glass Lewis also noted that, in certain, very limited circumstances where the exclusion of a shareholder proposal is “detrimental to shareholders,” it may recommend against members of the governance committee.

C. Environmental and Social Risk Oversight

Glass Lewis states that “an inattention to material environmental and social issues can present direct legal, financial, regulatory and reputational risks that could serve to harm shareholder interests,” and that these issues should be carefully monitored and managed by companies, including ensuring that there is an “appropriate oversight structure in place to ensure that they are mitigating attendant risks and capitalizing on related opportunities to the best extent possible.” The key is to have appropriate board-level oversight of material risks to a company’s operations.

In certain instances where “a company has not properly managed or mitigated environmental or social risks to the detriment of shareholder value, or when such mismanagement has threatened shareholder value, Glass Lewis may consider recommending that shareholders vote against members of the board who are responsible for oversight of environmental and social risks.” In instances where there is no explicit board oversight on these issues, Glass Lewis states that it may recommend that shareholders vote against member of the audit committee.

Action Items:

• A company that finds itself without any female board members should provide a sufficient rationale for not having any female board members. Issues addressed in explaining the rationale could include a disclosed timetable for addressing the lack of diversity on the board and any notable restrictions in place regarding the board’s composition, such as director nomination agreements with significant investors.
• A company that qualifies as a Smaller Reporting Companies (SRC) under the new SEC guidelines should consider retaining the full CD&A disclosure, rather than taking advantage of the reduced disclosure requirements available to a SRC.

3. NON-GAAP MEASURES—EQUAL OR GREATER PROMINENCE

On December 26, 2018, the SEC settled charges with a public company that its disclosure gave undue prominence to non-GAAP financial measures included in two earnings releases in violation of section 13(a) of the Exchange Act and Rule 13a-11 thereunder. Although not admitting the factual basis of the charges, the public company agreed to cease and desist from future violations and agreed to pay a civil penalty of $100,000.

Action Items:

• Issuers should review their use of non-GAAP financial measures in SEC filings and earnings releases in light of the May 2016 CD&Is and the SEC’s recent action. Issuers should pay particular attention to ensuring that they present GAAP measures with “equal or greater prominence” whenever they present non-GAAP measures.
• The SEC will measure for “equal or greater prominence” within each particular section of the relevant filing or release. If a headline mentions a non-GAAP measure, then that headline should also mention the comparable GAAP measure. If a group of bullet-pointed highlights mentions a non-GAAP measure, then the bullets should also mention the comparable GAAP measure. Providing the comparable GAAP measure later in a filing or release (or in a footnote) is not sufficient.
• Practically, even though “equal or greater prominence” is the standard used in Regulation S-K, issuers should aim for GAAP measures to have greater prominence than any non-GAAP measures. This means using the comparable GAAP measure first, and before any comparable non-GAAP measure, and highlighting the GAAP measure to a greater degree than the non-GAAP measure. Issuers should also carefully review the use of any non-GAAP measures that indicate an improving picture of the issuer’s finances, where the comparable GAAP measure would indicate the opposite.
• Although the SEC has been willing to allow issuers to correct their disclosures in future filings, this action indicates that the SEC believes that it has provided issuers with enough advance notice of its position on undue prominence of non-GAAP measures, and that the grace period it provided for compliance may be coming to an end.

The 2019 proxy season is well underway, and the topics noted above are a few items that are expected to generate some interesting headlines.

[1] This article is based on a series of Proxy Season client alerts we published in early 2019. The full series is available here <https://www.dlapiper.com/en/us/insights/publicationseries/2019-proxy-season-hot-topics/>.

Indictments are often viewed as a death knell for a publicly traded company. As a result, whenever a government investigation involves a potential criminal penalty, obtaining a civil or administrative resolution in lieu of a criminal resolution is typically viewed as a favorable outcome for the company. Fares v. Smith[1] highlights that civil administrative actions by components of the U.S. Department of the Treasury (Treasury) can be as devastating for a company as a criminal indictment. Moreover, although an indictment at least requires a grand jury to find that probable cause exists to support criminal charges, Treasury can immediately act without an independent review, and any after-the-fact judicial review of Treasury’s determinations is severely limited.

The Fares matter stemmed from an administrative action taken by Treasury’s Office of Foreign Assets Control (OFAC) that essentially killed a global business: OFAC issued a blocking order that immediately caused the shutdown of a duty-free enterprise that earned over $600 million in revenue in 2015 and employed more than 5,000 individuals throughout Latin America.[2] Although OFAC provides a nominal path for administrative reconsideration,[3] this type of proceeding effectively shifts the burden of proof, requiring the company seeking reconsideration to provide evidence as to why it does not satisfy the criteria for the blocking that OFAC has already imposed. Such a burden requires a business entity to do the nearly impossible work of proving a negative—that it is not engaged in unlawful transactions. The challenging party in Fares did not fare well when it sought judicial review: the court not only granted substantial deference to agency determinations, but citing national security, law enforcement sensitivities, and confidentiality restrictions, also allowed OFAC to withhold substantial portions of the evidence upon which the government relied in making its determination.

The decision in Fares illustrates the challenges with successfully obtaining judicial review of an adverse finding by Treasury. Therefore, the best approach is to take all reasonable steps to avoid being in a situation where judicial review is even necessary through a robust compliance program that identifies and reviews potentially problematic transactions before they become so great that Treasury decides to take administrative action.

Background on Fares v. Smith

In Fares, the plaintiffs asserted due process violations against OFAC for freezing their assets under the Foreign Narcotics Kingpin Designation Act (Kingpin Act).[4] The Kingpin Act authorizes the president to block the U.S. assets of “foreign person[s] that play a significant role in international narcotics trafficking,” referred to as “significant foreign narcotics traffickers.”[5] The secretary of Treasury can derivatively designate foreign persons who “materially assist” or provide “financial or technological support” or “goods or services in support of the international narcotics trafficking activities of” a significant foreign narcotics trafficker.[6] The secretary can also derivatively designate foreign persons deemed to be “owned, controlled, or directed by, or acting for or on behalf of, a significant foreign narcotics trafficker,” or foreign persons who “play[] a significant role in international narcotics trafficking.”[7] Foreign persons designated under the Kingpin Act are referred to as “specially designated narcotics traffickers” (SDNTs).[8]

A designation under the Kingpin Act immediately freezes “all . . . property and interests in property within the United States, or within the possession or control of any United States person, which are owned or controlled by” the designated person.[9] There is no prior notice. A foreign person is permitted to see the unclassified, nonprivileged basis for the designation and seek administrative reconsideration only after getting designated and having all of his or her assets blocked.[10] OFAC will typically disclose a heavily redacted, unclassified administrative record, primarily consisting of news articles and other publicly available information.[11] OFAC can provide an unclassified summary of the classified information upon which it relied for the designation, or even allow counsel with security clearances to view the classified record, but it is often not required to do so.[12] To seek reconsideration, a designated party usually must complete a detailed questionnaire from OFAC and ultimately make a written submission.[13] There are essentially two grounds for delisting: an insufficient basis for the designation or a subsequent change in circumstances.[14]

In Fares, OFAC designated two Panamanian men and the companies they controlled as SDNTs for allegedly laundering money on behalf of multiple international drug traffickers.[15] The companies they controlled, including a company that sold duty-free goods internationally, had hundreds of millions of dollars in revenue and thousands of employees.[16] A few weeks after the designation, the plaintiffs requested OFAC to reconsider its decision, arguing that the designation would cause permanent adverse consequences and that they should be allowed to put their assets into trusts managed by independent persons approved by the U.S. government.[17] OFAC denied the initial request for reconsideration, but agreed to begin production of the administrative record.[18] One month later, OFAC produced the administrative record in two batches, and it was “very heavily redacted” because OFAC maintained that “law enforcement sensitiv[e]” or other forms of “privilege” required the almost complete redaction of the evidence underlying the designation.[19]

About a month after that, the plaintiffs filed suit against OFAC, arguing that OFAC failed to adequately disclose the basis for their designations and therefore did not provide sufficient notice under the Due Process Clause of the Fifth Amendment.[20] Only one day after the plaintiffs filed suit, OFAC provided a “terse[,] . . . two[-]paragraph,” unclassified summary of the evidence underlying the redacted portions of the administrative record.[21] Two months later, OFAC produced “a more substantial summary spanning several pages.”[22] After reviewing the entire record disclosed by OFAC, including the summaries disclosed months after the plaintiffs filed suit, the district court held that “the total body of information” gave the designated parties adequate notice and, therefore, satisfied due process.[23] In particular, unlike other challengers to OFAC’s blocking actions, “who were left in the dark as to the reasons for their designations,” the plaintiffs in Fares were “apprised, primarily via the [more substantial summary provided two months after they filed suit], of the government’s view regarding the basis for their designations, and as such, [could] meaningfully” rebut OFAC’s evidence and arguments.[24]

The D.C. Circuit affirmed the district court’s ruling, but it viewed the issue before it to be very narrow, holding that it essentially had no choice but to rule in OFAC’s favor because the plaintiffs in Fares declined to challenge the unclassified summaries, their involvement in money laundering, the nonspecific nature of the summaries, or the scope or legitimacy of the government’s “sweeping redactions to the administrative record.”[25] Rather, the court found that the plaintiffs in Fares chose to “present a single claim on a single theory[,] . . . insist[ing] that the court . . . order the agency to turn over the actual underlying evidence (or details regarding that evidence that would aid them in identifying its sources), or else require the agency to delist plaintiffs.”[26] The court held that this “all-or-nothing argument” was unavailing and decided the matter based on the narrow issue the plaintiffs in Fares chose to present.[27] To be sure, the D.C. circuit court, in dicta, signaled an openness to consider the broader due process concerns presented by the government’s ability to rely on heavily redacted administrative records,[28] particularly when the government cites law enforcement interests as opposed to national security concerns.[29] Although the dicta might provide cause for hope, it does not provide binding authority with which a designated entity can challenge the current practice of extensively redacting the administrative record.

The Importance of Compliance

Once a company is in the crosshairs of a Treasury component like OFAC and receives notice of an administrative action, the odds are already heavily stacked against the company. For large companies, such as the duty-free company in Fares, which process thousands of transactions each day, rebutting allegations from publicly available news articles and short summaries of confidential or classified information will essentially require a company to prove a negative—that it is not involved in unlawful activity—an endeavor that will require a costly and time-intensive review of tens, if not hundreds, of thousands of transactions that occurred during whatever multiyear period is under investigation. Even after such a review is completed, there is no guarantee that the review will directly address, or address to OFAC’s satisfaction, all of the specific transactions reflected in the classified, or otherwise confidential, portions of the evidence upon which OFAC relied but has withheld.

These substantial procedural and evidentiary obstacles highlight the need to take the necessary steps to maximize the likelihood that OFAC will not even consider initiating one of these administrative actions. Companies should work with outside counsel to ensure that they have a robust, state-of-the-art compliance program in place that minimizes the likelihood that sustained, violative transactions might occur and that can be lauded if some violative transactions do nevertheless occur. The immediate and substantial penalties associated with administrative action, coupled with minimal opportunity for agency or judicial review, make it incumbent on companies to do everything within their power to be proactive and to avoid an SDNT designation or any other comparable designation. As Fares demonstrates, obtaining post-designation relief can be challenging. For many businesses, designation in and of itself may be a fatal blow, and even if the business survives that blow, the prospects for relief through reconsideration can be dim.

[1] Fares v. Smith, 249 F. Supp. 3d 115 (D.D.C. 2017), aff’d, 901 F.3d 315 (D.C. Cir. 2018).

[2] Fares v. Smith, No. 16-1730 (CKK), at Dkt. No. 1 (Compl.) ¶ 7 (D.D.C. filed Aug. 25, 2016).

[3] 31 C.F.R. § 501.807 (setting forth administrative reconsideration process that, inter alia, requires Treasury to “provide a written decision to the blocked person”).

[4] Fares, 249 F. Supp. 3d at 118.

[5] 21 U.S.C. §§ 1903(b), 1907(7).

[6] Id. § 1904(b)(2).

[7] Id. § 1904(b)(3)–(b)(4).

[8] See 31 C.F.R. §§ 598.803, 598.314.

[9] 21 U.S.C. § 1904(b).

[10] See 31 C.F.R. § 501.807.

[11] Fares, 249 F. Supp. 3d at 125. See also Sulemane v. Mnuchin, No. 16-1822 (TJK), 2019 WL 77428, at *5–*7 (D.D.C. Jan. 2, 2019) (rejecting arguments that OFAC’s reliance on “open-sourced” news articles violated the Administrative Procedures Act).

[12] See, e.g., Al Haramain Islamic Found., Inc. v. U.S. Dep’t of Treasury, 686 F.3d 965, 983 (9th Cir. 2012).

[13] See, e.g., Kadi v. Geithner, 42 F. Supp. 3d 1, 29 (D.D.C. 2012).

[14] 31 C.F.R. § 501.807(a).

[15] Fares, 249 F. Supp. 3d at 119.

[16] U.S. Treasury Office of Foreign Assets Control, “Treasury Sanctions the Waked Money Laundering Organization” (May 5, 2016); 81 Fed. Reg. 28,937 (May 10, 2016); Fares v. Smith, No. 16-1730 (CKK), at Dkt. No. 1 (Compl.) ¶ 7 (D.D.C. filed Aug. 25, 2016).

[17] Fares, 901 F.3d at 319.

[18] Id. at 319–20.

[19] Id. at 320.

[20] Id.

[21] Id.

[22] Id.

[23] Fares, 249 F. Supp. 3d at 127.

[24] Id.

[25] Fares, 901 F.3d at 322–23.

[26] Id. at 323.

[27] Id. at 323–26.

[28] Id. at 324–25.

[29] Id.

The requirements of the Bank Secrecy Act (BSA) and anti-money-laundering laws (AML) are pervasive and longstanding, yet they continue to vex companies trying to comply with them. Regulators have hit virtually all large banks, and many nonbanks, with BSA/AML-related enforcement actions, resulting in large fines, deferred prosecution agreements, criminal consequences, and reputational damage.

New BSA/AML requirements are making compliance more, not less, challenging. The Financial Crimes Enforcement Network’s Customer Due Diligence Rule,[1] for example, will add to compliance costs and could contribute to further de-risking of bank accounts for money services businesses and other customers. This has made it more difficult for customers to maintain accounts and added to the demanding nature and already high cost of BSA/AML compliance.

The nexus between BSA/AML requirements and law enforcement and national security concerns will ensure that compliance remains a top priority for regulators and the Department of Justice. Understanding exactly what is required of an institution from a BSA/AML perspective is therefore more critical than ever.

Background

Enacted in 1970, the BSA is primarily a recordkeeping and reporting statute. Its purpose is to require certain reports or records where they have a high degree of usefulness in criminal, tax, or regulatory investigations or proceedings, or in the conduct of intelligence or counterintelligence activities, including analysis, to protect against international terrorism.[2]

Tax evasion was the BSA’s initial purpose, but it subsequently became a primary weapon in the fight against narcotics, money laundering, terrorist financing, human trafficking, elder abuse, and other illicit activity. The Patriot Act,[3] enacted shortly after 9/11, expanded the BSA beyond banking, and now most nonbank financial institutions have BSA-related obligations, including compliance programs and suspicious-activity reporting. Even entities not subject to the BSA often assume compliance responsibilities because they contract with an entity subject to the BSA.

Chief among this expanded scope of institutions subject to the BSA are money services businesses (MSBs)—money transmitters, check cashers, providers of prepaid access, and dealers in foreign exchange, among others—and residential mortgage loan originators (RMLOs). The specific requirements for these categories of institutions are discussed in detail below.[4]

Requirements for MSBs

Compliance program. The fundamental requirement for MSBs under the BSA is the development and implementation of a BSA/AML compliance program that is reasonably designed to prevent the MSB from being used to facilitate money laundering and the financing of terrorist activities. The written compliance program must be commensurate with the risks posed by the location and size of, and the nature and volume of the financial services provided by, the MSB and made available for inspection by the Department of the Treasury.

These programs must incorporate what are referred to as the four pillars:

1. policies, procedures, and internal controls that are reasonably designed to assure compliance with the BSA, including procedures to verify customer identification (applicable only to providers or sellers of prepaid access), file reports, maintain records, and respond to law enforcement requests;
2. a designated person to assure day-to-day compliance with the program;
3. education and training of appropriate personnel; and
4. independent review to monitor and maintain an adequate program.

Registration. MSBs (other than providers of prepaid access) are required to register with FinCEN and renew that registration every two years; states in which the MSB does business often require registration as well. Agents generally do not have to register.

Reporting. MSBs have specific reporting requirements, the most important of which are currency transaction reports (CTRs) on cash transactions exceeding $10,000 and suspicious-activity reports (SARs) on suspicious transactions exceeding $2,000. MSBs must retain CTRs and SARs for five years from the date of filing.

An MSB may disclose SARs to only a limited group: FinCEN; a federal authority (such as the IRS) or state authority with power to examine the MSB for compliance with the BSA; and federal, state, and local law enforcement. Strict confidentiality requirements apply, with criminal penalties for unauthorized disclosure. The business may share facts, transactions, and documents underlying a SAR with other institutions and, in limited circumstances (permitted by regulation or regulatory guidance), may share the actual report within the organization. MSBs are protected from civil liability extending from SAR filings. FinCEN and its delegates are responsible for examining MSBs for compliance with these requirements.

Requirements for RMLOs

RMLOs are subject to program requirements that are similar to those applicable to MSBs. Although RMLOs are not required to submit CTRs, they are required to file similar reports (Form 8300) when receiving cash payments over $10,000. They are also subject to SAR requirements, although the filing threshold is $5,000. The SAR recordkeeping and confidentiality requirements also apply, as well as the safe harbor from civil liability. As with MSBs, FinCEN and its delegates conduct compliance examinations.

Sanctions

Sanctions are not formally part of the BSA, but are related and important. Compliance with the sanctions regime is required for all U.S. persons, not just financial institutions. The Office of Foreign Assets Control (OFAC) is responsible for administering U.S. sanctions. There is no formal program requirement, but regulators expect banks and most nonbank financial institutions to have an effective filtering process in place to screen accounts and transactions for the involvement of individuals and entities that are on the Specially Designated Nationals and other lists or are OFAC-sanctioned jurisdictions, such as Iran and North Korea. Companies are expected to block or reject (depending on the exact sanctions) attempted transactions that result in hits and report them to OFAC. Sanctions compliance has been under intense scrutiny in recent years, and violations have resulted in large fines.

Conclusion

Although nonbanking institutions are not regulated for BSA/AML and sanctions compliance to the same degree that banks are, they are widely perceived as vulnerable to illicit activity and therefore subject to significant scrutiny. Enforcement agencies include FinCEN, DOJ, and OFAC as well as federal, state, and local regulators. As fines over many years have made clear, the costs of getting it wrong in this area can be severe. Institutions subject to the BSA/AML requirements should therefore take care to develop, implement, and maintain procedures covering the following areas:

• risk assessment
• customer identification
• customer due diligence/enhanced due diligence (CDD/EDD)
• customer risk rating
• monitoring
• investigation
• SARs
• CTRs

The primary purpose of these procedures is to help companies develop a deep enough understanding of their customers to be aware of which ones present AML risks, and then help companies successfully manage those risks while identifying and reporting suspicious transactions.

Given the expanding role of nonbanking institutions in the payment system and the overall economy—and the persistent focus on money flows implicating national security or law enforcement concerns—BSA/AML compliance is poised to be an area of increasing importance for the foreseeable future.

[1]  See Customer Due Diligence Rule, 31 C.F.R. § 1010.230.

[2] See Bank Secrecy Act, 31 U.S.C. § 5311 et seq.

[3] See Pub. L. No. 107-56, 115 Stat. 272 (2001).

[4] Much of the subsequent discussion of the requirements of BSA/AML laws and related compliance obligations are descriptions drawn from 31 C.F.R. §§ 1010, 1020, and 1029. For more information, see https://www.law.cornell.edu/cfr/text/31/subtitle-B/chapter-X.

INTRODUCTION

For much of 2018, Canada was the focal point of the global cannabis industry due mainly to Canada’s federal legalization of cannabis for recreational purposes, which occurred on October 17, 2018. Fueled by optimism surrounding both Canadian and global prospects, we saw a significant uptick in capital raising in the cannabis industry, with nearly US$13.8 billion raised in 2018, up from US$3.5 billion in 2017. Much of this capital raising activity was a result of U.S. cannabis companies that looked north of the border for access to capital markets.

Despite being only 6 months removed from legalization, Canadian licensed producers (LPs) appear to have shifted their focus to (i) developing “next generation” products, such as edibles and “vapes,” which are set to become legalized in Canada in October 2019, but which have been legal for some time in certain U.S. states, such as Colorado, California and Washington, and (ii) implementing a rest-of-world strategy that includes exposure to the U.S. cannabis market—both resulting in an increasing number of transactions reaching across the border. As U.S. clients are requiring more and more guidance from counsel, U.S. law firms are grappling with how to advise with respect to both the Canadian and U.S. cannabis industries.

With respect to the development of next generation products, significant investments from major U.S. alcohol and tobacco companies have given credibility to the Canadian cannabis industry and provided certain players with an experienced partner for the next phase of legalization (both domestically and abroad). Constellation Brands (Constellation), a leading international producer of wine, beer and spirits, made a US$4 billion investment in Canopy Growth Corporation (Canopy). The investment closed in November 2018 and brought Constellation’s ownership stake in Canopy to approximately 37%. In December 2018, Altria Group Inc. (Altria), parent company of Philip Morris USA, announced a US$1.8 billion investment in Cronos Group Inc. (Cronos), representing a 45% ownership interest in Cronos.

With respect to exposure to the U.S. market, the enactment of the 2018 Farm Bill in the U.S., which created a federally legal environment for the cultivation, distribution and sale of industrial hemp, has provided an opportunity for Canadian LPs to establish a toe-hold in the U.S. market after having previously been denied access due to the restrictions of the major Canadian and U.S. stock exchanges against operations which are offside U.S. federal law. The significance of the Farm Bill stems from the presence of the non-psychoactive cannabinoid, cannabidiol (CBD), which is found in industrial hemp and for which the Brightfield Group has estimated a potential market of US$22 billion by 2022 in the U.S. alone.

Canadian LPs, including Canopy and Tilray Inc. (Tilray), have already taken advantage of the liberalized U.S. hemp laws to establish a presence south of the border. On October 15, 2018 Canopy announced that it had entered into an agreement to acquire the assets of Ebbu, Inc., a  Colorado-based hemp research leader. Canopy has also taken a step toward establishing a cultivation presence in the U.S. by announcing on January 14, 2019 that it had been granted a licence by New York State to process and produce hemp. Canopy stated that it intends to invest between US$100 million and US$150 million toward the establishment of large-scale production capabilities focused on hemp extraction and product manufacturing within the U.S. Tilray, meanwhile, announced the acquisition of Manitoba Harvest, a Canadian hemp-based food processor with products currently sold in grocery store chains throughout Canada and the U.S. The company has been developing products containing hemp-derived CBD and plans to enter the U.S. CBD market once approved by the FDA.

CONSIDERATIONS FOR US LAW FIRMS

Cannabis continues to be a Schedule I narcotic under the federal Controlled Substances Act in the US. We have found little evidence of enforcement of federal law against cannabis companies operating within states that have established a legal framework, but, despite this, U.S. law firms have understandably been hesitant to provide legal services to companies that operate in the cannabis space. However, as was the case in Canada, the volume of activity in the space and the involvement of well-established, “traditional” clients have necessitated that major U.S. law firms become familiar with both the U.S. and Canadian cannabis industries.

The primary consideration from a U.S. legal perspective is that providing advice to a company that operates in violation of U.S. federal law, regardless of compliance with state cannabis laws, could be seen as aiding and abetting in the commission of a federal crime. Furthermore, a firm that accepts payment for such services could be in receipt of proceeds of crime under applicable anti-money laundering statutes. However, to advise a cannabis company that operates exclusively in Canada, or any other jurisdiction which has a legal framework regulating cannabis, does not appear to be a violation of U.S. law. As a result, many U.S. law firms have gotten comfortable advising cannabis companies that do not have U.S. cannabis operations, such as Canopy and Tilray. Similarly, U.S. law firms have gotten comfortable advising U.S. companies who do business with cannabis companies that operate solely outside of the U.S., such as Constellation, Altria and other U.S. investors.

U.S. law firms should take comfort from the policies of major stock exchanges (the TSX and TSX-V in Canada, and the NYSE and NASDAQ in the U.S.), which prohibit the listing of cannabis companies that operate in violation of U.S. federal law. Although such issuers are subject to continuous monitoring by the exchanges, law firms are best advised to conduct their own diligence prior to agreeing to act on behalf of any cannabis company.

Another consideration that has provided some comfort for U.S. law firms with respect to aiding and abetting in the commission of a federal crime is the degree to which a prospective client “touches the plant.” Any company that cultivates, processes, or sells cannabis would be said to “touch the plant”—these are the clients that U.S. law firms have been most hesitant to advise. However, as the degree of contact with the plant decreases, the comfort with providing legal services increases. For example, a client that is providing security systems or hydroponic lights to in the cannabis industry is generally viewed as a much less risky client than one that directly touches the plant.

Even still, some U.S. law firms have gotten comfortable advising clients that touch the plant with the reasoning that general corporate, securities and transactional advice is not aiding and abetting the commission of a crime, as they are not advising on any matter that is a violation of federal law.

One final concern expressed by some U.S. law firms is that of reputational risk. There remains a degree of stigma associated with cannabis use, and that is considered by the general counsel and ethics committees of law firms when deciding whether to accept a cannabis-related mandate. Furthermore, as a relatively nascent sector, the cannabis industry has experienced some growing pains in both Canada and the U.S. in the form of questionable dealings by executives and directors. Many firms fear the prospect of seeing their name alongside their client’s in a news story regarding unscrupulous behaviour.

Ultimately, the level of comfort a law firm has with working in the cannabis space exists on a spectrum. Many large firms simply won’t advise on cannabis-related matters. Others have taken a cautious approach, working exclusively on deals that do not involve U.S. cannabis operations or with companies that are several steps removed from touching the plant. At the opposite end, there are those that have leapt headfirst into the industry, advising U.S.-focused clients that do in fact touch the plant, with an eye toward establishing a first-mover advantage in the industry and “being on the right side of history.”

LOOKING FORWARD

Even for firms that have avoided the cannabis industry to date, the reality in the U.S., as it was in Canada, is that traditional firm clients, whether it be investment banks, retailers, pharmaceutical or consumer packaged goods companies, will get involved in the cannabis space and firms will need to get smart in a hurry.

Federal legalization of cannabis in the U.S. appears to be on the horizon, whether it be as part of a 2020 election campaign or sometime prior. We expect that there will continue to be interest in U.S. hemp and cannabis assets from Canadian LPs in the interim and expect that there will be an explosion of activity in the form of capital raising and domestic M&A upon federal legalization in the U.S. At that time, firms that have developed experience, expertise and relationships in the cannabis industry will be well positioned to capitalize on the opportunity.

Recent months have been busy for banking lawyers focused on the cannabis industry and the legal and regulatory risks of providing financial services to marijuana-related businesses. Of principal note, in mid-December, President Trump signed the Agriculture Improvement Act of 2018 (the 2018 Farm Bill) into law, which lifted the federal prohibition on hemp production. This law also has significant implications regarding the legality of cannabidiol (CBD), a popular hemp derivative. This article will first explain the significance and implications of the 2018 Farm Bill, describe possible divergences in state and federal law regarding cannabis generally, and briefly touch on international developments.

For decades, the United States has been the only industrialized nation where hemp was not a legally authorized crop. Schedule I of the federal Controlled Substances Act of 1970 (CSA), 21 U.S.C. § 801 et seq., has long prohibited the growing, production, and sale of marijuana, which has been defined under the CSA as including all parts of the Cannabis sativa L. plant, with the exception of “the mature stalks of such plant, fiber produced from such stalks, oil or cake made from the seeds of such plant, any other compound . . . of such mature stalks (except the resin extracted therefrom), fiber, oil, or cake, or the sterilized seed of such plant which is incapable of germination.”[1] Hemp has been subject to the marijuana definition because it is also a variety of the Cannabis sativa L. plant. Hemp is characterized by low levels of tetrahydrocannabinol (THC), the primary psychoactive chemical in marijuana, and high levels of CBD, believed to have numerous therapeutic benefits. It is also capable of use in a diverse array of products, including construction materials, clothing, paper, cosmetics, pharmaceuticals, food, and dietary supplements.

Passage of the 2018 Farm Bill marks the first change in the federal classification of marijuana since Congress designated it a Schedule I controlled substance in 1970. Specifically, the 2018 Farm Bill’s hemp-specific provisions amend the CSA so that hemp, so long as it contains 0.3 percent THC or less, no longer comes within the federal definition of marijuana.[2] Certain cannabinoid derivatives of hemp would therefore also be removed from the purview of the CSA, including hemp-derived CBD. The 2018 Farm Bill’s hemp provisions build on the framework set forth in the 2014 farm bill, which allowed for some legal cultivation of hemp by states. The previous iteration of the farm bill allowed cultivation of hemp for research purposes under state-approved pilot programs connected to universities or state agricultural departments.[3] Some states declined to participate, however, and the Drug Enforcement Agency often took the position that the 2014 farm bill allowed only for the cultivation, not sale, of hemp and hemp-derived products.[4]

Section 10113 of the 2018 Farm Bill allows states to regulate hemp production if they so choose. Otherwise, federal requirements to be promulgated by the U.S. Department of Agriculture (USDA) will constitute the default regulatory regime in all 50 states. States must submit their plans to the USDA for approval prior to becoming effective. USDA review is meant to ensure that state laws comply with at least the minimum level of federal statutory requirements, and the USDA must act within 60 days of receipt. However, the USDA has indicated that it will not begin acting on state plans it receives until it promulgates its own regulations regarding hemp production, which it expects to do in fall 2019.

Under section 10113, state plans must include information concerning locations of hemp production, testing for THC concentration, disposal of noncompliant plants, compliance with the bill’s enforcement provisions, participation in law enforcement information sharing, and a certification that the state has sufficient resources to carry out its plan. These requirements indicate Congress’s desire to maintain a strict legal separation between marijuana and hemp.[5] As an additional step to ensure that marijuana is not grown under the auspices of hemp legalization, the 2018 Farm Bill bars individuals with felonies related to a controlled substance from entering into hemp production for 10 years following conviction.[6]

Notwithstanding hemp’s removal from Schedule I of the CSA, the legality of certain FDA-regulated categories of hemp products—including products containing hemp-derived CBD—remains uncertain at the federal level. Specifically, the 2018 Farm Bill provides that it does not “affect or modify the Federal Food, Drug, and Cosmetic Act [‘FFDCA’] . . . [or] the authority of the Commissioner of Food and Drugs and the Secretary of Health and Human Services.”[7] The U.S. Food and Drug Administration (FDA) has taken the position that cannabinoids, including CBD, are impermissible for use in food and dietary supplements.[8] Despite the existence of counterarguments, at the present time certain CBD products currently on the market, particularly those intended for ingestion, may therefore remain unlawful. The FDA has intermittently sent warning letters to entities that sell CBD products, including dietary supplements and topical cosmetic products, for making unproven drug claims about CBD’s health-related properties.[9] Moreover, FDA Commissioner Scott Gottlieb indicated in a statement released with the passage of the 2018 Farm Bill that the agency will “continue to closely scrutinize products that could pose risks to consumers . . . warn [them] and take enforcement actions.”[10] That said, the FDA is under significant political pressure to take a more relaxed attitude toward these issues. For instance, Oregon Senators Ron Wyden and Jeff Merkley recently sent a letter to the FDA Commissioner arguing that “it was Congress’ intent to ensure that both U.S producers and consumers have access to a full range of hemp-derived products, including hemp-derived cannabinoids.”[11] As a result, the FDA has indicated it will hold a public meeting in the near future to evaluate ways in which the current regulatory framework should be changed.[12]

Another difficulty for stakeholders in the industry will be accounting for the various treatments of hemp and CBD under state law. The 2018 Farm Bill does not preempt state law, and states could choose to regulate hemp and hemp-derived CBD in a more restrictive manner. In fact, it provides: “No Preemption—Nothing in this subsection preempts or limits any law of a State or Indian tribe that (i) regulates the production of hemp; and (ii) is more stringent than this subtitle.”[13] States have their own controlled substances laws that often mimic the provisions of the CSA as it existed prior to the 2018 Farm Bill’s amendments. This means that hemp and certain hemp products may still come within the marijuana definition under state law. Many state attorneys general have even publicly declared—prior to passage of the 2018 Farm Bill—that products containing CBD come within state marijuana prohibitions and are therefore subject to state enforcement.

States have chosen to react to the passage of the 2018 Farm Bill in several different ways. Some have chosen the path of Alabama. Alabama’s attorney general recently announced that because of the 2018 Farm Bill, the state is altering its prior position that the sale of CBD products violates state law.[14] Iowa has chosen to move more cautiously. The state attorney general and state agriculture officials met in January to determine whether CBD processed from industrial hemp should be legalized, and resulting legislation is currently pending.[15] On the other hand, not all states have reacted in tandem with the federal government. The South Dakota attorney general, for instance, confirmed that CBD products would remain illegal in the state and that the law would be enforced.[16] Although state legislators passed a bill legalizing hemp, the South Dakota governor vetoed it, and so the state’s prohibition remains in effect.[17] Participants in the industry, and financial services firms that deal with them, must be cognizant of the laws of states in which CBD products may be distributed.

Looking forward, there is ample evidence that the rules of the road regarding cannabis regulation will continue to evolve. FDA Commissioner Scott Gottlieb has stated that federal legislation addressing the divergence between state and federal law regarding marijuana is “inevitable” and will happen “soon.”[18] Several bills to this effect have already been introduced into Congress this year.[19] Further, it seems that President Trump is amenable to these changes. In June 2018, he said that he supported the STATES Act, which would protect states with legal marijuana regimes from federal interference.[20] He also nominated William Barr for attorney general, who has said that he would not go after companies that have relied on the “Cole Memorandum,” the U.S. Department of Justice guidance issued during the Obama administration directing prosecutors generally not to enforce the federal marijuana prohibition in states that have legalized marijuana (so long as those marijuana activities do not target minors or present other risks).[21] This represents a decidedly less aggressive approach than former Attorney General Jeff Sessions, who rescinded that guidance early last year.

With these federal developments looming in the background, states have continued to legalize marijuana use in different contexts. As of this writing, medical marijuana is legal in 33 states and the District of Columbia, with 10 of these and the District of Columbia also having legalized recreational marijuana. The pace of this change appears to be accelerating: 21 states considered adult-use marijuana legalization bills in 2018.[22] Voter initiatives ushered in legalization in Michigan,[23] Missouri,[24] Oklahoma,[25] and Utah.[26] For financial services companies, whether and how to engage with cannabis companies operating legally under state law will thus present a growing challenge.

Change also is evident both north and south of U.S. borders. Canada’s Cannabis Act was fully implemented as of October 18, 2018; as a result, U.S. financial institutions (and others) have been faced with how to engage with companies conducting legal cannabis business there.[27] Additionally, Mexico’s Supreme Court held in October that an absolute ban on recreational marijuana use is unconstitutional. A bill introduced by the ruling party (the National Regeneration Movement, or MORENA) in November would allow companies to grow and sell marijuana for commercial, medicinal, and recreational use.[28] However, Mexican legislators are still considering how marijuana legalization should be implemented.[29]

These shifting developments continue to pose compliance and legal challenges for financial services firms. Until a final U.S. federal resolution is reached, those challenges will remain present.

[1] 21 U.S.C. § 802(16) (2018).

[2] Agriculture Improvement Act of 2018, Pub. L. No. 115-334, sec. 12619 (2018).

[3] 7 U.S.C. § 5940 (2018).

[4] Statement of Principles on Industrial Hemp, 81 Fed. Reg. 53395 (Aug. 12, 2016).

[5] See 7 U.S.C. § 5940(a)(2); Agriculture Improvement Act of 2018, Pub. L. No. 115-334, sec. 10113, § 297A(1) (2018).

[6] Agriculture Improvement Act of 2018, Pub. L. No. 115-334, sec. 10113, § 297B(e)(3)(B) (2018).

[7] Agriculture Improvement Act of 2018, Pub. L. No. 115-334, sec. 10113, § 297D(c)(1) (2018).

[8] U.S. Food and Drug Admin., FDA and Marijuana: Questions and Answers (June 25, 2018).

[9] See, e.g., U.S. Food and Drug Admin., Warning Letter to Hemp Oil Care (Feb. 26, 2015); U.S. Food and Drug Admin., Warning Letter to Natural Organic Solutions (Feb. 26, 2015).

[10] Statement from FDA Commissioner Scott Gottlieb, M.D., on signing of the Agriculture Improvement Act and the agency’s regulation of products containing cannabis and cannabis-derived compounds (Dec. 20, 2018).

[11] Letter from Ron Wyden & Jeffrey A. Merkley, U.S. Senators, to Scott Gottlieb, FDA Commissioner (Jan. 15, 2019).

[12] See supra note 11.

[13] Agriculture Improvement Act of 2018, Pub. L. No. 115-334, sec. 10113, § 297B(a)(3) (2018).

[14] Office of the Alabama Attorney General, Guidance on Alabama Law Regarding the Possession, Use, Sale, or Distribution of CBD (Dec. 12, 2018).

[15] Associated Press, Iowa Lawmakers To Weigh Hemp Regulations, Keloland Media Group, Jan. 3, 2019.

[16] Christopher Vondracek, South Dakota unlikely to allow CBD oil even though it’s in farm bill, Rapid City J., Dec. 16, 2018.

[17] Lisa Kaczke, What’s South Dakota missing without legal industrial hemp?, Argus Leader, March 22, 2019.

[18] Kyle Jaeger, Federal Marijuana Action Is An ‘Inevitability,’ Trump FDA Chief Says, Marijuana Moment, Nov. 19, 2018.

[19] See, e.g., Regulate Marijuana Like Alcohol Act, H.R. 420, 116th Cong. (2019); Strengthening the Tenth Amendment Through Entrusting States Act, S. 3032, 115th Cong. (2018).

[20] Eileen Sullivan, Trump Says He’s Likely to Back Marijuana Bill, in Apparent Break With Sessions, N.Y. Times, June 8, 2018.

[21] Sarah N. Lynch, U.S. attorney general nominee will not target law-abiding marijuana businesses, Reuters, Jan. 15, 2019.

[22] National Conference of State Legislators, Marijuana Overview (Dec. 14, 2018).

[23] Michigan Proposal 1, Marijuana Legalization Initiative (2018) (recreational).

[24] Missouri Amendment 2, Medical Marijuana and Veteran Healthcare Services Initiative (2018) (medical).

[25] Oklahoma State Question 788, Medical Marijuana Legalization Initiative (2018) (medical).

[26] Utah Proposition 2, Medical Marijuana Initiative (2018) (medical).

[27] Cannabis Act, S.C. 2018, c. 16 (2018) (Can.).

[28] Carrie Kahn, Mexico Looks To Be Next To Legalize Marijuana, NPR, Nov. 14, 2018.

[29] Chris Roberts, Mexican Lawmakers Reach Across Party Lines to Launch Marijuana Reform Process, Marijuana Moment, March 15, 2019.

Often referred to as the intersection between venture capital and leveraged buyouts,[i] growth private equity investment (“growth equity”) has skyrocketed in recent years and continues to draw the attention of limited partners seeking exposure to emerging technology companies with potentially lower risk profiles than those financed at earlier stages of development.[ii] In 2018, growth equity investment reached record levels, with $66.1B invested across 1,057 deals in the United States (“U.S.”) alone.[iii] 2018 also saw the largest-ever growth equity fundraise with the close of New York-based Insight Venture Partners’ $6.3B technology-focused growth equity fund.[iv] This article will provide an overview of growth equity as an alternative investment asset class, and will also discuss its increasingly important presence in the financial technology (“Fintech”) sector.[v]

I. Defining Growth Equity

To date, there is no universally accepted definition of growth equity (also commonly referred to as growth capital or expansion capital) due, in part, to its similarity to other forms of alternative investment. The U.S. National Venture Capital Association (“NVCA”) and its Growth Equity Group have described growth equity as a “critical component” of the venture capital industry, and have defined growth equity investments as those that exhibit some, if not all, of the following characteristics: investors typically acquire a non-controlling minority interest in the company; investments are often unlevered or use only light leverage; the company is founder-owned and/or founder-managed with a proven business model, positive cash flows and rapidly growing revenues; and, invested capital is geared toward company expansion and/or shareholder liquidity, with additional financing rounds typically not expected until the growth equity investor’s exit.[vi] The European Bank for Reconstruction and Development has defined growth equity in a similar way, but has included mezzanine financing within its definition as a result of private equity investment patterns in the emerging Europe and Central Asia regions, which typically consist of combinations of venture, growth and buyout strategies.[vii] 

From the company perspective, growth equity investment, in its varying shapes and sizes, fundamentally serves as a financing mechanism that fuels later-stage expansion into new product and/or geographic markets, often in preparation for a future merger, acquisition or initial public offering. In contrast to multi-investor early-stage venture financing rounds, growth equity investment may provide the company with the benefit of a higher-stake single investor who can provide strategic business and operational guidance that can translate into greater market share and profitability. This benefit, however, can become a double-edged sword for founders as a result of the growth equity investor’s potentially more significant influence over management decisions.

II. Growth Equity Investors

Growth equity investors include, but are not limited to, traditional private equity and venture capital firms that offer growth equity as one of several investment strategies, specialist growth equity firms, strategic corporate investors, and non-traditional institutional investors, such as pension funds and single family offices, which historically have not invested in emerging companies. According to Pitchbook data, the ten most active growth equity investors in 2018 were Business Growth Fund, Bpifrance, Foresight Group, Warburg Pincus, Kohlberg Kravis Roberts, The Blackstone Group, CM-CIC Investissement, Caisse de dépôt et placement du Québec, TPG Capital and General Atlantic. Of the 24 most active growth equity investors in 2018, the majority were concentrated in the U.S., France and the United Kingdom (“UK”), respectively.[viii]

III. Growth Equity Investment in Fintech

From an industry perspective, technology startups are considered attractive growth equity investment targets as a result of their perceived revenue stability and high growth potential.[ix] Software startups in the Fintech sector, in particular, received an aggregate of $11.9B in funding in 2018,[x] and are projected to attract continued interest from growth equity investors in 2019.[xi]

In the UK alone, growth equity investment in the Fintech sector rose by 57% to $1.6B in 2018,[xii] including General Atlantic’s $250M investment in lending startup Greensill Capital and Banco Bilbao Vizcaya Argentaria’s £85.4M investment in mobile-banking platform Atom Bank. In the U.S., recent examples of growth equity investment in Fintech include DST Global’s lead investment into Chime Bank, Goldman Sachs Principal Strategic Investments’ lead investment into Nav Technologies, and Edison Partners’ lead investment into YieldStreet.

With injections of growth equity financing, Fintech startups are able to deepen their domestic market share, as well as their international reach. Growth equity investment in UK Fintech startups, in particular, has contributed to their expansion into the U.S. market. One such example is UK-based small and medium-sized enterprise lending platform Oak North, which plans to launch in the U.S. in 2019 following a $440M growth equity investment from Softbank Vision Fund and the Clermont Group.[xiii]

IV. Conclusion

Growth equity is projected to continue its upward trend as an investment strategy of choice for later-stage investors in the Fintech sector. With higher levels of growth equity invested in promising Fintech startups, Fintech M&A and IPO activity is likely on the way. Private equity and venture capital attorneys should therefore pay close attention to developments in this space.

Disclaimer

The views and opinions expressed in this chapter are those of the author alone, and do not necessarily reflect the views of the American Bar Association, Crowell & Moring LLP, Stanford University or the University of Vienna.  The material in this chapter has been prepared for informational purposes only and is not intended to serve as legal or investment advice.

[i] PitchBook, 3Q 2018 US PE Breakdown (2018). Available at: https://pitchbook.com/news/reports/3q-2018-us-pe-breakdown.

[ii] Preqin, Growth Equity: Return Expectations and Prospects in Growth PE Investing (November 15, 2017).

[iii] PitchBook, 4Q 2018 Pitchbook–NVCA Venture Monitor (2019). Available at: https://pitchbook.com/news/reports/4q-2018-pitchbook-nvca-venture-monitor.

[iv] PitchBook, 3Q 2018 US PE Breakdown (2018).  See also Insight Venture Partners, Software Investor Insight Venture Partners Closes $6.3 Billion Fund X (July 19, 2018).  Available at: https://www.insightpartners.com/about-us/news-press/software-investor-insight-venture-partners-closes-6-3-billion-fund-x/.   

[v] A further detailed report will be featured in the International Comparative Legal Guide to Fintech 2019, to be published in May 2019.

[vi] National Venture Capital Association Growth Equity Group, Defining Growth Equity Investments.  Available at: https://nvca.org/growth-equity-group/.

[vii] European Bank for Reconstruction and Development, EBRD Transition Report 2015-16 (2015).  Available at: https://www.ebrd.com/news/publications/transition-report/ebrd-transition-report-201516.html https://www.ebrd.com/news/publications/transition-report/ebrd-transition-report-201516.html

[viii] PitchBook, 2018 Annual Global League Tables (January 31, 2019). Available at: https://pitchbook.com/news/reports/2018-annual-global-league-tables).

[ix] PitchBook, 1Q 2018 Pitchbook–NVCA Venture Monitor (April 9, 2018).  Available at: https://pitchbook.com/news/reports/1q-2018-pitchbook-nvca-venture-monitor.

[x] American Banker, Money Keeps Flowing to Fintechs (March 14, 2019).  Available at: https://www.americanbanker.com/list/money-keeps-flowing-to-Fintechs.

[xi] CB Insights, Fintech Trends to Watch in 2019 (February 2019).  Available at: https://www.cbinsights.com/research/report/Fintech-trends-2019/.

[xii] Innovate Finance, 2018 Fintech VC Investment Landscape (February 2019).  Available at: https://cdn2.hubspot.net/hubfs/5169784/Innovate-Finance-2018-FinTech-VC-Investment-Landscape.pdf.

[xiii] Finextra, OakNorth raises $440 million for US expansion (February 8, 2019).  Available at: https://www.finextra.com/newsarticle/33346/oaknorth-raises-440-million-for-us-expansion

In a case that could indicate the U.S. Supreme Court’s take on contemporary public attitudes toward the use of profane language and lewd images as trademarks, and have wider implications on the authority of the government to regulate and restrict profanity in other contexts, the court is set to decide whether a century-old provision of the U.S. trademark law, which authorizes the U.S. Patent and Trademark Office (USPTO) to reject registration of a trademark it considers to be “immoral” and “scandalous,” passes constitutional muster under the First Amendment.

The “scandalous clause” contained in section 2(a) of the U.S. Trademark Act instructs the USPTO to reject applications for registration of any mark that “consists of or comprises immoral, deceptive, or scandalous matter; or matter which may disparage or falsely suggest a connection with persons, living or dead, institutions, beliefs, or national symbols, or bring them into contempt, or disrepute.”[1] Invoking this clause, the USPTO rejected an application by Erik Brunetti for the mark FUCT for use in connection with a clothing line. The Trademark Trial and Appeal Board (TTAB) affirmed the examiner’s rejection.[2]

Brunetti appealed the TTAB rejection to the Federal Circuit Court of Appeals. While the appeal was pending, the U.S. Supreme Court issued a landmark ruling in Matal v. Tam,[3] which invalidated the disparagement provision of section 2(a) for being in conflict with the First Amendment’s right of free speech. Relying on Tam and expanding its holding, the Federal Circuit struck down the scandalous clause of section 2(a) as similarly failing the constitutional test of the First Amendment.

The USPTO filed a writ of certiorari to the U.S. Supreme Court requesting review of the Federal Circuit’s Brunetti decision, which the Supreme Court granted.[4] Now the issue for the Supreme Court in Brunetti is whether the analysis and reasoning it applied in Tam to reject the disparagement clause of section 2(a) will result in invalidation of the section’s scandalous clause as well.

Eight of the Supreme Court’s regular nine justices participated in the Tam decision. The justices were unanimous in concluding that the disparagement clause of section 2(a) was unconstitutional, but split on their analysis and approach to the issue, resulting in two plurality opinions penned by justices Alito and Kennedy, each of which was signed by four justices. Both plurality opinions rejected the USPTO’s argument that registering a trademark is a form of government speech and that, under the long-standing Supreme Court precedent, the government is permitted to communicate its own viewpoints without violating the First Amendment. The two plurality opinions also agreed that applying the disparagement clause requires the USPTO to engage in impermissible viewpoint discrimination. The opinions split, however, as to the other arguments put forth by the USPTO urging the court to uphold the disparagement clause. The Alito plurality rejected the government’s argument that allowing a trademark to register is analogous to providing a government subsidy and that the government need not subsidize programs it prefers not to encourage. Finally, Justice Alito’s plurality opinion analyzed the disparagement clause as a form of commercial speech and concluded it could not even pass muster under the more relaxed review standard applied to such speech.

On the other hand, the plurality Tam opinion issued by Justice Kennedy focused its analysis and reached its conclusion based on its application of a viewpoint discrimination test, which it articulated as inquiring into “whether—within the relevant subject category—the government has singled out a subset of messages for disfavor based on the view.”[5] The Kennedy plurality found that in exercising its authority under the disparagement clause, the USPTO necessarily engaged in impermissible viewpoint discrimination sufficient to make it constitutionally untenable. Having reached its conclusion based on viewpoint discrimination, the Kennedy plurality found it unnecessary to address the other government arguments, which the Alito plurality opinion had considered and rejected.

Because both Justice Kennedy and Justice Alito’s plurality opinions converged in their rejections on the viewpoint discrimination effect of the disparagement clause, the Supreme Court is expected to apply that ground and its accompanying reasoning and analysis to the scandalous clause at issue in Brunetti. Thus, the key inquiry in Brunetti may well be whether the USPTO’s exercise of its authority under the scandalous clause amounts to discrimination based on viewpoint. If so, then the clause will follow the fate of its disparaging counterpart and fall. If not, then the scandalous clause is likely to survive constitutional First Amendment scrutiny.

The USPTO regularly applies the scandalous clause provision of section 2(a) to reject marks that contain profane language or graphic sexual images—features that were not at issue in Tam. The application of the scandalous clause thus involves evaluation and judgment by the USPTO as to content of the trademark and not any viewpoint it may convey. It has long been settled that the First Amendment permits governments at the federal, state, and local levels to regulate graphic sexual images and profane language on government-run public forums, such as city buses. Relevant to First Amendment analysis of the USPTO’s trademark registration authority is that although a section 2(a) rejection denies registration of the mark with the USPTO, it does not preclude use of the mark in trade and commerce, given that under U.S. trademark laws the underlying rights in a trademark are obtained not by registration of the mark but by use of the mark to identify goods and services in trade and commerce. An owner of an unregistered mark would still have legal “common law” rights in the mark, which rights can be enforced in courts.[6] Therefore, trademark registration is not a requirement for possession of a legally valid and enforceable trademark.

The Supreme Court may well reverse the Federal Circuit’s Brunetti decision and restore the USPTO’s authority to reject trademarks under the scandalous clause of section 2(a), albeit perhaps on a narrower scale. Under either of Tam’s plurality opinions addressing viewpoint discrimination, the scandalous marks provision survives First Amendment scrutiny because the USPTO practice in this regard is content-based and viewpoint-neutral. A fair reading of Tam makes clear that the Supreme Court did not aim to grant First Amendment protection to words, phrases, and imagery that the general public accepts as profane and lewd, and that government restrictions on such is permitted so long as the restriction policy and practice is based on content and does not advocate or discriminate on the basis of particular viewpoint. In fact, even Justice Alito’s plurality opinion specifically recognizes that trademark registration is “more analogous” to “cases in which a unit of government creates a limited public forum for private speech,” wherein “some content-based restrictions are permitted.”[7]

Those “more analogous” cases have repeatedly upheld content-based restrictions on speech in limited public forums created by the government. For example, the Second Circuit Court of Appeals has upheld a Department of Motor Vehicle policy banning use of profane and lewd language on license plates, finding no First Amendment right to use the SHTHPNS license plate.[8] Governmental bans on the use of nude or sexually explicit imagery in clubs have similarly been held to be viewpoint-neutral. In that regard, the Supreme Court has held that “being in a state of nudity is not an inherently expressive condition.”[9] In another case, the Supreme Court held that the First Amendment did not prevent a school district from restricting the use of an offensive form of expression in a public school debate forum.[10] The decision went on to explain that “nothing in the Constitution prohibits the states from insisting that certain modes of expression are inappropriate and subject to sanctions.”

A compromise approach, suggested by Judge Dyk in his concurring opinion in the Federal Circuit’s Brunetti decision invalidating the scandalous provision of section 2(a), is to adopt a narrower reading of the scandalous provision to limit its application to obscene marks. In that regard, Judge Dyk noted that under the Supreme Court’s time-tested “saving construction” precedents, where possible, courts must construe federal statutes to “avoid serious doubt of their constitutionality.”[11] Moreover, certainty in curing an identified defect is not required for a court to engage in a saving construction. Rather, curing the constitutional defect need only be “fairly possible,” and “every reasonable construction must be resorted to.”[12] Judge Dyk’s concurring opinion suggested limiting the reach of the scandalous clause to “obscene marks, which are not protected by the First Amendment.”[13]

[1] 15 U.S.C. § 1052(a).

[2] In re Brunetti, No. 85310960, 2014 WL 3976439 (Aug. 1, 2014).

[3] Matal v. Tam, 137 S. Ct. 1744 (2017).

[4] Iancu v. Brunetti, No. 18-302, 2019 WL 98541 (U.S. Jan. 4, 2019).

[5] Tam, 137 S. Ct. at 1750.

[6] Id. at 1753.

[7] Id. at 1744.

[8] Perry v. McDonald, 280 F.3d 159, 170 (2d Cir. 2001).

[9] City of Erie v. Pap’s A.M., 529 U.S. 277, 289 (2000).

[10] Bethel Sch. Dist. No. 403 v. Fraser, 478 U.S. 675, 685 (1986).

[11] In re Brunetti, 877 F.3d at 1358.

[12] Id.

[13] Id.

More than 740,000 bankruptcy petitions were filed in 2017 by individuals with debts that are predominantly consumer in nature. Through November last year, there were over 700,000 new filings. From these numbers, lawsuits over alleged violations of bankruptcy discharges are frequently in the news, particularly because some of those lawsuits resulted in big sanctions. See, e.g., First State Bank of Roscoe v. Stabler, 247 F. Supp. 3d 1034, 1046 (D.S.D. 2017) (bank and its principal were jointly and severally liable to pay $159,605 in attorney’s fees plus individually liable to pay $25,000 in punitive damages). Attorneys have also borne the brunt of those sanctions. See In re Jon-Dogar Marinesco, Case No. 09-35544 (CGM) (Bankr. S.D.N.Y. Dec. 1, 2016) (compensatory and punitive damages awarded against two law firms).

For consumer debtors, the “principal purpose” of the Bankruptcy Code is a “fresh start.” This means a “new opportunity in life and a clear field of future effort, unhampered by the pressure and discouragement of preexisting debt.” Grogan v. Garner, 498 U.S. 279, 286 (1991). To achieve that purpose, debtors “discharge” most prepetition debts under section 727(b) of the Bankruptcy Code. An injunction under section 524(a)(2) of the Bankruptcy Code prohibits activity to collect discharged debts. See Bessette v. Avo Fin. Servs., Inc., 230 F.3d 439, 444 (1st Cir. 2000).

Congress has not designated a specific sanction for a violation of a discharge injunction. However, bankruptcy courts are vested with powers to protect their jurisdiction. Under section 105(a) of the Bankruptcy Code, a bankruptcy court may “issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title” and may “tak[e] any action or mak[e] any determination necessary or appropriate” to “enforce or implement court orders or rules.” 11 U.S.C. § 105(a). Hence, a bankruptcy court may use the contempt power to protect its jurisdiction and address violations of the discharge injunction under section 105(a). See Walls v. Wells Fargo Bank, N.A., 276 F.3d 502, 508 (9th Cir. 2002) (contempt is the “traditional remedy” and perhaps the sole remedy for discharge violations).

Discharge violations often arise when a creditor takes action that may be considered an effort to collect on a discharged debt. To prove a violation, the debtor as “the moving party has the burden of showing by clear and convincing evidence that the [creditor] violated a specific and definite order of the court.” Lorenzen v. Taggart (In re Taggart), 888 F.3d 438, 443 (9th Cir. 2018). Clear and convincing evidence is evidence that “instantly tilt[s] the evidentiary scales in the affirmative when weighed against the evidence [the nonmoving party] offered in opposition.” In re Taggart, 548 B.R. at 288 n.11 (citation omitted). Some arguments turn on a creditor’s intentions and awareness of the debtor’s discharge, which can be an important consideration if the underlying conduct was done innocently. However, not all courts agree that these issues should be considered at all. The United States Supreme Court will now decide.

The Emergence of the Good-Faith Defense

There is an argument that a creditor should be shielded from a discharge violation by its good-faith belief that the discharge injunction does not apply to its action relating to a discharged debt. The argument may apply even if the belief was “unreasonable.” Now, the Supreme Court will decide whether to permit this defense, following its grant of certiorari in Taggart. Taggart involves a dispute over interests in a limited liability company. On the eve of a state court trial, Mr. Taggart filed for Chapter 7 bankruptcy. The trial was therefore stayed, and Mr. Taggart ultimately received a discharge of the claim. However, the state court refused to dismiss Mr. Taggart from the litigation, although the parties agreed not to pursue a money judgment against him. Nonetheless, the plaintiffs sought attorney’s fees from Mr. Taggart, alleging his post-bankruptcy participation in the case fell outside the discharge injunction. In defense, Mr. Taggart moved to reopen his bankruptcy to hold his creditors in contempt for violating his discharge injunction.

The bankruptcy court agreed with Mr. Taggart and found the plaintiffs in contempt because they were aware of the discharge and intended their actions. The Bankruptcy Appellate Panel reversed because the bankruptcy court found that subjective or good-faith beliefs were irrelevant. The Ninth Circuit Court of Appeals affirmed that ruling, deciding that creditors could not be in contempt if they believed in good faith that the discharge injunction did not apply. The court of appeals reasoned that a creditor’s good-faith belief excuses a discharge injunction “even if the creditor’s belief is unreasonable.” Taggart, 888 F.3d at 444.

The Rejection of the Good-Faith Defense

Other courts disagree with this reasoning and refuse to allow consideration of the creditor’s intent and awareness. In In re Hardy, 97 F.3d 1384, 1390 (11th Cir. 1996), the Eleventh Circuit held that “the focus of the court’s inquiry in civil contempt proceedings is not on the subjective beliefs or intent of the alleged contemnors in complying with the order, but whether in fact their conduct complied with the order at issue.” Likewise, in In re Pratt, 462 F.3d 14, 19–21 (1st Cir. 2006), the First Circuit held that the creditor’s violation was actionable despite the lack of “bad faith.” The Fourth Circuit reached a similar conclusion in In re Fina, 550 F. App’x 150, 154 (4th Cir. 2014), holding a “good faith mistake is generally not a valid defense.”

Now the Supreme Court will step into the breach. The Court’s rejection of a “good-faith mistake” defense would certainly solidify the debtor’s “fresh start.” However, voiding this defense would subject creditors to strict liability for otherwise innocent activity. In addition, although a creditor’s good-faith intent may remain a factor for determining sanctions, see In re Szenes, 515 B.R. 1, 7–8 (Bankr. E.D.N.Y. 2014) (mere showing that the actions were deliberate is not sufficient for punitive damages; rather, the actions must have been taken with “either malevolent intent or a clear disregard and disrespect of the bankruptcy laws”), damages awards, including shifting attorney’s fees, would remain available where there is liability. As noted, these risks extend to creditors’ counsel personally.    

Fortunately, there should soon be a more uniform standard of accountability. As of this writing, opening briefs have been filed, amici are weighing in with their policy arguments, and the Supreme Court will hear argument on April 24, 2019. The Solicitor General has also expressed interest, requesting argument due to ambiguity over the application of the discharge order to debts owed to the government.  Under the circumstances, the outcome is uncertain, but we can predict that this will be an important benchmark for consumer creditors and debtors as well as the bankruptcy judges who decide these issues. This is equally so for the lawyers who represent those parties.