Considerations in Drafting Board Advisor Arrangements

Posted on April 21, 2014 by - Uncategorized

This article and the companion article on board advisors both address a corporate governance arrangement under which the skill set of the formal board of directors is supplemented by individuals who are appointed to serve in an observational or advisory capacity. These individuals do not have the fiduciary duties of elected board members. Board observers are typically a phenomenon of venture capital backed companies and represent the interests of such investors. In contrast, the use of board advisors is increasingly becoming a feature of board of directors meetings across the spectrum, including closely-held family-controlled businesses, venture capital or private equity-backed companies, and public companies. 

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Companies increasingly are including board advisors or corporate advisory boards in their corporate governance arrangements. This trend is not limited to any particular segment, but spans across companies large and small, public and private, and corporations and alternative entities (such as limited liability companies). 

Board advisors are individuals with business experience or other relevant expertise who advise a company’s directors and management, most frequently on management and strategy issues. Board advisors are voluntarily appointed and serve at the pleasure of the board or company management. Board advisors attend board meetings and may advise the company’s directors and management, but have no actual authority to make business decisions. 

Since advisors are not elected and have no authority to make business decisions, they do not owe fiduciary duties to the shareholders of the company by virtue of their advisory role. This is a key difference from the company’s directors, who do owe fiduciary duties, and are subject to liability arising from any breach of those duties. This distinction may be a contributing factor to the increasing use of advisory boards, which allows advisors to contribute to the company’s management and strategic planning without the duties (and liability exposure) accompanying service as a director of the company. 

There is little case law or other legal authority addressing the rights, duties and potential liabilities of board advisors. Reference to basic principles of corporate law and corporate authority, however, should provide corporations sufficient guidance in structuring advisory board arrangements. This article is intended to provide insights and tools that practitioners can use to advise their clients who may currently use advisors or may be considering using them. 

While much of the discussion applies to businesses using other entity forms, this article assumes that the company is organized as a corporation. 

Role of the Advisory Board

Unlike the members of a company’s board of directors, shareholders do not elect board advisors. The advisors instead are appointed by, and generally serve at the pleasure of, the board or company management. Before a company begins a relationship with a board advisor or establishes an advisory board, the company and its counsel should have a clear idea of the benefits the company expects from the relationship and how the relationship will function in practice. A company and its counsel should also be prepared to address common board advisor concerns and protect key company interests throughout the relationship. 

A board advisor’s precise duties and responsibilities depend on the company’s particular needs and objectives. Board advisors generally provide the company with knowledge, expertise, and connections that expand those of the company’s management and directors. For example, an entrepreneurial company may engage board advisors who have started their own businesses to help identify common pitfalls or be a sounding board for product or business plan ideas. A mature, public company may organize an advisory board because, unburdened by regulatory and oversight responsibilities, the advisors will be free to focus exclusively on strategic issues, such as technology improvements, product marketing and development, and the like. 

Advisors Distinguished from Board Observers

In many cases, investors in companies financed by venture capital or private equity firms have a contractual right to appoint board observers to attend meetings and receive information available to the directors. A board observer represents the interests of the investor that appointed the observer, and therefore, from the company’s perspective, the board observer is a mandatory requirement driven by the investors’ rights and needs. For this reason, while observers may provide valuable advice and perspective to the board and company management similar to advisors, they may face greater skepticism or hostility from directors or management because they primarily protect the investor group they represent. 

Like board advisors, board observers attend and participate in meetings of a company’s board of directors and are typically entitled to receive all information provided to board members. Also like board advisors, board observers have no voting rights. 

Fiduciary Duties

Similar to a board observer, a board advisor should not be considered a fiduciary of the corporation solely by virtue of his or her role as an advisor. The imposition of fiduciary duties on board advisors would be largely inconsistent with the corporate law underpinnings of fiduciary duties. Corporate law fiduciary duties arise from trust law concepts – a party who manages an asset for the benefit of another party is held to standards of care and loyalty in managing the asset for the beneficiary. Thus in a corporation, as its business and affairs are managed by or under the direction of the board of directors, the directors owe fiduciary duties to the stockholders. 

Members of a company’s board of directors have fiduciary duties to shareholders and can be liable for breach of those duties. Board advisors, on the other hand, are not elected by shareholders and have no authority to make business decisions for the company. Accordingly, under corporate law, they do not owe fiduciary duties to company shareholders solely because of the advisor role. 

Nonetheless, board advisors may be concerned about potential liability to the company’s shareholders and other parties arising out of their role. Therefore, the company should reduce the risk of liability by (1) creating documents that clearly identify advisors and distinguish their duties from those of the members of the board of directors; (2) ensuring that board advisors do not, in practice, perform duties traditionally reserved to a director (such as participating in board or committee voting); and (3) ensuring that advisors do not exert (or appear to exert) control over members of the board of directors when they meet in their capacity as directors.

Advisory Board Agreements

For practical and legal reasons, a company should define its relationship with its advisory board members in a written agreement or policy. While there is no legal requirement to have any particular documents, clearly drafted agreements and other documents can help avoid misunderstandings and confusion about the advisors’ roles, limit their liability exposure, and protect the company’s interests, including confidentiality and intellectual property rights. 

Board advisor relationships are typically documented by using an advisory board or consulting agreement. Some companies also adopt by-law provisions and separate advisory board charters. To the extent an advisor’s role is not detailed in the agreement, it may be helpful to prepare an onboarding memo outlining the role of the advisory board and the particular advisor. In any case, the company’s board should formally approve the creation of the advisor relationship or advisory board with resolutions or a written consent, including adoption of the advisory board agreement. 

Advisory Board Agreements – Key Provisions

Duties 

The agreement should specify that the advisor’s role is to provide consulting services, either to the board of directors or to management, as an independent contractor. It should make clear that the advisor has no power to act for, represent, or bind the company and cannot take action that implies it has this type of authority. The agreement also should specify the duties the company expects the advisor to perform, which may include: (1) the number of meetings, conference calls, or other events the advisor must attend; (2) any preparation the advisor should complete in advance of these meetings or events, including reviewing materials such as business plans or budgets; and (3) any other duties the company and advisor have agreed upon, such as identifying business opportunities or assisting the board with management communications. 

Term of Service 

Advisors generally serve at the will of the board or company management. However, providing for a term encourages advanced planning and helps ensure the company and advisor are on the same page about the minimum commitment expected. It also provides the company a graceful way to exit the relationship if the advisor does not add value. Even if the agreement specifies a term, it should also clearly state that the advisor serves at the will of the board or management and that the agreement may be terminated at any time by either party, with or without reason. 

Compensation

Companies take different approaches to compensating their board advisors. Whether or not the advisor is compensated, the agreement should address which party is responsible for expenses and how expenses must be reported. If the advisor will be compensated, the amounts and timing of payments should be specified. If the compensation involves an equity component, then there will be many more issues for consideration and much more documentation involved, all of which is beyond the scope of this article. 

Information and Participation Rights 

Unlike directors, board advisors have no statutory or common law right to receive notice of meetings of the board, to receive any materials or other information provided to directors, or to inspect the corporation’s books and records. Any rights extended to the advisors, therefore, are provided voluntarily by the directors or company management. Also, unlike board observer arrangements, the right to access company information is, in most cases, expressly reserved to the company in its sole discretion. 

In order to ensure that the advisors can assist the board or management effectively, however, the company should provide copies of all notices, minutes, reports, and other materials that the corporation provides to members of the board (or committee) at such time as those documents and materials are provided to members or the board or committee. That said, the agreement should be clear that the company, in its sole discretion, may or may not provide information as it deems necessary or appropriate. 

Confidentiality and Privilege 

Given that board advisors will have access to board meetings and sensitive corporate materials, all confidential and proprietary materials and information furnished to the advisor must remain the property of the corporation, and the use and disclosure of such materials and information should be restricted. The agreement should contain a detailed definition of what constitutes “confidential information” and should require the advisor to keep those materials confidential, subject to customary exceptions (e.g., where the disclosure is required by law). 

The advisor will want to ensure, however, that the confidentiality restrictions are not drafted so broadly as to encroach upon his or her other business activities. For this reason, the company should carefully consider any conflicts of interest that might develop in light of its business and an advisor’s other activities and commitments. 

If the agreement permits the advisor to share confidential information and materials with his or her representatives, it should obligate the advisor to inform such representatives of the restrictions on the disclosure and use of such information and materials and instruct them to comply with those provisions. The agreement also should provide that the advisor is responsible for any breach of the agreement by his or her representatives. 

A corollary to confidentiality is attorney-client privilege. A recent Illinois decision confirms that, generally speaking, the privilege does not extend to advisors. (See BSP Software, LLC v. Motio, Inc. (N.D. Ill., June 12, 2013).) This includes discussions during board of directors’ meetings with counsel regarding privileged matters. As a practical matter, this means that advisors should be asked to step out of any meeting when privileged matters are being discussed, and privileged documents should not be shared with advisors. 

Protecting Intellectual Property, Disclosing Conflicts of Interest 

The company also should take steps to protect any intellectual property its advisors may create while performing their roles. Developments or other works created by advisors generally would not be deemed work-for-hire owned by the company. As a result, any intellectual property rights would generally be retained by the advisor. Therefore, the agreement should contain an express assignment to the company of any developments or works created by the advisor within the scope of his or her engagement, or that otherwise arise from the use of the company’s confidential or proprietary information. 

More broadly, the company again should consider potential conflicts of interest of its advisors or prospective advisors. Generally speaking, a company may not want to engage an advisor that is also serving on the board of, or consulting with, a competitor or company in a related industry. Those circumstances create conditions for potential cross-over discussions of proprietary information or trade secrets, which may lead to disputes over IP rights. For this reason, the agreement should clarify whether the advisor’s role with the company is exclusive, and the advisor should represent and warrant that his or her duties under the advisory board agreement do not conflict with any arrangement with another company or venture. 

Indemnification and Advancement

Due to his or her participation in board meetings and access to materials, a board advisor runs the risk of being named as a defendant in shareholder lawsuits or other actions involving the corporation. This is particularly true for start-up companies, when an advisor often has a net worth greater than the corporation itself (and therefore may be viewed as a “deep pocket” by potential litigants). 

The company typically will indemnify the advisor and advance expenses in connection with any suits or proceedings brought against the advisor, or to which the advisor is otherwise made a party or witness, by reason of his or her role with the company. Assuming such rights are extended, the agreement should specify that the corporation is providing third-party indemnification rights, and is not providing rights to indemnification or advancement of expenses to the advisor in his or her capacity as a director or officer of the corporation. 

Governing Law and Consent to Jurisdiction or Arbitration 

The agreement should specify the law by which it is governed. In general, the parties should provide that the agreement will be governed by the law of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. The agreement should also require that disputes be resolved in a specified jurisdiction and venue. Given that any disputes are likely to be business disputes among sophisticated parties, the parties should waive the right to a jury trial. 

Alternatively, the parties may wish to provide that disputes arising under the agreement be submitted to binding arbitration. In that case, the agreement should set forth with specificity the provisions that would govern the arbitration proceedings. Any such provisions should have a carve-out for the enforcement of any restrictive covenants (such as confidentiality restrictions). 

Conclusion

Board advisors can provide tremendous value to a company’s board and management. Like board observers, however, this arrangement is defined almost entirely by contract, with few statutory or common law rights or obligations granted to or imposed upon the corporation or the advisor. For that reason, directors and management should ensure that the agreement governing the arrangement covers the key issues that are important to the parties and is drafted with precision.

 

Considerations in Drafting Board Observer Arrangements

Posted on April 21, 2014 by - Uncategorized

This article and the companion article on board advisors both address a corporate governance arrangement under which the skill set of the formal board of directors is supplemented by individuals who are appointed to serve in an observational or advisory capacity. These individuals do not have the fiduciary duties of elected board members. Board observers are typically a phenomenon of venture capital backed companies and represent the interests of such investors. In contrast, the use of board advisors is increasingly becoming a feature of board of directors meetings across the spectrum, including closely-held family-controlled businesses, venture capital or private equity-backed companies, and public companies. 

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Although board observer arrangements are not uncommon, there is little case law squarely addressing the rights, duties, and potential liabilities of board observers. Reference to basic principles of corporate law, however, should provide corporations and investors sufficient guidance in structuring board observer arrangements. These arrangements may offer several advantages over a traditional designated board seat. From the investor’s standpoint, the arrangement may provide insight into a corporation that operates in a business line in which the investor is currently active or in which it is seeking to expand. At the same time, the arrangement helps to avoid subjecting the investor’s designee to traditional fiduciary duties. From the corporation’s standpoint, the arrangement may give the corporation access to an investor designee who has knowledge of the corporation’s business, and it may serve to promote a relationship with a potential strategic partner. The arrangement might also represent a compromise by which the corporation grants greater access and information to the investor in exchange for assurances that the investor will not be able to exert undue influence over corporate decisions or, in the event of intra-corporate disputes, gain access to privileged information. To function as all parties intend, a board observer arrangement should be carefully documented. This article sets forth some of the key issues that parties documenting board observer arrangements should consider. 

General – Fiduciary Duties

A board observer should not be considered a fiduciary of the corporation whose board he or she observes solely by virtue of his or her role as observer. The imposition of fiduciary duties on board observers would be largely inconsistent with the corporate law underpinnings of fiduciary duties. Corporate law fiduciary duties arise from trust law concepts – a party who manages an asset for the benefit of another party is held to standards of care and loyalty in managing the asset for the beneficiary. In the corporate law setting, the business and affairs of the corporation are managed by or under the direction of the board of directors, and the directors, in discharging their duties, owe fiduciary duties to the stockholders, as the residual beneficiaries of the corporation. Board observer arrangements generally do not confer upon the observer managerial discretion or control over the corporation’s assets, nor do they give rise to such discretion or control. Since board observers, as such, have no control over the corporation’s assets and business, they should not be bound by traditional fiduciary duties. 

The board observer agreement should nevertheless specify the limitations on the observer’s role and functions. Such limitations will help to constrain the observer, and thereby protect against claims that the observer is serving in a fiduciary capacity. Specifically, the board observer agreement should expressly provide that the observer has no right to vote on matters brought before the board (or any committee), and that the observer’s presence will not be necessary to establish a quorum at any meeting. In addition, the board observer agreement should not grant the observer any veto rights over corporate matters, including with respect to the establishment of budgets, financing arrangements, investment decisions, or any other matter brought before the board. Any such rights, if granted, should be given to the investor in the form of charter-based protective provisions or negative covenants in a separate agreement between the corporation and the investor. Even if the board observer agreement precludes the observer from voting on corporate matters, the observer may offer his or her views for consideration by the board of directors. In fact, the directors may from time to time seek the observer’s input. The observer should not, however, participate in any formal vote of the board or in any “straw poll” on a matter brought before the board. 

Board Observer Agreements

Parties 

The corporation and the investor are the principal parties to the board observer agreement. Since the agreement will impose obligations upon the observer, however, the observer should be named as a party. The agreement should also provide that if the investor removes any board observer, no person may be designated as a replacement observer unless and until he or she shall have executed a counterpart to the agreement. 

Information and Participation Rights 

Unlike directors, board observers have no statutory or common law right to receive notice of meetings of the board, to receive any materials or other information provided to directors, or to inspect the corporation’s books and records. Any rights extended to the observer, therefore, must be provided contractually. The board observer agreement should specify, among other things, the meetings the observer will be entitled to attend and of which he or she will be given notice. For example, the agreement may provide that the board observer will be given notice of and may attend all meetings of the board, whether regular or special, or only a subset of such meetings (e.g., the regularly scheduled quarterly meetings of the board). 

The agreement may also specify the observer’s rights with respect to meetings of committees of the board of directors. If the investor wants to secure rights for the observer to receive notice of and to attend committee meetings, it should ensure those rights are expressly granted in the agreement; in the absence of such rights, the corporation may be entitled to exclude the observer from committee meetings. The corporation, however, may resist any such request, or it may seek to limit the observer’s rights to specified committees. In all cases, the corporation should ensure that it retains the power to exclude the observer from meetings of committees established for the purpose of negotiating with the investor or negotiating transactions that could implicate or affect the investor’s rights. 

The agreement should also provide that the observer is entitled to receive copies of all notices, minutes, reports, and other materials that the corporation provides to members of the board (or committee) when such documents and materials are provided to members or the board or committee. The investor should include within the list of materials the observer is entitled to receive every form of action by unanimous consent in lieu of a meeting of the board and of each committee that the observer is entitled to observe, together with the exhibits and annexes to any such consent. 

The agreement should specify the manner and form in which notice of meetings will be provided to the observer. In many cases, the agreement will provide that the observer will be entitled to the same notice as is provided for regular or special meetings of the board or committee, as applicable, under the corporation’s bylaws. 

Limitations on the Observer’s Rights 

In addition to specifying the observer’s rights to participate in meetings and receive information and materials, the board observer agreement should set forth the express limitations on those rights. Typical limitations relate to the observer’s right to receive information and materials or to participate in meetings if the board determines in good faith that the provision of such information or materials to the observer or the observer’s participation in such meetings would result in a waiver or compromise of the attorney-client privilege. The investor may seek to require that the board, in making such determination, do so after consultation with outside counsel, or that the board’s determination be based on the advice of counsel. 

The corporation may wish to seek limitations that extend beyond the attorney-client privilege, limitations that restrict the observer’s access to specified classes or categories of confidential or sensitive information or materials. In addition, the corporation may wish to specify that it will not be required to furnish to the observer information relating to transactions or potential transactions between the corporation and the investor, or information that implicates or would affect the investor’s rights and obligations vis-à-vis the corporation. 

In all cases, the corporation should bear the burden of determining the information and materials from which the observer should be shielded and which meetings (or portions of meetings) from which the observer should be excluded. The board or a committee, acting in good faith, should make the determination on behalf of the corporation. Although the corporation would be responsible for making those determinations, the observer may nevertheless wish to disclaim the right to receive information or participate in a meeting (or portion thereof), even if not specifically requested to do so. For example, in a situation in which the investor is considering a bid to acquire the corporation or some or all of its assets, or is considering a recapitalization or similar proposal, the investor may wish to remain unburdened by confidential information. This will help to allay, for example, complications that may arise if the investor is imputed with constructive knowledge of material information regarding the corporation. 

Confidentiality 

Given that the observer will have access to board meetings and sensitive corporate materials, the corporation will want to ensure that the board observer agreement makes clear that all materials and information furnished to the board observer remain the property of the corporation and imposes restrictions on the use and disclosure of such materials and information. The agreement should contain a detailed definition of what constitutes “confidential information” and should require the observer to keep those materials confidential, subject to customary exceptions (e.g., where the disclosure is required by law). The investor will want to ensure, however, that the confidentiality restrictions are not drafted so broadly as to prevent the observer from sharing information and materials with the investor. Where the observer is permitted to share information and materials with the investor, the agreement should impose on the investor restrictions on disclosure and use. 

If the agreement permits the observer or investor to share confidential information and materials with their representatives, it should obligate the investor or observer to inform such representatives of the restrictions on the disclosure and use of such information and materials under the board observer agreement to instruct such representatives to comply with such provisions. The board observer agreement should also provide that the investor is responsible for any breach of the agreement by its or the observer’s representatives. 

Indemnification and Advancement 

Due to his or her participation in board meetings, and his or her access to materials furnished to the board, a board observer runs the risk of being named as a defendant in stockholder lawsuits and in other actions involving the corporation. The observer or investor may seek provisions obligating the corporation to indemnify and advance expenses to the observer in connection with actions, suits, or proceedings brought against the observer, or to which the observer is otherwise made a party or witness, by reason of the observer’s position. If such rights are extended, the board observer agreement should specify that the corporation is providing third-party indemnification rights, and is not providing rights to indemnification or advancement of expenses to the observer in his or her capacity as a director or officer of the corporation. 

Governing Law and Consent to Jurisdiction or Arbitration 

The board observer agreement should specify the law by which it is governed. In general, the parties should provide that the agreement will be governed by the law of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. The board observer agreement should also require all parties to agree that all disputes will be resolved in a specified jurisdiction and venue. The parties likely would want to select the courts of the jurisdiction in which the corporation is incorporated or in which its principal place of business is located. Given that any disputes are likely to be business disputes among sophisticated parties, the parties should waive the right to a jury trial. The parties may wish to provide instead that disputes arising under the agreement shall be submitted to binding arbitration. In that case, the board observer agreement should set forth with specificity the provisions that would govern the arbitration proceedings. 

Specific Enforcement 

In light of the nature of the parties’ obligations under the board observer agreement, it is likely that any disputes between the parties would involve a request for equitable relief. Accordingly, the board observer agreement should include a standard specific performance clause in which each of the corporation, the investor, and the observer acknowledges and agrees that it, he, or she would be irreparably harmed in the event of a breach by any other party, that monetary damages would not be a sufficient remedy, and that each will be entitled to specific performance or injunctive relief. The parties may also consider including a fee shifting clause. 

Conclusion

Board observer arrangements may be advantageous to both investors and corporations. The arrangement, however, is defined almost entirely by contract, with few statutory or common law rights or obligations granted to or imposed upon the corporation or the observer. For that reason, corporations and investors should ensure that the agreement governing the arrangement covers the key issues that are important to the parties and is drafted with precision.

 

Collecting Interest on Charged Off Debts and How Debt Collectors Must Disclose the Accrual of Interest to the Debtor

Posted on April 7, 2014 by - Uncategorized

The debt collection community has been concerned with whether a debt collector can charge interest under the Fair Debt Collection Practices Act (FDCPA), 15 U.S.C. § 1692 et seq. A creditor will usually “charge off” a debt when a consumer fails to make monthly payments for six consecutive months, at which point the account is closed to future charges, although the consumer still owes the debt. Many creditors will not collect interest on a charged off debt even if they have the right to do so. One pressing issue is whether a debt collector may collect interest on a debt in a situation where the creditor had stopped charging interest. The second issue is interpreting a debt collector’s responsibilities under the FDCPA regarding providing the debtor with information as to the accrual of interest. 

Waiver of Interest by Creditor

The Consumer Financial Protection Bureau has offered the following guidance as to whether debt collectors are permitted to collect interest on charged off debts: 

A debt collector may not collect any interest or fee not authorized by the agreement or by law. The interest rate or fees charged on your debt may be raised if your original loan or credit agreement permits it. Some state laws and some contracts allow interest to be charged and costs to be added. If you still have the contract, it may say what interest rate can be charged or how much it can increase. State law may also limit the amount of interest charged. 

Creditors often stop charging interest after they charge off a defaulted account because of certain business reasons and because they are otherwise obligated under the Truth in Lending Act to send monthly statements to cardholders. Many debt collectors have attempted to collect interest both retroactively and monthly moving forward in their collection attempts. Some attorneys for debtor plaintiffs have successfully argued that in this situation, the creditor may have legally waived the right to collect interest and that the waiver may apply to the debt buyer who purchases the debt. 

For example, in Simkus v. Cavalry Portfolio Servs., LLC, et al., 2014 U.S. Dist. LEXIS 9470 (N.D. Ill. Jan. 27, 2014), Cavalry attempted to collect interest retroactively from the time that the creditor charged off the debt to the point that it sold the debt to the debt buyer. The court denied Cavalry’s motion for summary judgment on the Section 1692e and 1692f claims and held that under Arizona law, a fact finder would need to determine whether the creditor waived its right to collect interest. The Simkus court stated that if a trier of fact determined that the creditor waived its right to collect interest, then Cavalry violated Section 1692e. However, the court dismissed Simkus’ Section 1692f(1) claim and held that Cavalry did not attempt to collect an unauthorized debt, reasoning that there was no dispute that the original contract permitted the collection of interest. The court noted that “§ 1692f(1) is ‘directed at debt collectors who charge fees not contemplated by the original agreement, not debt collectors who seek to charge fees contemplated by the agreement but arguably waived thereafter.’” 

While the Simkus court held that only a jury could decide the waiver issue and that there was no Section 1692f(1) violation, in McDonald et al. v. Asset Acceptance, LLC, 2013 U.S. Dist. LEXIS 110829 (E.D. Mich. Aug. 7, 2013), the court decided those same issues on summary judgment and did not leave them to be heard by a jury. The court granted summary judgment to McDonald and held that Asset violated Sections 1692e(2)(A) and 1692f(1) when it attempted to collect interest, including retroactive interest. The judge reasoned that “because Chase and WFNB waived the interest, Asset could not retroactively impose interest for the period in which it did not own the accounts. . . . To hold otherwise would create a monetary interest out of thin air and provide a potential windfall to Asset.” 

Finally, it is important for debt collectors to research state laws in the state in which they are collecting to determine whether debt collectors are permitted to charge interest, and if so, the rate at which they are permitted to collect. Even in cases where the creditor waived its contractual right to collect interest, some states permit debt collector to charge statutory interest at a rate approved by state law. 

Disclosure of Interest Accrual

The second hot topic issue is how debt collectors must disclose to the debtor the accrual of interest, if at all. Section 1692g(a)(1) of the FDCPA only requires the debt collector to state the “amount due” when communicating with debtors. Courts have been left to interpret how exactly the debt collector must disclose the accrual of interest. Various judges have reached opposite conclusions in interpreting this section. 

A Pennsylvania judge in Jones v. Midland Funding, LLC, 755 F. Supp. 2d 393 (D. Conn. 2010), granted summary judgment to Jones, holding that Midland violated Section 1692g(a)(1) where Midland stated the “balance due” in its initial letter, the subsequent letter stated a “balance due” for a greater amount, and neither letter mentioned interest accrual. The court determined that only the initial letter violated the FDCPA because it failed to state that interest was accruing and the rate at which it was accruing. Another Pennsylvania judge in Lukawski v. Client Servs., Inc., 2013 U.S. Dist. LEXIS 124075 (M.D. Pa. Aug. 29, 2013), considered a case with slightly different facts and ruled that where the first letter discloses that interest will accrue, subsequent letters must also disclose the accrual of interest. 

Certain federal judges in New York have not required debt collectors to disclose the interest accrual so long as the initial letter and subsequent letters state the correct balance due. However, some debt collectors have been exposed to liability when they attempt to explain the interest accrual. In Weiss v. Zwicker & Associates, P.C., 664 F. Supp. 2d 214 (E.D.N.Y. 2009), Zwicker & Associates sent an initial letter to Weiss stating: 

[A]s of the date of this letter, the balance on your account is $30,982.09. Your balance may include additional charges including delinquency charges, as applied at the direction of American Express, if said charges are permissible in accordance with the terms of your agreement. 

Zwicker & Associates sent another letter stating that the balance was $32,596.04, which is higher than the balance listed in the first letter. The court held that the initial letter violated Section 1692g(a)(1) of the FDCPA because it could be read by the least sophisticated consumer in two ways; one being that the amount included interest, the other that the amount did not include interest. Interestingly, the court found that the second letter was permissible under the FDCPA because a debt collector “has [no] obligation to explain why a consumer’s debt has increased. 

The Weiss court did not consider the issue of whether a debt collector is obligated to inform the consumer in the initial letter that interest is accruing. However, the year after the Weiss decision, the judge in Pifko v. CCB Credit Servs., 2010 U.S. Dist. LEXIS 69872, at *10 (E.D.N.Y. July 7, 2010), addressed that exact issue. In Pifko, the debt collection letters simply stated the balance owed and the letters reflected a higher balance with each letter sent. The letters did not mention interest accrual. The court held that none of the letters violated Sections 1692g or 1692e(10), because the letters contained no confusing language. Certain federal judges in Arizona and Massachusetts have reached the same conclusion based on similar reasoning in cases with nearly identical facts and claims. (See Goodrick v. Cavalry Portfolio Servs., 2013 U.S. Dist. LEXIS 117171 (D. Ariz. Aug. 19, 2013); Schaefer v. ARM Receivable Mgmt, Inc., 2011 U.S. Dist. LEXIS 77828 (D. Mass. July 19, 2011.) 

Taking a look back at Simkus v. Cavalry Portfolio Servs., LLC et al., 2014 U.S. Dist. LEXIS 9470 (N.D. Ill. Jan. 27, 2014), the same case as was discussed in the first section of this article pertaining to the waiver issue, the court also addressed how debt collectors must communicate interest accrual to debtors. The Simkus facts are the same as Pifko, Goodrick, and Schaefer, where the letters made no mention of whether interest had been added to the amount owed and simply stated the balance owed. In contrast to those cases, where the courts held that the collectors had no obligation to inform the debtors that interest was accruing, the Simkus court held that while the letters on their face did not violate Sections 1692e or 1692f because Cavalry was not required to itemize interest and principal, the parties had to brief the related issue of whether Simkus had extrinsic evidence to prove that the least sophisticated consumer would be confused by the letters. 

Some courts have suggested particular safe harbor language that collectors may use in letters to debtors. For example, in Miller v. McCalla, Raymer, Padrick, Cobb, Nichols and Clark, LLC, 214 F.3d 872 (7th Cir. 2000), the Seventh Circuit approved the following language: 

As of the date of this letter, you owe $___ [the exact amount due]. Because of interest, late charges, and other charges that may vary from day to day, the amount due on the day you pay may be greater. Hence, if you pay the amount shown above, an adjustment may be necessary after we receive your check, in which event we will inform you before depositing the check for collection. For further information, write the undersigned or call 1-800-[phone number]. 

A Connecticut judge, in Jones v. Midland Funding, LLC, 755 F. Supp. 2d 393, 398 (D. Conn. 2010), suggested the following language: 

As of today, [date], you owe $___. This amount consists of a principal of $___, accrued interest of $___, and fees of $___. This balance will continue to accrue interest after [date] at a rate of $___ per [day/week/month/year]. 

Debt collectors must carefully draft their letters based on the state and federal law in the jurisdiction where the debtor resides in order to lessen the chances of being held liable for an FDCPA violation regarding disclosure of interest. If the debt collector chooses to inform the debtor that interest is accruing, then using the safe harbor language suggested by courts within the jurisdiction may reduce the debt collectors’ exposure to FDCPA liability. 

Conclusion

Certain judges have held that only a jury can decide the issue of whether a debt collector may charge interest in situations where the creditor stopped collecting interest after charging off the debt. Debt collectors must understand whether state laws restrict collectors from charging contractual or prejudgment interest. Additionally, courts have interpreted the FDCPA differently regarding whether a debt collector must disclose that interest is accruing on the account. Some judges require the debt collector to inform the debtor in the initial letter that interest may be accruing and the rate at which it is accruing. Other judges have determined that debt collectors have no obligation to disclose that interest is accruing, and that the debt collectors must only correctly state the total amount due. Many collectors are finding that attempting to collect post-charge off interest is too much of a risk and have been foregoing the practice in its entirety.

 

Who Decides: The Court or the Arbitrator?

Posted on March 20, 2014 by - Uncategorized

As anyone who practices in the field of arbitration knows, the mere existence of an arbitration clause does not answer all the questions of what will happen in the arbitration. Indeed, often it will not even answer clearly the question of who will decide what with respect to the arbitration. Courts have concluded that, unless the parties have agreed otherwise, “procedural arbitrability” will be decided by the arbitrator and “substantive arbitrability” will be decided by the court.

As the recent decisions discussed in this article illustrate, how courts have applied this distinction continues to depend on the specific facts and circumstances of each dispute and the particular contract language.

Who Decides the Timeliness of an Arbitration Demand?

In United Steel, Paper & Forestry, Rubber, Mfg., Energy, Allied Indus. & Serv. Workers Int’l Union, Local 13-423 v. Valero Servs., Inc., ­No. 1:12-cv-113, 2013 U.S. Dist. LEXIS 19175, at *14-15 (E.D. Tex. 2013), the plaintiff union filed a grievance on behalf of a terminated employee of defendant Valero. After the grievance was denied, the union filed a demand for arbitration under a collective bargaining agreement (CBA). The CBA required the union to file any demand for arbitration within a prescribed time. Neither party disputed the existence of a valid agreement to arbitrate or that an arbitrator should decide the merits of the dispute. The defendant conceded that arbitrators generally decide issues of procedural arbitrability, including timeliness of an arbitration demand, but argued that under the terms of the CBA, the parties had agreed to submit all questions of arbitrability to the court. In particular, the CBA provided that “[a]ny dispute as to the arbitrability of a given matter shall be resolved by a court of competent jurisdiction and not by an arbitrator, unless the parties specifically agree otherwise in writing.” It also provided that “[a]ny question on any matter outside of this Agreement shall not be the subject of arbitration.”

To decide whether the issues of timing was one of “arbitrability,” or was otherwise “outside” the agreement and thus for a court, the district court looked at the entire language of the arbitration clause, which expressly excluded certain issues from arbitration, such as the use of contractors or the exercise of the company’s right to lay off after notice, both of which are issues of substantive arbitrability. Applying principles of contract interpretation, it held that the CBA language applied only to substantive arbitrability and did not displace the general rule that procedural arbitrability is for the arbitrator to decide. Moreover, because the underlying dispute about the employee’s discharge was subject to arbitration, the related question of the timeliness of the arbitration demand was more appropriately before the arbitrator. The court acknowledged that a court may deny arbitration when the procedural provision in question operates to bar arbitration altogether, but there was nothing in the arbitration clause indicating that the timing provisions would completely preclude arbitration.

Who Decides Whether an Arbitration May Proceed on a Class or Consolidated Basis?

In Planet Beach Franchising Corp. v. Zaroff, C.A., No. 13-438 Section: J:1, 2013 U.S. Dist. LEXIS 121908 (E.D. La. Aug. 27, 2013), the plaintiff franchisee filed a unitary demand for arbitration with the AAA for damages based on a franchisor’s alleged misrepresentations and omissions in sales materials used to induce the franchisee to enter into four separate franchise agreements. Each of the four relevant franchise agreements stated that “[n]either party shall pursue class claims and/or consolidate the arbitration with any other proceeding to which the franchisor is a party . . . .” The franchisor then sued to compel the franchisee to maintain separate arbitration proceedings under each of its four separate agreements. The franchisee replied that it had filed a single arbitration, not a “consolidated” demand, and that an arbitrator must decide if the arbitration could proceed on a unitary basis.

The Eastern District of Louisiana first sought to decide “who should make the determination as to whether the [franchisee] can pursue one arbitration proceeding against [franchisor] consisting of all of [its] claims that arise or relate to the four franchise agreements. . . .” (Emphasis in original.) It held that, contrary to the franchisor’s arguments, Stolt-Nielsen S.A. v. Animal Feeds Int’l Cor., 130 S. Ct. 1758 (2010), did not instruct courts to make the decision of whether an agreement prohibits class arbitration. Instead, the court held, based on the general presumption in favor of arbitration and the broad nature of the arbitration clause, that an arbitrator must interpret whether the parties’ agreement permits consolidated arbitration. It therefore denied the franchisor’s motion to compel four separate arbitrations.

In Parvataneni v. E*Trade Fin. Corp., No. C 13-02428 JSW, 2013 U.S. Dist. LEXIS 136950 (N.D. Cal. July 2, 2013), the plaintiff sued defendant E*Trade for violations of California state law related to unpaid overtime. E*Trade removed to federal court and moved to dismiss or compel arbitration pursuant to an arbitration provision in the plaintiff’s employment agreement. The arbitration clause, which was concededly broad, stated that “[i]n the event of any dispute or claim arising out of or relating to your employment . . . such Disputes shall be fully, finally, and exclusively resolved by binding arbitration . . . ” conducted by the AAA.

The plaintiff argued that this clause should be read to allow him to pursue collective arbitration, or, if not, that the arbitration provision was void under state law. The district court held that the issue of class arbitration was a question for the court in the absence of “clear and unmistakable evidence” that the parties intended to arbitrate arbitrability. The court noted, for example, that the parties did not choose to incorporate the rules of the AAA which would have constituted such “clear and unmistakable evidence” to permit an arbitrator to decide arbitrability. The court then proceeded to hold, however, that because the arbitration agreement was silent as to class arbitration, under Stolt-Nielsen, it could not construe the agreement to include class arbitration.

Who Decides the Validity of an Arbitration Agreement and Arbitrability?

In Rent-A-Center, West, Inc. v. Jackson, 130 S. Ct. 2772 (2010), the Supreme Court held that parties may agree to arbitrate “threshold issues” regarding the arbitrability of their disputes. Since Jackson, courts have struggled to define the exact limits of this rule.

In Holzer v. Mondadori, No. 13-civ-5234(NRB), 2013 U.S. Dist. LEXIS 37168 (S.D.N.Y. Mar. 14, 2013), on remand and dismissed by Holzer v. Mondadori, 40 Misc. 3d 1233(A) (N.Y. Sup. Ct. 2013), for example, the defendants had marketed investments in a Dubai real estate venture to the plaintiffs. When the venture failed, the plaintiffs sued for damages in New York state court. One of the defendants petitioned for removal on the basis of Section 205 of the Federal Arbitration Act, 9 U.S.C. § 205 (implementing the New York Convention on Recognition and Enforcement of Foreign Arbitral Awards), which permits removal of an action “relating to” a foreign arbitration or arbitral award under the New York Convention, and sought to compel arbitration of the plaintiffs’ claims. This defendant was not a signatory to the underlying purchase agreements containing the arbitration clause. Furthermore, these agreements contained a Dubai choice of law provision. The court concluded, however, based on precedent in other circuits, that United States law must govern the arbitrability question because determinations of agreements governed by the New York Convention implicate the allocation of power between courts and arbitrators. It therefore held that, under federal common law, a party must provide “clear and unmistakable evidence” of intent for an arbitrator to arbitrate arbitrability.

The purchase agreements expressly incorporated by reference the Arbitration Rules of the Dubai International Arbitration Centre (DIAC Rules). The district court found that this incorporation by reference could serve as “clear and unmistakable evidence” that the signatories intended to submit questions of arbitrability to the DIAC arbitration tribunal. But the language of the arbitration clauses in the purchase agreements also provided that arbitration of “all disputes between the parties in relation to or arising from” the contract would be submitted to arbitration. Because the moving defendant was not a signatory to the agreements, nor had a sufficiently close relationship to signatory defendants, the district court concluded that it could not compel arbitration and remanded to state court.

In contrast, in Oracle Am., Inc. v. Myriad Group A.G., 724 F.3d 1069 (9th Cir. 2013), the district court concluded that UNCITRAL rules did not provide such evidence that an arbitrator should decide arbitrability; a decision, however, that the Ninth Circuit promptly reversed. The defendant Myriad, a Swiss mobile software company, licensed Java, a computer programing language, from the plaintiff Oracle. Based on that license, Oracle sued Myriad in the Northern District of California, asserting claims for breach of contract, violation of the Lanham Act, copyright infringement, and unfair competition under California law. Myriad moved in response to compel arbitration based on an arbitration clause in the parties’ license agreement that called for arbitration in accordance with the UNCITRAL rules.

The district court granted Myriad’s motion to compel arbitration with respect to Oracle’s breach of contract claim, but denied Myriad’s motion with respect to all other claims. The court concluded that it had the authority to decide whether the other claims were arbitrable because UNCITRAL arbitration rules “did not constitute clear and unmistakable evidence that the parties intended to delegate questions of arbitrability to the arbitrator.”

On appeal, the Ninth Circuit reversed the district court’s decision. It held instead that “as long as an arbitration agreement is between sophisticated parties to commercial contracts, those parties shall be expected to understand that incorporation of the UNCITRAL rules delegates questions of arbitrability to the arbitrator.”

Whether a Contract as a Whole is Void Remains an Issue for the Arbitrator

Almost half a century ago, the Supreme Court held that while challenges to an agreement to arbitrate contained in a contract may be decided by a court, challenges to the contract as a whole must be decided by an arbitrator. See, e.g., Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967). While litigants sometimes try to avoid the rule, it remains firmly planted in the judicial language.

In Damato v. Time Warner Cable, Inc., No. 13-cv-944(ARR)(RML), 2013 U.S. Dist. LEXIS 107117 (E.D.N.Y. July 30, 2013), the plaintiff subscribers filed a putative class action against defendant Time Warner Cable for violations of multiple states’ consumer protection laws. Time Warner Cable replied with a motion to stay or dismiss the action pending arbitration pursuant to an arbitration clause in the plaintiffs’ subscriber agreements. The arbitration clause provided for binding arbitration unless the subscribers elected to opt out. The plaintiffs nonetheless argued that the arbitration clause was invalid as illusory because the subscriber agreement gave Time Warner Cable the power to change its terms unilaterally and therefore the agreement to arbitrate was not supported by any mutual obligation. The court found that these arguments challenged the validity of the contract as a whole, rather than just the arbitration clause, because Time Warner Cable retained power to change the terms of the entire agreement. It rejected the plaintiffs’ claims that the agreement to arbitrate was unconscionable, because the plaintiffs relied on terms that affected the entirety of the subscriber agreement rather than solely the arbitration clause. The court therefore concluded that plaintiffs’ arguments “chiefly attack the validity of the contract as a whole,” and must be determined by the arbitrator.

Who Decides Procedural Issues Related to Arbitration?

In AFSCME, Council 4, Local 1303-325 v. Town of Westbrook, 75 A.3d 1 (Conn. 2013), the plaintiff union filed an action to vacate an arbitration award deciding that the defendant town’s decision not to reappoint its assessor was outside the terms of a collective bargaining agreement. The trial court, limiting the scope of its review to only the arbitrators’ determination that the plaintiff’s claim was not arbitrable, affirmed the arbitrators’ award. On appeal, the union claimed that the trial court improperly limited its scope of review and had incorrectly concluded that the defendant’s reappointment decision was not arbitrable.

The union argued that the arbitrators had exceeded their authority by considering state and city laws and thus that the trial court should have applied a broad scope of review to the arbitration decision. The Connecticut Supreme Court disagreed. It affirmed, holding that the arbitration agreement gave the arbitrators “broad authority” to decide the question of arbitrability, and noting that the award clearly revealed that the arbitrators had decided only that question. The parties had committed the question of arbitrability to the authority of the arbitrators and fully expected to be bound by the arbitrators’ decision on that issue. As the court held, “[w]hen a party that has agreed to arbitrate the question of arbitrability wishes to challenge the arbitrators’ determination regarding that issue, the court’s review of that determination, like its review of any other issue that parties empowered the arbitrators to decide, is limited.”

In Duran v. The J. Hass Group, L.L.C., 531 Fed. Appx. 546 (2d Cir. 2013), plaintiff Duran sued the defendants, various debt settlement companies located in Arizona, under the Credit Repair Organizations Act and state law. The district court granted the defendants’ motion to dismiss the action and compel arbitration. On appeal to the Second Circuit, the plaintiff conceded that her claims were subject to arbitration, but contended that the forum selection clause contained in the arbitration agreement, which mandated arbitration in Arizona, was unconscionable. Because the plaintiff conceded that her claims were subject to arbitration, the Second Circuit agreed with the district court that it was for the arbitrator, rather than the court, to decide in the first instance whether the forum selection clause was unconscionable. As the court of appeals held, “[w]hile ‘a gateway dispute about whether the parties are bound by a given arbitration clause raises a question of arbitrability for a court to decide,’ [. . .] an arbitrator presumptively resolves issues of ‘contract interpretation and arbitration procedures.’” The Second Circuit noted that, had the plaintiff argued only that the arbitration agreement was itself unconscionable due to the forum selection clause, the court would have had to decide the matter. But because the plaintiff conceded that her claims were arbitrable, the unconscionability of the forum selection clause was for the arbitrator to decide.

Who Decides Res Judicata in Arbitration?

The decisions in Carlisle Power Transmission Prods., Inc. v. United Steel, Paper & Forestry, Rubber, Mfg., Energy, Allied Indus. & Workers Int’l Union, 725 F.3d 864 (8th Cir. 2013), arose from a dispute between a union and an employer (Carlisle) over long-term disability benefits for a Carlisle employee injured on the job. The union brought a grievance against Carlisle per the procedures listed in a 2001 collective bargaining agreement (CBA). A few days later, that CBA expired and was replaced by a 2006 CBA. The parties agreed to submit to an arbitrator the procedural issue of whether the union’s claim on behalf of the employee was arbitrable under the 2006 CBA. This arbitrator found that the grievance was arbitrable under the 2006 CBA even though the dispute arose while the 2001 CBA was in effect. Carlisle and the union then picked a different arbitrator to hear the substantive claims and scheduled a hearing date. But Carlisle also sought a declaratory judgment in court that the union’s claims were not arbitrable under the 2006 CBA (chiefly because the union was seeking disability benefits governed by a separate agreement).

The union moved for summary judgment in the disability benefit action. It argued that Carlisle’s claim was barred by res judicata. The district court found that the requirements of res judicata were met, but that the union had waived its right to raise that defense by agreeing to limit the scope of the initial arbitrator’s decision to arbitrability of procedural issues. Proceeding to the merits, the district court then held that the 2006 CBA excluded disputes concerning long-term disability benefits and thus the union’s claims were not subject to arbitration.

On appeal, the Eighth Circuit reconsidered the res judicata issue. It viewed the initial arbitrator’s decision as a decision on the merits, and concluded that Carlisle’s declaratory judgment claim arose out of the same facts, even though it advanced different legal theories. The Eighth Circuit agreed with the union that res judicata does not foreclose an action if the parties agree to allow a plaintiff to split its claim and proceed in two different actions. But it found that the union did not agree to allow claim-splitting because it did not agree to defer the merits determination until after the arbitrator decided the issue of arbitrability under the 2006 CBA. Moreover, while Carlisle had not raised the argument that the long-term disability benefits claims were not arbitrable in its initial arbitration proceeding, it could have done so. The court of appeals therefore vacated the district court’s order, holding that the initial arbitrator’s award was final and precluded Carlisle’s argument as to nonarbitrability of long-term disability benefits.

In the case of In re: Yin-Ching Houng, 499 B.R. 751 (C.D. Cal. 2013), appellee Tatung initiated an arbitration proceeding against appellants Westinghouse Digital Electronics, LLC (WDE) and Houng for breach of contract. The arbitrator found Houng to be liable as an alter ego of WDE and assessed damages, plus interest. Houng then filed for bankruptcy. Tatung sought relief from the automatic stay in bankruptcy to complete the arbitration proceedings and confirm the award, as well as an order from the bankruptcy court that Houng’s debt was nondischargeable.

The bankruptcy court held that the debt from the arbitration was nondischargeable, finding that the arbitration award had preclusive effect. Houng responded by appealing this decision to the district court. The district court held that the bankruptcy court had erred in giving the arbitration award preclusive effect under California law before it was confirmed. However, because the arbitration award was later confirmed, the district court found that the error was harmless. It therefore affirmed the bankruptcy court’s decision that the debt was nondischargeable.

Who Decides Claims of Fraud in the Inducement?

In Tower Ins. Co. of N.Y. v. Davis/Gilford, A JV, No. 13-0781 (RBW),2013 U.S. Dist. LEXIS 127121 (D.D.C. Sept. 6, 2013), plaintiff Tower, an insurance company, issued a performance bond to the defendant, a joint venture, guaranteeing work performed under a subcontract executed between the defendant and a third party. The bond incorporated the subcontract by reference. When the third party defaulted, Tower elected to continue performance and drafted a takeover agreement with the defendant that also referenced the subcontract.

When a dispute arose, the defendant moved to compel arbitration pursuant to the arbitration provision in the subcontract. Tower separately instituted suit in district court seeking a declaration that it was not required to arbitrate because it had been fraudulently induced to issue the performance bond. Tower conceded that its allegations of fraud concerned the issuance of the performance bond in its entirety, and not the arbitration provision itself, but argued that submission of its fraudulent inducement claim to an arbitrator was “illogical” because “if a bond is void ab initio, then it never existed, and never incorporated the subcontract or the arbitration clause by reference in the first place.” The district court rejected the argument, basically relying on the Supreme Court’s decision in Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006), which acknowledged that a party may be forced to arbitrate even pursuant to a contract that an arbitrator later finds to be void. The court concluded that Tower was therefore required to arbitrate its fraudulent inducement claims.

As the discussion of the recent cases above reveals, questions of who decides certain threshold issues of arbitrability, including issues of timeliness, unconscionability, and whether an arbitration may proceed on a collective basis, continue to provide fodder for numerous opinions. Modern Supreme Court cases provide some guidance, but the many different mixes of the parties’ circumstances, arbitration clauses, and arbitration rules, continue to present unanswered issues, particularly where the clauses and rules chosen by the parties do not exactly match their particular circumstances. Parties who make an agreement to arbitrate simply by inserting what they think is a short and simple clause for a streamlined alternative dispute resolution mechanism, may, in the end, find that they have instead acquired a protracted and expensive dispute over threshold issues. This is why (despite the availability of boilerplate provisions from many sources) arbitration clauses should be carefully crafted by experienced counsel, using language tailored to the specific forum selected and any anticipated issues.

The Importance of Bilateral Investment Treaties (BITs) When Investing in Emerging Markets

Posted on March 19, 2014 by - Uncategorized

Tax planning forms a natural part of any decision-making process regarding the optimal structure of foreign investments. Strangely enough, until recently, BIT-planning (i.e., planning to protect the investor’s interests against unfair treatment by the host country’s government via bilateral investment treaties), rarely received a seat at the table. Venezuela’s actions in the oil and gas industry have emphasized, however, that the value of bilateral investment treaties cannot be overestimated. The decision by Mobil Corporation and ConocoPhilips to structure (or restructure) their investments in the Orinoco Oil Belt projects in Venezuela through a company incorporated under Netherlands law will probably save them billions of dollars. These investors invoked the protection of the Bilateral Investment Treaty entered into between the Kingdom of the Netherlands and Venezuela after the expropriation of their investments, and are currently involved in multibillion dollar arbitrations with Venezuela. 

Foreign investors, especially those investing in emerging markets, are well advised to analyze not only the tax efficiency of a particular investment vehicle, but also the existence and substance of BITs to which the host country is a signatory. Sometimes the tax and BIT analyses point to the same optimal investment vehicle. If not, the solution may be to use two investment vehicle layers so that optimal tax planning is combined with the best protection under BITs. 

This article discusses what BITs are, how investors can enforce claims under BITs, and why using a Dutch or Curaçao entity and the associated extensive BIT treaty network of the Netherlands and Curaçao may prove useful when investing in countries that are perceived to be politically unstable. Finally, this article will also briefly address BIT developments in the EU. 

What are BITS?

BITs are agreements between two countries protecting investments made by investors from one contracting state in the territory of the other contracting state. The purpose of BITs is to stimulate foreign investments by reducing political risk. The number of BITs entered into has increased exponentially over the last two decades. The first BIT was entered into between Germany and Pakistan in 1959. At the end of the 1980s, there were approximately 385 BITs, whereas currently the number approaches 3,000. Most BITs include the following substantive obligations that each country undertakes toward investors from the other country, with only narrow exceptions: 

  • Treating foreign investors’ investments fairly and equitably, i.e., not taking unreasonable or discriminatory measures and treating investments of foreign investors at least as favorably as investments from its own nationals and nationals of third states;
  • Not nationalizing or expropriating investments from foreign investors, unless the measures taken are non-discriminatory, taken in the public interest, and while observing due process, are taken against payment of prompt, adequate, and fair compensation. Importantly, regulations substantially negatively affecting the value of an investment can qualify as an expropriation for these purposes; and
  • Allowing funds relating to investments to be freely transferred by foreign investors without delay, which includes protection against foreign exchange restrictions. This protection was invoked several times under BITs entered into by Argentina. 

In this article we only address bilateral investment treaties. Please note that there are a few multinational treaties that also offer investment protection, the most important ones of which are NAFTA and the Energy Charter. 

Enforcement of BITs

BITs are quite unique in that they provide a basis for claims by an individual person or company against a state. In an effort to avoid the need to turn to the national courts for a judicial remedy, BITs usually contain an arbitration clause submitting disputes to a neutral arbitration tribunal, normally the International Centre for Settlement of Investment Disputes (ICSID), the most frequently used alternative being arbitration under the rules of the United Nations Commission on International Trade Law (UNCITRAL). Awards rendered by the ICSID are binding on parties and not subject to any court or other appeal, provided that an award can be annulled by a second ICSID panel, but only on grounds that are significantly narrower than the grounds that can be found in the New York Arbitration Convention. The ICSID was established under the Convention on the Settlement of Investment Disputes between States and Nationals of other States on March 18, 1965 (the “Washington Convention”), as an initiative of the World Bank. The Washington Convention entered into force on October 14, 1966, after having been ratified by 20 countries. Under Article 54 of the Washington Convention, each of the current 150 states that have ratified it must recognize an award rendered pursuant to the Washington Convention as binding and must enforce the monetary obligations imposed by that award as if it were a final judgment of a court of that state. However, it should be noted that local law of the country in which enforcement is sought will ultimately determine whether particular sovereign assets can be seized. 

There are currently 183 cases pending before the ICSID, including the $7 billion case Mobil Corporation, Venezuela Holdings B.V. and others v. Venezuela and the $30 billion case ConocoPhillips Petrozuata B.V. and others v. Venezuela, both based on the BIT entered into between the Kingdom of the Netherlands and Venezuela. In the Mobil case, the arbitration panel confirmed, in accordance with existing case law from ICSID panels, that the fact that a Dutch intermediary holding company was added to the structure years after the original investment and probably with a view to the political environment in Venezuela, did not negatively affect the rights of Mobil to seek protection under the Dutch BIT. In the ConocoPhillips case, the arbitral tribunal ruled on September 3, 2013, that Venezuela has unlawfully expropriated the investments of ConocoPhillips in three oil projects in Venezuela by failing to offer just compensation for the taking of ConocoPhillips assets in the oil projects. The arbitration will continue to determine the level of compensation. Venezuela (27) and Argentina (24) head the list of countries against which the most ICSID cases are pending. 

BIT Due Diligence

Not all BITs are created equal. If a host country has entered into multiple BITs, it is worthwhile to review the contents of those BITs in order to determine which BIT provides the best protection for a specific investment. Some BITs are worded more investor-friendly than others. We’ll explore below some of the issues to look for when doing due diligence on BITs: 

  • Which investments are protected? Each BIT will have a definition of “Investments.” Some of these definitions are worded broadly, but it may also be the case that BIT protection is only awarded to a narrow category of investments, or that certain investments are expressly excluded. It may, for example, be limited to protection of equity interests.
  • When does the BIT apply? It will be important to see whether BIT protection is only granted to citizens of, and companies incorporated under the laws of, or having their head quarters in, the contracting state, or whether for example, companies in third countries owned and/or controlled by such citizens or corporations also qualify for protection.
  • Term of BIT protection. BITs are entered into for a specific term and may, or may not, be extended for a certain period after a termination notice has been given. In addition, it may be important to check whether the protection is also afforded to investments made before the BIT becomes effective. 

Use of Dutch or Curaçao Investment Vehicles

Dutch or Curaçao investment vehicles are already often used for tax reasons. Dutch policy aims at removing international double taxation, and the Netherlands has therefore entered into nearly 100 international tax treaties. In addition, Dutch tax law does not provide for withholding tax on outbound interest and royalties. Lastly, profits received by a Dutch parent company from a foreign subsidiary or made through a permanent establishment situated abroad are exempt from taxation in the Netherlands (often referred to as the “participation exemption”). The extensive BIT treaty network of the Netherlands and Curaçao provides another strong argument for using a Dutch or Curaçao investment vehicle when making foreign investments in countries which are perceived to be politically risky. 

The Kingdom of the Netherlands entered into 97 BITs of which 89 are currently in effect. These BITs generally apply to The Netherlands, Curaçao, St. Maarten, and Aruba. Curaçao is probably the only well-known off-shore jurisdiction that provides the benefit of such an extensive BIT treaty network. The model treaty on which most are based is considered to be very investor-friendly. The issues referred to above are dealt with as follows: 

Which investments are protected? In virtually all BITs entered into by the Kingdom of the Netherlands, the definition of “investments” is worded broadly and is open-ended. The definition generally covers any kind of asset, including, but not limited to: (1) movable and immovable property and security rights in relation thereto; (2) rights derived from shares, bonds, and other interests in corporations and joint ventures; (3) monetary claims; (4) intellectual property rights; and (5) rights to explore, extract, and win natural resources and other rights granted under public law. 

To which investors does the BIT apply? The Dutch Kingdom’s BITs typically not only apply to citizens and corporations of the Netherlands, Aruba, Curaçao, and St. Maarten, but also to foreign corporations that are directly or indirectly controlled by such citizens or corporations. A significant number of BITs of other countries require qualifying investors to be both established in the contracting country and to have their head office there. These other BITs would therefore not provide protection on the basis of intermediary holding companies located in the state that entered into the BIT with the host country. The Dutch Kingdom’s approach gives a lot of flexibility to structure investments in a tax efficient manner, while allowing the investor at the same time to benefit from the rights granted to investors under the relevant BIT, since it is possible to use multiple layers of investment vehicles. Almost all Dutch Kingdom BITs provide protection as long as there is a Dutch or Dutch Caribbean vehicle in the corporate structure. 

Term of BIT protection. The BITs of the Dutch Kingdom are in most cases valid for an initial period of 15 years. They usually also apply to investments that have been made before the date of entry into force. Unless a six-month advance termination notice has been given by one of the contracting states before its expiry date, they will automatically be extended for 10 years. Importantly, in the case of a termination, the provisions of the BIT generally survive for a further period of 15 years for investments that were made before its termination. Consequently, the Dutch Kingdom-Venezuela BIT that has been terminated upon Venezuela’s request as of November 1, 2008, will for example, remain in force until November 1, 2023, for investments made before November 1, 2008. 

BITS in Effect

Netherlands       89

Curaçao             89

Brazil                   0

China               100 (not including U.S.)

India                  65 (not including U.S.)

U.S.                   40

Cayman Islands  0

Bermuda             5

Canada              27

BITs and BRICs

Below, we will briefly describe the BIT situation in the BRIC (Brazil, Russia, India and China) countries and provide, if applicable, some details of the BITs entered into by the BRICs with the Kingdom of the Netherlands, which are among the most investor-friendly BITs entered into by the relevant countries. 

Brazil 

Brazil executed 14 BITs, including one with the Kingdom of the Netherlands, but apparently had a change of heart and has not ratified any of them. It is not a party to the Washington Convention. 

Russian Federation 

The Russian Federation is a signatory to 44 BITs. The Russian Federation, or rather its predecessor, the Soviet Union, entered into a BIT with the United States in 1992, but never ratified it, so it is not effective. The BIT with the Kingdom of the Netherlands became effective in 1991. Russia has executed the Washington Convention, but has not ratified it. 

The Dutch-Russian BIT has the following features: 

  • The definition of investments is very broad and includes, for example, intellectual property rights and concessions to explore natural resources.
  • It offers protection for the benefit of intermediary holding companies.
  • It offers direct access to ad hoc arbitration with arbiters to be appointed by the president of the chamber of commerce in Stockholm. 

India 

India has 65 BITs in effect, with a few pending. There is no BIT with the United States. The BIT between India and the Kingdom of the Netherlands has the following main features:

  • The definition of investments is very broad and includes for example intellectual property rights and concessions.
  • It offers protection for the benefit of intermediary holding companies.
  • It offers access to ICSID or UNCITRAL arbitration. 

China 

China entered into about 100 BITs. The list does not include the United States. When investing in China, U.S. investors could therefore benefit from interposing an intermediary holding company from a jurisdiction with an investor-friendly China BIT. Obviously, interposing the intermediary holding company should not result in the payment of additional taxes, so the choice of jurisdiction will also depend on a thorough tax analysis. Interposing a Dutch intermediary holding company may fit the bill. 

The Dutch-China BIT has the following features:

  • The definition of investments is very broad and includes, for example, intellectual property rights.
  • It also offers protection for the benefit of intermediary holding companies.
  • It offers direct access to ICSID or UNCITRAL arbitration (contrary to many other China BITs). 

In the case of China, it is especially interesting that the BIT offers protection for the benefit of intermediary holding companies. Given that the Dutch-China Tax Treaty provides for a 10 percent dividend withholding tax, whereas, for example, an investment by a Hong Kong entity would only trigger a 5 percent withholding tax burden, the investment should not be directly made through a Dutch subsidiary. To add BIT protection, the Dutch subsidiary should be interposed above, for example, such Hong Kong entity. Interposing the Dutch entity will not lead to additional taxes, given the Dutch participation exemption for subsidiaries (income derived though qualifying subsidiaries are not subject to corporate income tax) and the fact that dividends paid by the Dutch entity to a U.S. parent can be made without dividend withholding tax, either by using the U.S.-Dutch Tax Treaty, or by structuring the Dutch entity as a “cooperative.” 

Developments in the EU

As of December 1, 2009, the EU became exclusively authorized to enter into new BITs on behalf of its member states. However, existing BITs entered into by an EU member state remain effective, unless and until the EU enters into a new BIT with the relevant other state. 

Conclusion

When contemplating foreign direct investments, especially in emerging markets, BIT due diligence should be part of the work undertaken. Basing the decision on which investment vehicle to use solely on tax considerations may prove costly if a host government takes hostile action. 

Using a Dutch or Curaçao entity may not only make sense from a tax perspective, but also because of the extensive BIT network of the Netherlands and Curaçao.

Unauthorized Practice of Law and the Transplanted In-House Counsel

Posted on March 19, 2014 by - Uncategorized

 

George, an in-house lawyer employed by Acme Corporation, is licensed to practice law in New York. Fifteen years ago, George moved to Acme’s headquarters in Chicago, where he has worked ever since. He is not a member of the Illinois bar. Is George engaged in the unauthorized practice of law (UPL), and if so, what might be the consequences? 

In-House Lawyers and Unauthorized Practice

Lawyers move – including, frequently, both across state lines and from private law firm practice to in-house legal departments. For decades prior to the adoption of Rule 5.5(d) of the American Bar Association’s Model Rules of Professional Conduct, an in-house lawyer licensed only in a state other than where he or she worked rarely attracted scrutiny with respect to UPL, from bar authorities or otherwise. To the extent that issues arose, it was often when the lawyer left the in-house position to return to private firm practice and applied for local bar admission; at that point some state bar regulators might pose pointed questions about what the lawyer did during his or her in-house tenure. 

The Model Rule 5.5(d)-(e) Safe Harbor for In-House Lawyers

Model Rule 5.5(d)-(e), adopted by the ABA House of Delegates in 2002, was meant to create a safe harbor for in-house lawyers admitted in a U.S. jurisdiction, but not where they work. This was one of several multijurisdictional practice safe harbors added to Rule 5.5. In general, it is relatively easy for an in-house lawyer to comply with subsections (d) and (e) of Model Rule 5.5, which reflect a policy judgment that such an in-house role “does not create an unreasonable risk to the client and others because the employer is well situated to assess the lawyer’s qualifications and the qualities of the lawyer’s work.” Model Rule 5.5, Comment 16. 

New In-House Registration and Limited Admission Rules

Illinois adopted a modified version of Model Rule 5.5(d). If that had been the only step taken on this topic in Illinois and elsewhere, George and other in-house lawyers licensed only in other states would have little to worry about with respect to UPL (as long as they kept their licenses current and confined their practices to representation of their employers). In tandem with the adoption of versions of Model Rule 5.5(d)-(e), however, many states (including Illinois, where George works) also adopted rules requiring in-house lawyers who are only admitted elsewhere in the United States to register with or obtain limited admission from the state bar regulatory authority. While the safe harbor in Illinois Rule of Professional Conduct 5.5(d) covers George, Comment 17 to the Illinois rule (based on Comment 17 to Model Rule 5.5) also contains a cross-reference to another Illinois rule on limited admission of in-house counsel in George’s position. The 2014 edition of the Comprehensive Guide to Bar Admission Requirements, compiled by the National Conference of Bar Examiners and the American Bar Association Section of Legal Education and Admission to the Bar, states that 33 states now have license, registration, or certification requirements for corporate counsel not otherwise admitted in-state, with application fees ranging from zero to $1,300. 

The ABA has adopted a Model Rule for Registration of In-House Counsel, but state rules on this topic vary on a number of subjects, including whether: 

  • The rule is framed in terms of “registration” or “limited admission” of in-house lawyers;
  • Representation is also permitted of organization personnel on matters relating to their organizational roles;
  • Court appearances on behalf of the organization are allowed;
  • Pro bono work for clients other than the organizational employer is authorized;
  • Time worked under the rule can later be used to “waive in” for general bar admission purposes;
  • The in-house lawyer must satisfy continuing legal education requirements; and
  • A one-time fee, annual payments, or both are required. 

Some states have no such in-house counsel rules. For that matter, not all states have yet even adopted a version of Model Rule 5.5(d)-(e); a number of states simply retain a vague prohibition on engaging in or assisting the unauthorized practice of law. 

A New Risk Spectrum

Whereas UPL by in-house lawyers was once a relatively low-risk subject nationwide, if only because of a relative lack of scrutiny, the UPL risk spectrum for in-house lawyers has broadened considerably. At one end of the spectrum, jurisdictions in which versions of Model Rule 5.5(d)-(e) have been adopted without any supplemental rules relating to registration of out-of-state in-house lawyers are even lower-risk from a UPL perspective than they once were. On the other hand, lawyers like George working in jurisdictions that have adopted registration or limited admission rules for in-house lawyers who are only licensed elsewhere now face greater risks than they did before Model Rule 5.5(d)-(e) – at least if they fail to comply. An initiative that was intended to help house counsel like George who are not locally admitted seems to have focused added local bar attention on in-house lawyers. 

Privilege Loss?

Another possible issue, on which there does not yet seem to be any case law, is whether George’s failure to comply with the Illinois house counsel rule could be used as a basis for claiming that Acme’s communications with George are not covered by the attorney-client privilege. A similar argument in analogous circumstances was rejected in Gucci America, Inc. v. Guess?, Inc., 2011 U.S. Dist. LEXIS 15 (S.D.N.Y. January 3, 2011). In that case, the in-house lawyer had been admitted in a state other than where he worked in-house, but had then gone on inactive status. The court concluded that a lawyer on inactive status was nonetheless a lawyer for purposes of the attorney-client privilege, and that the corporate employer was not under any obligation to check on the active bar status of its in-house lawyer. The case, however, did not address any in-house lawyer admission or registration rules, and it is unclear whether courts would take the Gucci approach in cases involving such rules. 

Illinois Amnesty

Responding to a perception that a significant number of in-house lawyers who are subject to the Illinois rule on this subject may not yet have obtained the required limited in-house licenses, the Illinois Supreme Court declared an amnesty for lawyers who apply for such licenses during 2014. In addition to the $1,250 registration fee provided for under the Illinois rules, an in-house lawyer taking advantage of the amnesty must also pay an additional $1,250 penalty, but is not expected to make up back payments or continuing legal education requirements. The court stated that the prior failure of such lawyers to apply under the rule would not be a basis for prosecution for having engaged in the unauthorized practice of law, that it would not be grounds for denying a license or discipline, and that such applicants would not be investigated by the Illinois Attorney Registration and Disciplinary Commission. Presumably implicit in those statements is the possibility that a lawyer such as George who is covered by the house counsel rule (Illinois Supreme Court Rule 716) and who does not take advantage of the amnesty could be subject to those actions thereafter. 

Conclusion

If unauthorized practice rules exist primarily to protect clients and others against unqualified lawyers, it is difficult to find many situations in which such problems have been experienced by corporations or other organizations employing in-house lawyers. To some, state rules regarding registration or limited admission of in-house lawyers like George are solutions in search of a problem. As a practical matter, these rules are probably designed, not to solve systemic problems relating to the performance quality of George or other in-house lawyers, but rather to (a) require such in-house lawyers to contribute financially to funding the state bar, and (b) ensure that such in-house lawyers are subject to local state bar jurisdiction. In-house lawyers such as George who have not complied with such rules should consider addressing the situation, and Acme and other employers of such lawyers may want to help or require them to do so.

Rule 5.5(d)-(e) of the Model Rules of Professional Conduct

(d) A lawyer admitted in another United States jurisdiction or in a foreign jurisdiction, and not disbarred or suspended from practice in any jurisdiction or the equivalent thereof, may provide legal services through an office or other systematic and continuous presence in this jurisdiction that:

(1) are provided to the lawyer’s employer or its organizational affiliates; are not services for which the forum requires pro hac vice admission; and, when performed by a foreign lawyer and requires advice on the law of this or another U.S. jurisdiction or of the United States, such advice shall be based upon the advice of a lawyer who is duly licensed and authorized by the jurisdiction to provide such advice; or

(2) are services that the lawyer is authorized by federal or other law or rule to provide in this jurisdiction.

(e) For purposes of paragraph (d), the foreign lawyer must be a member in good standing of a recognized legal profession in a foreign jurisdiction, the members of which are admitted to practice as lawyers or counselors at law or the equivalent, and are subject to effective regulation and discipline by a duly constituted professional body or a public authority.

Observations on Captive Insurance Companies: 10 Worst and 10 Best Things

Posted on February 18, 2014 by - Uncategorized

A captive insurance company (commonly referred to in short as a “captive”) is an insurance subsidiary that is set up by the parent company to underwrite the insurance needs of the other subsidiaries. For example, British Petroleum wisely set up a captive insurance company (Jupiter Insurance Ltd.) to provide environmental insurance to its operating units, and the moneys from its captive were used to fund in substantial part the Gulf cleanup. 

The vast majority of Fortune 500 companies now have captive subsidiaries (and many companies have several captives, including those for employee benefits), and captives are now also routinely used by small companies for the same purpose. Over 30 states now have captive-enabling legislation, most recently North Carolina and Texas, in addition to states such as Delaware, Kentucky, Missouri, Nevada, Utah, and Vermont, which are very active in marketing their states as premier jurisdictions for the formation of captives. 

A captive can be a wonderful risk management tool when used correctly; but therein lies the rub, many are not. The difference between a poorly-run captive and a well-run captive is often difficult for novices to discern. So, in reverse order, here are 10 bad practices involving captive insurance companies, followed by 10 good ones. 

Dangers of a Bad Captive Arrangement

10. Bogus Risk Pools

A lot of businesses with valid needs for insurance don’t have enough subsidiaries to pass what is known as the “multiple insured” test for risk distribution, and so they instead participate in what is known as a “risk pool” to obtain risk-distribution. 

In a nutshell, a “risk pool” is an insurance arrangement involving multiple, usually unrelated captive owners who share certain risks through their individual captives. Risk pools are usually set up by captive managers to facilitate the needs of certain of their captive clients. In various guidance, the IRS has validated the concept of the risk pool when run correctly. 

The difficulty is with the “when run correctly” part. The problem with most risk pools is that there is in fact very little sharing of risks, and thus, the large premiums being charged by the pool are neither actuarially sound nor bear anything but a coincidental relationship to reality. The IRS refers to these as “notional risk pools” – there is a notion of a risk, but not much beyond the mere notion. 

Many of these pools have been operated for years with few or no claims, which calls into serious question whether the large premiums they charge are realistic (the answer is that they are not). Maybe in the first year when the pool has no loss history, it can be aggressive in how it prices the premiums paid. By the fifth year, however, a run of large premiums with few or no losses probably indicates that the premiums were mispriced. 

By like token, if there is true risk-sharing in a pool, that means that the participants are subject to actual risk of loss – including the total loss of their premiums paid by their operating businesses into the pool. This is where the wink-wink, nod-nod of “That will never happen; actually you’ll never lose anything significant” usually shows up, which is another way of saying the risk pool is just a vehicle to facilitate the appearance of risk-shifting, without actual risk-shifting, i.e., tax fraud. 

While the saying around my office is “Pools are for fools!,” the truth is that some clients (including some of mine) cannot meet the test for risk distribution in any other way, and therefore make an informed business decision to participate in a risk pool. However, for these clients my advice is usually, “Do whatever reorganization of your business is necessary to get out of the risk pool as quickly as you can.” If a client is still in a risk pool after a few years just because they need the risk-distribution for tax purposes, there has been a serious failure in business planning by someone. 

9. Failure to Make Feasibility Study Prior to Formation

Before the decision to form the captive is even made, a feasibility study should be conducted that looks at all aspects of the captive and validates its viability and economics, as well as whether the captive will meet critical tests for risk-shifting and risk-distribution. 

If for no other reason, a feasibility study that carefully documents the non-tax purposes of the captive (to distinguish it from a tax shelter masquerading as a captive) should be done, since the IRS on audits of captives routinely asks for such documents as part of its evaluation. A good captive feasibility study will go a long way in showing the IRS that the captive is founded on solid business economics and does not exist merely to try to save some bucks in taxes. 

8. Ignoring State Tax Issues

There is a misconception that if the underlying business is doing business in State A, and the captive is formed in State B, then by virtue of that alone, State A cannot tax the captive. 

Not true. Actually, whether State A can tax the captive depends on a variety of factors. If business decisions regarding the captive are made in State A, for example (probably the most common way to blow this), then State A can probably tax the captive. 

Captive owners must be very careful to not let the captive “touch” State A in any way, unless of course the captive is formed in State A (and then it doesn’t matter, which is often the easiest and most sensible approach). This is usually accomplished by using a captive management firm (“captive manager”) to perform all the functions of the captive in State B; but just having a captive manager in State B isn’t enough – diligence is required not to blow this. 

7. Single-Line Myopia

Too often, captives are formed to underwrite one single risk of the organization, without looking at the myriad other risks of the enterprise. This happens the most when the captive is promoted by an insurance broker who is only focusing on helping the client with that one line of business, usually workers compensation, and it misses a lot of benefits for the client. 

In a sense, a captive is a lot like a casino – the more games in a casino, the better the risk distribution of the casino. The same is true with a captive having different types of policies; there is more risk distribution. Also, since the costs of a captive are often fixed or not dependent on how much insurance the captive underwrites, the more insurance that it underwrites, the better the economics of the captive. Which is to say that captives are usually the most efficient when they are underwriting all possible lines of coverage for the organization, not just a single line. 

Often, when a captive is being evaluated solely for a single line, the conclusion is reached that the captive will not be economical as to that single line only, when it might be very economical if it takes on other risks. It is difficult to understand why those involved with captives would not look to all the possible coverages the captive might underwrite for a particular client, but such myopia occurs very frequently. Frankly, there is a lot of “If I don’t sell it, I’m not going to worry about it” going on with the insurance brokers, but that attitude doesn’t serve their clients well. Good insurance brokers who assist their clients with captives will look at the entirety of the clients’ books of insurance business, as well as where the clients have chosen not to purchase third-party insurance because it is too costly. 

Take caution, however, that the IRS now apparently tests for “line-item homogeneity,” meaning it takes the position that each line of coverage must meet the tests for risk distribution separately, i.e., without regard to other lines of coverage being underwritten by the captive. Many captive tax professionals believe the IRS is flat wrong on that point and will lose a challenge on appeal to a U.S. Court of Appeals, but who wants to pay for that fight? 

6. Poorly-Drafted Policies

The policies underwritten by a captive should not be substantially different in their form than policies underwritten by any other insurance company. A good captive manager will use modified standard industry forms to draft policies. By contrast, bad captive managers will draft simplistic policies that often omit key insurance contract terms or else unnecessarily expose the captive to lawsuits by third-party claimants. 

There is a reason why there is so much boilerplate in typical insurance contracts – it works. But also, one of the biggest benefits to a client is the ability to custom-tailor coverage to more closely fit their needs by modifying the standard industry forms. Too many captive managers just slap out some basic policies and call it a day; what a shame for their clients to lose a wonderful opportunity. 

5. Bogus Insurance Contracts

I’ve actually sat in on meetings where some other adviser has told their prospective client something to the effect that, “You’ll pay premiums, but you don’t have to make claims!” (wink-wink, nod-nod). Then, I’ve had to inform the client that, “If you don’t make and pay valid claims under the policies, then you don’t have a captive, but instead, you just have a tax fraud.” 

The U.S. Supreme Court has defined “insurance” as including an “insurance contract.” If there is no valid, binding contract, which is fully honored between the captive and the operating subsidiaries, then there is no insurance. What you have then is simply a sham. 

4. Inadequate Capital

About once a month, somebody will call me to inquire about a captive, and say that they have already decided to put the captive in X jurisdiction. When I ask why, they say that it is because X jurisdiction only requires $25,000 in capital or some other small number. 

The problem here is that while a small amount of capital may be all that is required by local regulatory law, the minimum capital requirements of a captive for tax purposes is usually much higher, and must be set by an actuary. It is very rare that a captive will take in more than five times the amount of its capital in the first year, and more than three times the amount of capital in succeeding years. 

The idea is that the captive needs to have some “skin in the game” other than the premiums that it receives from insureds. In fact, the more capital that a captive has, the safer the arrangement will be from a tax standpoint. 

Note that this is primarily a first-year problem, since after the first-year’s policies expire, the reserves that back those policies then go into surplus and are available as capital for future underwriting. However, the problem can materialize in later years if there are excessive claims or the captive’s owners distribute too much of profits to themselves, leaving the captive’s capital cupboard bare. 

3. Highly Questionable Risks

A big problem with captives that are just disguised tax shelters is that their policies reflect the underwriting of longshot risks. Like, a really big longshot, as in a “10,000,000,000 to 1, an-asteroid-is-likely-to-hit-the-Earth-first” longshot. Think, hurricane insurance for a business whose operations are in Lincoln, Nebraska, or terrorism insurance for a business in Little Rock, Arkansas. 

Maybe it is possible that a really huge hurricane could make its way to Lincoln, or Al Qaeda someday decides to take out a firm in Little Rock, but what is the real risk of that happening? And even if one could say with a straight fact that it might happen, what is the correct amount of premiums for such a policy? $1 per $100,000,000 in coverage? It is sure not $500,000 for $2,000,000 in coverage, which is how the promoters of sham captives will often write it. 

Where a captive is formed as a tax shelter, sometimes the risks that are underwritten are already covered by insurance; such as where a doctor sets up a captive for tax reasons and tries to underwrite his or her malpractice liability risks, but then keeps an existing malpractice policy in place so that there is in actuality nothing being covered by the policy (since he or she doesn’t want the captive to actually have to pay a claim!). 

2. Premiums Not Bearing Any Relationship to Reality

There is an old joke in the captive insurance world, which is that “You don’t go to the bathroom without first getting an actuary to sign off on it.” That is not too far from the truth. Premiums must be set by a qualified actuary, or else they are probably not defensible in tax court. Unfortunately, what happens too often is that a tax attorney and the insurance manager meet with the client and ask, “How much do you want to save in taxes?” They then pull some premium numbers out of the sky to get the client to the desired target. 

Sorry, but it doesn’t work that way. The premiums of a captive have to be determined like any other insurance company; setting the premiums as would be done in an arm’s length transaction, which is by, among many other things, assessing the true risks of the operating subsidiaries, their needs for the particular insurance, and the minimum and maximum coverage required. 

Going back to the hurricane insurance for the business in Lincoln or the terrorism insurance for the company in Little Rock: what is the correct amount of premiums? It is going to be really low, as in dig-the-loose-change-out-of-your-couch low. It is not going to be $500,000 or even $100,000, yet such goofy premium calculations are common with captives that are merely a facade for a tax shelter. 

Note that having an actuary sign off on premium calculations is not always going to save you, as those premiums have to be reasonable too. Just like there are real estate appraisers whose first question is “What number do you want?,” there are corrupt actuaries who will give you either a $1 or $10,000,000 premium number for the exact same policy and risk. But remember: if the premium calculation is not reasonable, it will not survive a challenge no matter how lengthy the actuary’s credentials. 

1. Captive Insurance Companies Sold as Tax Shelters

The primary use of a captive must be for bona fide risk management purposes, and not to save taxes. Unfortunately, many of the same promoters of tax shelters who a few years ago were selling Son of Boss, CARDS, BLIPS, and other flavor-of-the-day tax shelters, are now selling captives as a way to save taxes, with only the barest lip-service being paid to the risk management function. 

Hale Stewart, an author of a book on captive insurance company taxation, told me recently, “Captives sold as a tax mitigation tool and not as a bona fide risk reduction, are not really captives at all. But I keep running into them.” So do I, mostly (but not all) so-called 831(b) captive insurance companies, i.e., captives that have made an election to be taxed as a small insurance company under IRS Code Section 831(b). While the vast majority of 831(b) captives are quite legitimate, there is still probably much more abuse going on with these companies than with non-831(b) companies. 

These “tax shelter captives” usually suffer from significant flaws, including inadequate capital, grossly overpriced premiums, insuring non-existent risks, lack of true risk distribution, or as a scheme to buy life insurance with pre-tax dollars. It is probably only a matter of time before these companies, and their owners, come to grief on any number of theories the IRS could assert. 

Avoiding the Hazards of a Bad Captive Arrangement

Like any other complex legal and financial structure, the money that one spends on a second opinion from truly independent counsel will be some of the best money they will ever spend. In this context, “truly independent” means somebody that a client finds themselves and is not related to or recommended by whoever is pitching them the captive. 

A lot of people in the captive world have gotten away for years with some really bad practices only because the IRS has not spent much time or effort looking in to the practices of captive insurance companies. But as the captive market has dramatically expanded, it is unrealistic to think that the IRS’s lack of attention will last much longer. 

So, either do a captive right, or don’t do it at all. Now, on to the good things about captive insurance, also presented in reverse order: 

10. Create a Giant War Chest for the Business

Like any insurance company, captives tend to accumulate a considerable amount of assets in reserves and surplus. While these assets back the policies issued by the insurance company, a portion of those assets may be available to the business owner in a worst-case scenario where the business owner needs the funds to cover a larger catastrophe. 

While there may be significant tax ramifications to “cashing out the captive” to meet some emergency not covered by a policy, at least the business owner has the option of so doing, and can then weigh the cost/benefit analysis at the time the money is needed. Certainly, getting money out of a captive is easier and more expedient than obtaining a business loan from a bank at a time when the business is in deep distress. 

During the 2008 crash, more than a few business owners did exactly that. And while their captives became empty shells for a while, they were able to use the money to save their businesses. While one who is setting up a captive certainly hopes their business never will have such a need, it is nice to know that safety net is there. 

9. Retain Key Employees

Occasionally, business owners will award a key employee or two by giving them equity in the captive as part of an overall strategy to retain those employees for the benefit of the business. Giving key employees stock in the captive is sometimes less messy and troublesome than giving them equity in the business itself, and can avoid the animosity that can sometimes materialize when other employees are not given a stake in the business. 

While this situation is rare, it works swimmingly. While ownership in the operating business is difficult to conceal, particularly for businesses with significant accounting staffs, often no one in the business except the owners knows what is going on with the captive, allowing great flexibility in creating key employee arrangements. 

8. Enterprise Asset Protection

A collateral benefit to a captive is that each dollar paid by the operating business to the captive reduces the assets of the operating business by that same dollar. Accordingly, if something goes dreadfully wrong for the business, those dollars are no longer available to creditors of the business. 

Indeed, captive insurance must rank as one of the best enterprise asset protection strategies ever created. Note that it would be very difficult for creditors of a business to prove that payments to a captive for bona fide insurance coverage would be a fraudulent transfer, since the business received back a substantial economic benefit in the insurance coverage from the captive. Also, the captive may (and usually is) structured to be remote from the underlying business for purposes of bankruptcy, so even if the operating business is forced into bankruptcy, the odds are low that the captive will be swept into the bankruptcy vortex. 

7. Cover Risks Otherwise Exposed

Businesses are often forced to effectively self-insure risks (whether they realize it or not) because either the risk is so unusual that insurance cannot be purchased for it at any price, or because the insurance to cover the risk is exorbitantly expensive. These are ideal risks to be covered by a captive, and indeed, this is one of the primary purposes of captive insurance. 

Moreover, even where a business has insurance against certain types of risks, the business will still be exposed to deductibles and exclusions. While in the past, general liability insurance (known in the industry as “GL”) covered a very broad range of risks, typical modern exclusions give such a policy more holes than Swiss cheese. These days, the typical GL policy may have exclusions for things like employment practices liability, which exposes the business to claims of sexual harassment, age discrimination, wage and hourly claims, and the like. The insurance provided by captives can fill these gaps. 

6. Draft Your Own Policies

Captives can (and should) draft carefully custom-tailored policies to fit the exact needs of the business. This not only means covering areas of exposure and eliminating exclusions, but also drafting the policy in ways that make it nearly impossible for a third-party claimant against the business to assert a claim directly against the policy (unlike most commercial policies). 

Because policies can be custom-tailored, they can be much more efficient. With commercial policies, a business might be stuck with $2 million in coverage of some risk, even though as to that particular risk, the business might only need a more precisely-calculated $1.45 million in coverage – so the business need not pay for what it doesn’t need, and instead allot those same premium dollars to other risks for which the business is exposed. 

5. Choose Your Own Counsel

When you buy insurance from a commercial carrier, they typically retain the right to hire an attorney for you. Theoretically, the attorney that your insurance company hires will be your attorney and only look out for your interests even to the detriment of the insurance company – but will he or she really do so? 

Insurance defense counsel may be assigned 200 cases from a particular insurance company in a year, only one of which is yours. Who do you think they will really owe their loyalty to? Additionally, insurance companies are notoriously cheap when it comes to hiring counsel – you may get someone whose primary qualification to handle your defense is that he or she bid lower than any other insurance defense attorney for the work. 

My advice has long been that if you are ever sued and your insurance company appoints counsel for you, get your own counsel to ride herd on your insurance company’s lawyers; i.e., make sure that they competently represent your interests first and foremost, and if possible, settle the claim within policy limits. 

With a captive, a business doesn’t have these problems at all. Since the business owners control the captive, they can select the counsel of their choice to handle particular claims. They have the option of not opting for the cheapest insurance defense counsel, but the best. Or, on the flipside, they can retain a good insurance defense attorney to handle most matters at a discount. All this usually has the effect of a better defense at a lower cost to the business. 

4. Administer Claims on Your Own Terms

A problem with commercial carriers is that they can allow a small claim to fester, either by not taking care of the claim early or by allowing it to drag on without resolution. Or, the insurance company may settle a frivolous claim just to save defense costs, thus encouraging more such frivolous claims against the business. 

With a captive, the business owners can administer their own claims on their own terms, and get on top of claims quickly before they spin into something much larger. The business owners can also choose to not settle frivolous claims, forcing the plaintiff’s attorneys to incur time and expense litigating the claims before dismissal, and by doing so, deter future lawsuits. 

A captive’s ability to draft its own policies, choose its own attorneys, and administer its own claims are all important cost-saving benefits of a captive. 

3. Save Money on Insurance

The primary purpose of a captive is to save money on insurance, and in this, captives have no equal. There are three main aspects to this: 

First, by underwriting the insurance needs of the business, the captive can capture and retain the underwriting profits that would ordinarily be lost to the commercial carrier. Additionally, considering that commercial carriers have enormous costs that must be priced into their policies, such as the expense of compensating agents, marketing and advertising expenses, and high executive compensation, there is a great deal of fluff having nothing to do with true risk in commercial policies that can be saved through the use of a captive. 

Second, even where the business decides to keep commercial insurance in place against particular risks, the captive can be used to reduce costs by raising deductibles, lowering coverage limits, or increasing exclusions – the idea being for the business to find the sweet spot where the commercial insurance is most economical, and then use the captive to insure around that area. Since the greatest expense of most insurance policies is the “first dollar” expense, simply increasing deductibles can result in dramatic premium decreases with commercial policies. 

Third, the mere existence of the captive and its ability to underwrite risks can save money even if the captive is never used for that purpose at all. This is because the insurance broker knows that if the premium prices offered to the operating business for insurance are not efficient, the operating business may decide to cover them in the captive instead – and once that particular book of business is lost, it may be forever lost to the broker. Thus, the threat of a captive can be used to significantly barter down the commercial carrier into offering insurance to the operating business at rock-bottom prices. 

The combination of all three of these factors can result in very substantial savings to the business enterprise, but the benefits of a captive can extend well beyond the immediate savings of insurance dollars. 

2. Forces the Business to Focus on Risk Management

When a business is buying insurance from a commercial carrier, the concept of claims is only loosely attached to the economic cost to the business in terms of increased premiums. But when claims are being paid from a captive – effectively, from the business owner’s pocket – the focus on claims can become intense, and consequently, the business becomes focused (often for the first time) on enterprise risk management. 

The benefits of enterprise risk management, while sometimes hard to exactly quantify, are enormous. The focus shifts to analyzing the business so as to spot potential risks. Claims are thus prevented instead of administered. In the end, the business owner gains a better understanding of the business and its limitations, and that is priceless. 

1. Create a New Business

Many business owners who form captives think of it for what it does, but they don’t realize that they have just created a new business – an insurance company – and thereby cast themselves into the business of insurance. The captive thus acts not just as an enterprise risk management tool, but also as a segue into a whole new business opportunity. 

An existing captive with sufficient capital can be converted to a full insurance company that offers insurance to the general public by changing its license and business plan, and meeting certain other state requirements. This usually doesn’t mean that the new insurance company owner will throw open the doors to the general public, but instead often limits business to the same business that the owner is familiar with – offering insurance to similar businesses where the insurance company owner can get a good feel as to their claims exposure, and accordingly, price premiums appropriately. 

The business of insurance can be a great business, and more than a few business owners find insurance an even better business than the successful business they are already in. I’ve had more than a dozen clients go from their captive being just another affiliate in their overall business organization, to running an insurance company and conducting the business of insurance as their primary business. 

A Final Note

Note that I haven’t mentioned tax savings as one of my favorite benefits of captives. While captives can offer certain tax advantages to business owners, my tendency is to view a proposed captive arrangement as tax-neutral and make sure that it works without any regard to any tax benefits. This is because to the extent that a captive offers tax benefits, those are the icing on the cake – the cake is the numerous other non-tax advantages of captives, and the cake by itself is pretty good.

 

 

Current Tax Issues with Captive Insurance Companies

Posted on February 18, 2014 by - Uncategorized

Large U.S. companies have been forming captive insurance companies (wholly owned insurance subsidiaries) since the 1950s. In general, such large captives are formed for one of three main reasons. First, some companies are unable to obtain necessary insurance coverage. For example, certain nuclear power companies formed a captive named Nuclear Electric Insurance Limited, because they could find no other insurance coverage. Second, some companies seek to obtain cheaper insurance. For example, the trucking market is currently “hardening” (premiums are increasing), leading to trucking companies forming captives. Third, some companies seek to gain more control over their current insurance program. 

The insurance code offers a small insurance company a strategic advantage: Internal Revenue Code (IRC) § 831(b) allows insurance companies with less than $1.2 million in premiums to be taxed on their investment earnings rather than on their gross income. As a simple example, suppose a small insurance company had $500,000 in income but earned 5 percent on its total portfolio earning $25,000 for the year. The company would use the $25,000 figure as their gross income figure for the year. 

A captive can also be formed offshore and still be deemed a U.S. captive, provided it makes an IRC § 953(d) election agreeing to be taxed as a domestic company. For many large captives, forming offshore may provide a great deal of flexibility not found onshore. However, it should be noted that the Internal Revenue Service (IRS) is currently spending a great deal of time focused on offshore tax enforcement. Recently, the IRS refused to issue a positive private letter ruling to a number of foreign captives seeking 831(b) status, which may be an indication of tougher IRS scrutiny in this area. Thus, while a compliant captive should ultimately have nothing to fear from operating internationally, there is at least some chance that doing so may result in some additional compliance costs if it gets caught up in the IRS dragnet. 

This article will: (1) provide a brief history of captive insurance companies; (2) outline key requirements for captive insurance including insurance risks, risk shifting, risk distribution, and reinsurance; and (3) discuss certain IRS enforcement areas in captives, including excessive premiums and IRC § 831(b) tax shelter issues.

A Short History of Captive Insurance Companies

The IRS defines a captive insurance company as a “wholly owned insurance subsidiary.” According to the case law of that time, companies started forming captives in the 1950s because they couldn’t find insurance, could only find very expensive insurance, or simply decided that forming their own insurance company made more sense. The taxpayers in both United States v. Weber Paper Co., 320 F.2d 199 (8th Cir. Mo. 1963) and Consumer’s Oil Corp. of Trenton, NJ v. United States, 188 F. Supp. 796 (NJ 1960) owned property for which they could not procure flood insurance, leading both to form an insurance company. While the taxpayer in Beech Aircraft Corp. v. United States, 797 F.2d 920 (10th Cir. Kan. 1986) did have an insurance policy, its carrier had complete control of its attorneys during litigation. When Beech was sued under a products liability claim in the early 1970s, it filed a motion to remove its insurer-appointed counsel several weeks before trial. The court denied this motion and Beech lost the case. Subsequently, Beech formed a captive to write its own insurance policy. Other cases provide similar examples. 

The IRS was concerned by the rise of captive insurance for two inter-related reasons. Their first concern was that the “captive insurer” was in fact a reserve account, defined as “an estimate of a definite liability of indefinite or uncertain amount.” While there is a certain amount of conceptual overlap between a reserve account and insurance (in both, a party is attempting to financially prepare for an anticipated contingency), contributions to a reserve account are non-deductible while premium payments are deductible. This leads to the IRS’ second concern – the rather uncertain nature of the legal definition of insurance. While the Supreme Court in Helvering v. Le Gierse, 312 U.S. 531 (U.S. 1941) defined insurance in 1943 as being comprised of both risk shifting and risk distribution, it provided no further guidance for either term. Hence, the IRS could legitimately argue that the captive insurance company was not in fact a bona fide insurance company but instead a reserve account, allowing the IRS to deny the deduction claimed by the parent company for the premium paid to the captive. 

Captive litigation can be broken down into pre- and post-Humana v. Commissioner, 88 T.C. 197 (1987). From the late 1970s to the late 1980s (pre-Humana) the IRS won a majority of their cases due to better preparation, weak taxpayer defenses, and a judiciary unaccustomed to dealing with the technical requirements of insurance. The Humana decision changed this, as the structure was well set-up and expertly defended and explained by counsel, leading to a partial taxpayer victory. Between Humana in the late 1980s and United Parcel Service of America v. Commissioner, 254 F.3d 1014 (11th Circuit 2001) in the early 2000s, the IRS lost most of its cases as taxpayers established better structures, these structures were better defended, and several states passed captive insurance-enabling legislation. The death knell for this initial wave of IRS captive litigation was the UPS decision, which the IRS won at trial based on an assignment of income argument, but which the appeals court disagreed with in a tersely worded decision, in which it reversed the tax court’s ruling and remanded for further action. Following the UPS case, the IRS largely ended its initial quest of litigating to prove the invalidity of captive insurance.&nbsp

Insurance Risks, Risk Shifting, and Risk Distribution

Counsel interested in recommending a captive to a client needs to be aware of several basic concepts, the first of which is derived from The Harper Group v. Commiss’r, 96 T.C. 45, 47 (1991), which states that all captives must comply with the following three factors: (1) the arrangement involves the existence of an “insurance risk”; (2) there is both risk shifting and risk distribution; and (3) the arrangement is for “insurance” in its commonly accepted sense. Points one and three can be reworded to simply say all captives must function as insurance companies; the insured must demonstrate it will be materially harmed (usually through financial loss derived from an ownership interest), and that the harm is “fortuitous” – one which is random and cannot be prevented. 

Risk shifting and risk distribution are a bit more complicated. Risk shifting is seen from the insured’s perspective and requires the risk of loss to “shift” from the insured to a third party. This is accomplished via an insurance policy (whose formation and terms are interpreted under basic contract law principles). Risk distribution is seen from the insurer’s perspective, and requires the insurer to pool risk from a sufficient number of resources such that losses smooth out over time. Non-compliance with either of these factors comprised the “economic family argument,” the IRS’ primary anti-captive weapon. 

Reinsurance or Safe Harbor IRS Revenue Rulings

One of the largest benefits of a captive is the ability to access the reinsurance market. Reinsurance is often called “insurance for insurance companies” as it allows insurers to spread out the risk of their own portfolios. For example, suppose an insurer was exposed to $5 million of potential claims for the year. The insurer could purchase reinsurance, thereby lowering its risk exposure. In our example, the insurer could purchase reinsurance that covered risks of about $2,000,000. Therefore, if the parent company had losses over $2,000,000, the reinsurer would be liable. 

The IRS has provided two safe harbors for captive insurance companies that decide not to use traditional reinsurance. All captives that wish to take advantage of a safe harbor must comply with one of two fact patterns outlined in specific IRS Revenue Rulings. In Rev. Rul. 2002-89, the captive insurer must derive at least 50 percent of its revenue and risk from a non-parent. For smaller captives, this is usually accomplished through the use of “risk pools” wherein a group of captives shares a portion of their risk with other captives, usually managed by the same captive management company. Participation is usually accomplished through a quota treaty retrocessional reinsurance arrangement. In Rev. Rul. 2002-90, a captive must underwrite risk for at least 12 different subsidiaries, with none comprising less that 5 percent nor more than 15 percent of the total risk underwritten by the captives. 

Excessive Premiums

One area that is currently being litigated by the IRS is excessive premium payments beyond what is reasonable for the claimed insurance risks. The IRS has a few cases in the U.S. Tax Court pipeline that address this issue, so it would not be unexpected that more such cases will follow. The IRS is concerned with transactions in which the tax deduction claimed is actually the reason for the existence of the policy. Treasury Regulation § 1.801-3(a) provides that an insurance company is “a company whose primary and predominant business activity . . . is the issuing of insurance or annuity contracts, or the reinsuring of risks underwritten by insurance companies.” When the captive charges commercially unreasonable or non-arm’s length premiums, it may not be treated as bona fide insurance company. Thus, if the true purpose of an insurance company is to provide tax deductions, then the company may not qualify as an “insurance company” under the IRC. 

In the area of small captives, the existence of a $1.2 million maximum premium payment makes this type of analysis particularly relevant. The IRS requires that a captive operate as an actual insurance company in order for it to receive the economic benefit allowed under IRC § 831(b). It is important to remember that the $1.2 million can purchase a large amount of commercial insurance, so any small captive claiming policy premiums of that size may come under IRS scrutiny unless it has a very significant amount of provable potential claims.

IRC § 831(b) Tax Shelter Issues

The IRS is aware of certain questionable tax shelter practices in the captive world, especially in connection with small IRC § 831(b) captive insurance companies. While these arrangements are certainly a minority of the larger pool of compliant captives, it is worth noting some of the more prevalent IRS tax shelter issues here. 

Some IRC § 831(b) captive policies insure risks that are unrealistic with respect to the insured business. Specifically, certain insurance risk pools centered on terrorism are currently attracting increased IRS attention. The concern arises here because so few businesses may actually have the need for insuring against a terrorist act, making this coverage appear to be too remote to be justified for most insureds. While there are certainly business operations that involve terrorism risk, there are also many businesses that do not have this risk. 

The IRS has also become aware of the use of life insurance in IRC § 831(b) captives as a pre-ordained investment. Since life insurance is not generally a deductible business expense, the concern here is that the IRS may see a pre-planned use of an IRC § 831(b) captive as a conduit for life insurance as both undermining the business purpose of the captive, as well as a device for taking a deduction that the business could not otherwise take directly. The judicial doctrines and codified economic substance doctrine could be applicable here. 

Since an IRC § 831(b) captive may result in the deferral of realization of ordinary income, over a long period of time, this type of captive may accumulate a very large amount of retained resources. Because a captive is taxed as a C corporation, this type of large reserve could be subject to the Accumulated Earnings Tax (AET). The AET is a 15 percent penalty tax designed to prevent corporations from unreasonably retaining after-tax earnings and profits in lieu of paying current dividends to shareholders. Accumulated taxable income is reduced by a credit for an accumulation amount sufficient to satisfy reasonable current and future anticipated business needs. 

Conclusion

Captive insurance companies have been around since the 1950s and are currently a popular alternative vehicle for insuring risks associated with businesses. There are several key requirements that must be met for captive insurance to be deemed proper by the IRS. These include insuring real risks, shifting the risk from the insured business to the insuring captive, and the captive distributing the shifted risk among several other captive insurance companies. The IRS has raised specific tax issues that are currently the subject of IRS enforcement actions. These include the payment of excessive insurance premiums, as well as several IRC § 831(b) tax shelter issues. Overall, captive insurance may be an excellent insurance option for midsize and large businesses, provided that the professionals structuring the arrangements comply with IRS requirements in connection with the formation and maintenance of the captive insurance company.

 

 

 

 

Choice of Domicile in Captive Insurance Planning

Posted on February 18, 2014 by - Uncategorized

A captive insurance company in its most typical form is essentially a new subsidiary that is created by a parent company to underwrite the insurance needs of its operating subsidiaries. The basic idea of a captive is to bring in-house the purchasing of insurance that was previously done from unrelated commercial insurance companies, and retain the underwriting profits for the benefit of shareholders. But even beyond that, captive insurance companies fulfill a large role in making the entire enterprise focus on the management of its various risks of loss and incurring liabilities. 

The factors that go into the decision to form a captive insurance company, and the steps to do so, are beyond the scope of this article and are well-treated elsewhere. This article will focus upon a critical inquiry that is inherent in the captive creation process, which is the choice of the jurisdiction where the captive will be formed and domiciled. 

Captive insurance companies were originally formed outside the United States, usually in well-known debtors’ havens such as Bermuda, the Cayman Islands, and the British Virgin Islands. This is because of a perception that there were certain potential local tax benefits to being formed in those domiciles, but much more importantly, because the U.S. states did not have captive legislation, and instead treated captives like normal commercial carriers. Doing so made little practical sense, insofar as normal commercial carriers are subject to a wide swath of laws designed to protect the general public, such as requiring large amounts of capital and reserves, public filing of policies, and making premium rate requests. These requirements were, of course, nonsensical in the captive context where there is little need to protect the operating subsidiaries from the captive insurance company ultimately owned by the same parent. 

Vermont cracked open the door to captives in 1981, and through sheer persistence and aggressively changing its laws to match or exceed those of the offshore havens in favorability, was able to hold its own and grow its captive business against the likes of Bermuda. The IRS kicked the door wide open in 2002, following its landmark loss in United Parcel Service v. C.I.R., 254 F.3d 1014 (11th Cir. 2001), by issuing Revenue Rulings 2002-89, 2002-90, and 2002-91, that not only recognized the fundamental legitimacy of a properly structured and operated captive insurance arrangement, but also created safe-harbors in the confused area of risk distribution. Numerous states then flooded the captive marketplace – 37 states as of this writing – by passing captive insurance enabling legislation. 

It should be noted that for most tax purposes, there is little difference between an offshore captive (one formed outside the United States) or a domestic one, since the vast bulk of captives make the election under Tax Code § 953(d) to be treated as a domestic company. These days, the reasons for a captive to “go offshore” most often relate to those relatively few captives that for tax reasons do not make the § 953(d) election (captives owned by charitable organizations, for instance, have tax reasons for wanting to be taxed as a controlled foreign corporation instead), or captives where financial privacy or practical immunity to the enforcement of a domestic judgment is at a premium. 

The analysis and planning that goes into the formation of a captive insurance arrangement may be likened to the solving of a Rubic’s cube, where decisions must be made that will affect several or all sides, and some key issues must be resolved at once as if some juridical algebra problem. Most often, the question of where the captive should be domiciled is one of the last – not first – issues to be resolved. This is because the resolution of other issues, such as availability of capital, specialty lines of insurance to be written, and particular needs for flexibility in the investment of the captive’s assets, quite often lead to the choice of a particular domicile. There is rarely a need for prospective captive owner to choose the domicile as a first step, and indeed to do so can lead to missed opportunities if the captive arrangement could have been more efficient if formed elsewhere. 

But even beyond that, the issue of state taxation of premiums now most often resolves the issue – particularly if the captive owner is headquartered in one of the ever-increasing number of captive-friendly states. In the past, states paid little attention to their fiscal losses occasioned by captive insurance, mainly for the reasons that the very concept of captive insurance was little known to the state tax authorities, and payments to captives (as opposed to ordinary commercial insurance carriers) are inherently difficult for state field auditors to pick up. While some states have long been aggressive in taxing the premiums paid to captives (Texas is probably the best example of this), it has only been recently that other states have taken note of their own fiscal losses and have grown more aggressive in taxing the premiums paid to captives. Yet, at the same time, when a state passes new captive insurance legislation, in order to make that state’s laws more attractive to new captive formations, the state will usually exempt or substantially limit the taxes on premiums paid to its in-state captives. This creates a very powerful incentive for new captive owners to choose their own state (if it is friendly to captives) to form their captive, and puts pressure on existing captive owners to bring their captives back home. 

So, the default rule might be well be – if it isn’t already – the best domicile to form your captive is the one you are in. This disregards, however, that some states such as California and Washington do not yet have captive enabling legislation, while other states have either done little or nothing to implement their legislation, or have implemented it very poorly. The upshot of this is that many prospective captive owners will have to look beyond their state’s borders for a place to land their new insurance company. It is for these owners and their advisers that the factors discussed below will be of the most importance. 

It would be easy enough at this point to dive into a discussion of the technical nuances of the laws of various jurisdictions. That would not do the subject proper justice. Long experience has shown that the single most important factor in choice of domicile for a captive is not any specific statute or regulation, but that of the amenability of the insurance regulators in the domicile to working with captive owners to make the arrangement a success. Laws and regulations are only so good, or bad, as they are interpreted by their regulators, and in the case of captives this typically means the insurance commissioner’s office or equivalent. 

Very simply, a bad insurance commissioner’s office can make hash out of the best captive laws and regulations with the result that the captive owner becomes quite miserable. A good insurance commissioner’s office can, by contrast, work through mediocre laws and regulations to make captives in the state a happy success. Of course, no chart could adequately spell out the differences in how these regulators treat captives, and any such chart would be obsolete as quickly as the personnel changes occurred in the insurance commissioner’s office, which they do with some regularity. Suffice it to say that the best information about regulators must be obtained anecdotally from captive managers and other captive professionals who have done business in the state, while noting that the regulators of some states have a long and consistent history of favorable treatment of captives, while other states have undergone uncomfortable fluctuations dependent upon whomever is in charge at a given time. 

With that caveat firmly in mind, we turn to an examination of the statutory and regulatory factors that go into domicile selection for captives. What we will see is that the specific requirements of each jurisdiction are very similar. There is a good reason for that, which may be accurately expressed in a single word: competition. To vie for business, the various domiciles must offer regulations that are as, or more, favorable than that of competing jurisdictions. One may attribute Vermont’s long run of success to the fact that its state legislature, mindful that the captive sector is its second largest industry, has demonstrated a willingness to quickly consider and pass cutting-edge legislation so as to keep Vermont’s captive laws competitive with those of other jurisdictions. 

Minimum capitalization, i.e., how much cash the captive will need to qualify and stay qualified for its insurance license, is a significant factor of consideration in choosing a domicile. Obviously, the less money that a captive owner has to tie up in the captive, which moneys may be deployed to greater returns elsewhere, the more efficient the captive arrangement will be. Thus, captive domiciles compete for business by lowering their capital requirements to certain minimum amounts. 

It is here that our Rubic’s cube reappears, where we have to solve more than just one side of the puzzle at once. Although captive owners naturally desire to place as little capital as possible in their captive, the requirements of tax law must be taken into consideration. For tax purposes, one of the elements to establish the existence of an insurance contract is the requirement of “risk shifting,” which posits that the captive must have more risk of loss than simply the premium that it takes in from its insured. The captive must have, the slang goes, enough of its “own skin in the game” such that it can satisfy claims against a policy over and above the premium received. 

Thus, there are both actuarial and tax variables in the minimum capitalization equation. From the actuarial side, the limits on the maximum potential losses that the captive may underwrite – and thus policy limits – are limited by some combination of the total premiums to be received by the captive, loss expectancy, existing reserves, and capitalization. Plus, while the IRS has provided painfully little guidance on what constitutes minimum capital for tax purposes, it seems (largely anecdotally) that the captive’s capital should not be less than one-third of the premiums received in any given year, i.e., as it is usually articulated, premiums should not exceed capital by a ratio of greater than 3:1. 

There seems to be an accepted exception to this ratio for the first year of a captive’s existence, when the ratio of premiums to capitalization should not exceed 5:1, and which takes into consideration that relatively few claims are likely to have matured to where they will require payment in the first year. It is this 5:1 ratio that has worked to set the standard for minimum capitalization in most captive domiciles. The vast majority of captives start out as companies that make the Tax Code § 831(b) election, which means that the captive will not be taxed on its premium income so long as its premiums received do not exceed $1.2 million during the year. Applying the 5:1 ratio to $1.2 million results in a minimum capitalization requirement for tax purposes of $240,000 (which has been rounded up for statutory purposes to $250,000), which represents by far the most common minimum capitalization requirement of domestic domiciles. The states that have higher statutory minimum capital requirements are usually avoided by captive owners. 

However, not all new captives will take in the maximum amount of $1.2 million in premiums the first year, and this is where regulatory flexibility to lower the minimum capital for the first year only can be a very significant advantage for a captive domicile. These exceptions are created by the very practical recognition that by the second year, the premiums paid in the first year for the first year’s policies which have not expired, will be available to apply toward the statutory minimum. 

Offshore domiciles often have much lower minimum capital requirements (Nevis only requires $10,000 in capital for a single-owner captive) in consideration that many of the captives they form will not be subject to the minimum capitalization requirements for U.S. tax purposes, as their owners will often have little or no connection to the United States. But again, the statutory minimum capital requirements are but one side of the captive Rubic’s cube for U.S. taxpayers. 

Investment flexibility, i.e., the particular domicile’s rules about how the captive’s assets may be deployed, is a very significant factor in choosing a captive domicile – some might suggest the single most important factor. Non-captive commercial insurance companies are usually subject to “permitted asset” rules, which are an exhaustive list of the things that such insurance companies may invest in, so as to help protect the financial health of those companies from speculative investments (and also the state insurance fund from having to take over the liabilities of an insolvent carrier). The investment rules relating to captives can be much more flexible, and it is here that the domiciles have an opportunity to really compete against each other. 

Prior to the 2008 crash, which resulted in the liquidation of not just a few captives whose investments had failed, the investment rules relating to captives were typically very lax. The typical statement was that an investment was appropriate, “so long as it does not threaten the minimum liquidity of the company.” In application, this had an “almost anything goes” air, and led to captives making all sorts of creative, speculative, but often ill-advised investments, of their assets. 

After the 2008 market crash, many regulators started to the take back the reins over captive investments. This has been most commonly seen in how regulators view a large, single investment that comprises a large percentage of the captive’s overall assets, say over 30 percent – regulators now often cringe when so many of the captive’s eggs are be placed in one basket, and may either refuse to approve the investment or require additional capital to be infused into the company. But it is also seen in regulators occasionally requiring that certain captives abide by the very regimented investment restrictions for non-captive commercial carriers. 

As with so many things in the captive sector, the best information regarding a domicile’s investment flexibility is not necessarily found in its laws or regulations, so much as learned anecdotally from conversations with captive managers and owners of existing captives in that state. It should also be noted that investment flexibility in a particular domicile has the potential to change literally overnight as personnel changes in the insurance commissioner’s office bring different attitudes about how captives should be safely investing their assets. This issue can be a moving target, and more than a few captives have left particular domiciles and migrated elsewhere when they felt that investment restrictions had become too strict. 

Infrastructure support, i.e., the ability of the insurance commissioner’s office to effectively handle captives, is also a very important consideration. Newer domiciles in particular are often unwilling to extend adequate funding to the captive division within the insurance commissioner’s office until the economic benefits of captives within the state have been established. Indeed, while 37 states have passed captive enabling legislation, probably a third or so of these states could be said to have adequately funded their insurance commissioners to allocate resources for separate captive regulators; this is why captive development is stillborn in those states. 

On the other hand, the legislatures of the handful of states that lead the sector in the number of captives domiciled have seen the economic benefits of captives and have well-funded their insurance commissioners’ offices to properly administer them. These states have independent “captive deputy commissioners,” full time staffs, and quality financial analysts and examiners who are highly experienced with captives and their peculiar needs. 

But infrastructure support is not just limited to the insurance commissioner’s office. The best domiciles will have many quality captive managers who have been at least minimally vetted by the commissioner, and a cadre of other professionals such as accountants and attorneys who are likewise familiar with captives in that state. The availability of numerous of these captive service providers and professionals gives captive owners both the ability to choose between numerous competent providers and professionals, and the benefits of competition between them to drive down the pricing of their services.

In summary, there is quite a bit of analysis that goes into the selection of the domicile for a captive insurance company, and much of that analysis will be based on anecdotal information obtained from others who have practical experience in particular domiciles. The resolution of other considerations in the planning of the captive will quite often require the elimination from consideration of certain (if not many) domiciles, and make the choice of domicile in the end that much easier. But even if the grass appears greener on the other side of the fence, strong consideration to forming the captive in the state where the operating business is located now should always be made, even if that state’s captive laws and regulations are not the best.

 

Revisiting MAE MAC Clauses in M&A after Cooper T

Posted on February 18, 2014 by - Uncategorized

In what is now a familiar scenario, a megamerger unravels after post-signing events make the target less attractive to the acquirer, the acquirer develops considerable buyer’s remorse, and the target accuses the acquirer of delaying the deal.  If the acquirer has failed to negotiate a termination right triggered by the unforeseen events and also possesses an obligation to close, then the target may have a viable claim for breach of the merger agreement arising from the acquirer’s intentional delay. 

This fact pattern unfolded after Cooper Tire & Rubber Company announced a proposed $2.5 billion sale of the company to Apollo Tyres Limited (Apollo Tyres) in June 2013. The United Steelworkers (USW) asserted that the proposed merger required a renegotiation of the union’s contract with Cooper. After Apollo Tyres conditioned its participation in negotiations with the USW on Cooper accepting a $9 reduction in the deal price of $36, Cooper filed an action in Delaware. Cooper argued that Apollo Tyres breached a covenant to use its “reasonable best efforts” to obtain approvals required for closing. In Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd., C.A. No. 8980-VCG (Del. Ch. Nov. 8, 2013), the Delaware Court of Chancery rejected Cooper’s claims that Apollo Tyres breached the merger agreement, but cautioned Apollo Tyres against continuing to use the union issues to renegotiate the deal price. Cooper terminated the merger agreement in December 2013. 

The Cooper fact pattern was reminiscent of the events that unfolded after Hexion Specialty Chemicals, Inc., and its parent, Apollo Global Management, LLC (Apollo), agreed to acquire Huntsman Corp. in 2007. During the period between signing and closing, Huntsman reported disappointing earnings, and Hexion attempted to extricate itself from the transaction by claiming that Huntsman had suffered a material adverse effect and would be insolvent post-closing. In subsequent litigation, the Delaware Court of Chancery found that the changes in Huntsman’s financial performance did not constitute an MAE. Apollo Global Management, LLC v. Huntsman Corp., 965 A.2d 715 (Del. Ch. 2008). 

More recently, the Delaware Court of Chancery found that short-term changes in financial results could conceivably constitute a material adverse effect under an acquisition agreement for purposes of a motion to dismiss against a backdrop of allegations of fraudulently misconduct by the sellers of a privately-held business. Osram Sylvania, Inc. v. Townsend Ventures, LLC, C.A. No. 8123-VCP (Del. Ch. Nov. 19, 2013). 

The acquirer’s typical protection against undesirable risks from significant changes in the target’s business between signing and closing is the material adverse effect or “MAE” clause. As more fully outlined below, these cases suggest that short-term, forward-looking elements of the MAE definition in merger agreements merit more attention by deal practitioners. 

Cooper Tire & Rubber Company v. Apollo (Mauritius) Holdings Pvt. Ltd.

Background

This case arose after labor issues in both the United States and China threatened to unravel Apollo Tyres’ proposed $2.5 billion buyout of Cooper. Workers seized Cooper’s largest Chinese facility in July 2013, rendering it unlikely that Cooper could deliver timely, interim financial statements to Apollo Tyres. In addition, the USW filed an arbitration proceeding in Tennessee, alleging that the merger agreement violated the union’s collective bargaining agreements with Cooper. Thereafter, an arbitrator issued an order, preventing Cooper from consummating the merger absent renegotiation of its agreements with the USW. As a result, Apollo Tyres and Cooper agreed not to close the merger until the union contracts had been renegotiated. Subsequently, Cooper lowered its forecasted profits for 2013 by one-third, largely as a result of the labor issues. Thereafter, Apollo Tyres made some attempts to renegotiate the USW contracts (without Cooper’s input), but eventually halted negotiations because Cooper would not agree to a reduction in the merger price. Cooper estimated the cost of the USW developments to be about $10 million over six years, while Apollo Tyres argued that the economic effects would be more severe, warranting a $9 per share decrease in the merger consideration. 

In October 2013, Cooper initiated this action, alleging that Apollo Tyres breached Section 6.12 of the parties’ merger agreement by failing to use its “reasonable best efforts” to renegotiate the USW contracts. Cooper focused on Apollo Tyres’ decision to condition its participation in negotiations with the USW on a reduction in the merger price despite the parties’ exclusion of the impact of the announcement of the merger on Cooper’s relationship with its labor unions from the events that would constitute a material adverse effect. Cooper also had listed the possible renegotiation of the USW contracts on its disclosure schedules. 

The Court’s Decision 

Although the court found that Apollo Tyres did try to use the developments with the USW, the events at Cooper’s Chinese facility, and Cooper’s disappointing interim financials to reduce the merger consideration, it found no breach of Section 6.12. The court reasoned that Apollo Tyres possessed a good-faith but erroneous belief that the developments with the USW might constitute a material adverse effect under the merger agreement. The court also found no evidence that Apollo Tyres otherwise dragged its heels in violation of the reasonable best efforts covenant. Specifically, the court found persuasive evidence that Apollo Tyres’ executives and its hired experts immediately travelled to Tennessee to meet with the USW after learning of the arbitrator’s order and held meetings over the next several weeks with the USW. The court also found convincing the testimony of the experts hired by Apollo Tyres on the issue of whether Apollo Tyres had used its “reasonable best efforts” to reach the required agreement with the USW. 

However, in dicta, the court found unavailing Apollo Tyres’ position that it could continue to use the USW developments to renegotiate the deal price without breaching the reasonable best efforts provision given the parties specifically carved out union developments from the definition of an MAE. Subsequently, Apollo Tyres notified Cooper that financing was unavailable, and Cooper terminated the merger agreement. 

Apollo Global Management, LLC v. Huntsman Corp.

Background 

In July 2007, Hexion agreed to acquire all outstanding shares of Huntsman for $10.6 billion. Because Hexion had been eager to be the winner of a competitive bidding process, the merger agreement contained no financing contingency, and Hexion agreed to use its “reasonable best efforts” to consummate the financing, which was being provided by Credit Suisse and Deutsche Bank. In addition, the merger agreement entitled Huntsman to uncapped damages if Hexion “knowingly and intentionally breached” its covenants under the merger agreement. An MAE/MAC clause permitted Hexion to terminate the merger agreement upon the “occurrence, condition, change, event or effect that is materially adverse to the financial condition, business, or results of operations of the Company and its Subsidiaries, taken as a whole.” 

During the period between signing and closing, Huntsman reported several disappointing quarterly results, missing the numbers it projected at the time the deal was signed. Huntsman’s first-half 2008 EBITDA was down 19.9 percent year-over-year from its first-half 2007 EBITDA, and its second-half 2007 EBITDA was 22 percent below the projections Huntsman presented to bidders in June 2007 for the rest of the year. After receiving these financials, Hexion and Apollo began exploring options for extricating Hexion from the transaction. Initially, Hexion focused on arguing that Huntsman had suffered a material adverse effect. Subsequently, Hexion explored ways to disrupt the financing. Hexion (through Apollo) sought a written opinion of Duff and Phelps of the likely insolvency of the combined companies post-closing. After obtaining such an opinion, without any input from, or the knowledge, of Huntsman’s management, Hexion forwarded it to Credit Suisse and attached the opinion to the complaint that the company filed in Delaware. Plaintiffs sought a declaration that: (1) Hexion possessed no obligation to consummate the merger if the combined companies were insolvent, and (2) Huntsman had suffered a material adverse effect. Huntsman counterclaimed and sought, among other things, specific performance of the merger agreement. After the filing of the Delaware litigation, Credit Suisse and Deutsche Bank pulled their financing. 

The Court’s Decision 

In reviewing the parties’ claims, the court began with Hexion’s argument that its obligation to close was excused as a result of Huntsman suffering a material adverse effect. As quoted above, the definition of a “material adverse effect” did not specifically cover changes in short-term prospects. Accordingly, under Delaware law, the court was required to presume that Hexion was purchasing Huntsman as part of a long-term strategy. While Huntsman’s interim performance may have been “disappointing,” the court was unable to conclude that a change “consequential to the company’s long-term earnings over a period of years” had occurred. According to the court, at best, Hexion’s projections predicated Huntsman’s 2009 EBITDA to be 3.6 percent lower than expected at the time of the execution of the merger agreement. 

The court found that Hexion intentionally breached its covenant to use its “reasonable best efforts” to consummate the financing for the following reasons. First, the court found the mere fact that Hexion failed to approach Huntsman about the possible insolvency of the combined entity before engaging Duff and Phelps to render an insolvency opinion constituted an intentional breach of the merger agreement. Second, the court found Hexion intentionally breached the merger agreement by publishing the solvency opinion (both by filing it with a complaint and by sending it to Credit Suisse). The court also confirmed that the solvency of the combined entity was not a condition precedent to any of Hexion’s obligations under the merger agreement. However, the court found that it could not order Hexion to close. The merger agreement provided that, in circumstances where Hexion was obligated to consummate the merger, but had not: “Huntsman shall not be entitled to enforce specifically the obligations of [Hexion] to consummate the Merger.” The court therefore ordered Hexion to perform its obligations under the merger agreement, other than the obligation to close. 

In December 2008, Apollo and Hexion agreed to pay Huntsman $425 million to settle the litigation, in addition to a $325 million breakup fee. 

Osram Sylvania, Inc. v. Townsend Ventures, LLC

Background 

In September 2011, plaintiff Osram Sylvania Inc. (OSI), a preferred stockholder of Encelium Holdings, Inc. (Encelium), agreed to purchase all of Encelium’s common stock from Townsend Ventures, LLC, and members of Encelium’s management (Townsend) for $47 million pursuant to a stock purchase agreement (the SPA). In the months leading up to the execution of the SPA, Townsend provided OSI with a management presentation which included Encelium’s historical financials and some forecasts. The management presentation revealed that Encelium had a negative EBITDA for calendar year 2010, but projected sales for the calendar year 2011 of approximately $18 million. The management presentation also disclosed that two of Encelium’s employees were responsible for approximately 32 percent of the forecasted sales for 2011. In early July 2011, Townsend reported to OSI that Encelium’s actual sales for the second quarter of 2011 were consistent with the forecasted sales numbers contained in the management presentation. Further, Townsend forecasted sales of approximately $4 million for the third quarter of 2011. In October 2011, the stock sale closed. 

After the closing, OSI learned that Encelium’s sales for the third quarter of 2011 were only $2 million, or approximately one-half of defendants’ estimates. According to OSI, Townsend knew Encelium’s actual sales results for this period prior to closing, but concealed the company’s underperformance. OSI also alleged that defendants manipulated the second quarter 2011 numbers to conceal underperformance. Specifically, OSI contended that defendants: (1) held invoices for payment, (2) billed and shipping excess product to create reportable revenue (without disclosing the credits to be applied), and (3) failed to disclose discount policies to inflate revenues. Encelium also allegedly failed to disclose that its top two salespeople resigned during the summer of 2011. OSI supported its allegations with an Encelium internal e-mail, in which one of the defendants stated: “[G]iven where sales are going the distraction with senior management is far too great to keep up any charade on the chance that a deal does happen.” 

Based on the foregoing, OSI contended that Townsend breached numerous provisions of the SPA, including representations relating to the accuracy of Encelium’s financial statements and the absence of a material adverse effect or change. OSI also claimed that Townsend breached Section 6.4 of the SPA, which required defendants to notify OSI of any fact or circumstance that occurred during the period between signing and closing, which had or would reasonably be expected to have, individually or in the aggregate, a material adverse effect. OSI also included counts of fraud in its complaint. 

The Court’s Decision 

In reviewing OSI’s claims, the court found that OSI adequately pleaded breaches of a number of Townsend’s representations and warranties under the SPA, including Sections 3.5(c) (warranting that the company had been run in the ordinary course of business and that there had been no MAC/MAE since the end of the second quarter of 2011), Section 3.7 (warranting that there had been no event or change since December 31, 2010, that resulted in, or would reasonably be expected to result in an MAC/MAE), and 3.5(b) (warranting the accuracy of the financial statements from 2008 through the second quarter of 2011). 

The SPA defined an MAE/MAC as “any effect or change . . . that would be materially adverse to the Business, assets, condition (financial or otherwise), results or operations of [Encelium].” Here, the court found that it was reasonably conceivable that certain of Encelium’s business practices, such as the billing and shipping of excess product during the months preceding the signing of the SPA, could have a material adverse effect on the company’s “long-term performance.” Furthermore, the court found it reasonably conceivable that Encelium’s achievement of only one-half of projected revenues for the third quarter of 2011, constituted an MAC or MAE, requiring notification under Section 6.4 of the SPA. The court also found that OSI stated a claim for fraud by alleging that defendants misrepresented the financial condition of the company to induce OSI to purchase Encelium’s common stock at an inflated price. 

Looking Forward: Lessons from Recent MAE/MAC Decisions

The lessons from Osram, Cooper Tire, and its predecessors are clear: the definition of an “MAE” in any merger agreement deserves a second look. In public company agreements, the failure of a target to meet earnings or revenue projections is commonly excluded from the list of events than could constitute a MAE, as are developments which result from the announcement of the merger. Further, changes in “prospects” are rarely included in the MAE clause as an event that could constitute an MAE. The elimination or retooling of these exceptions to the MAE definition, coupled with the introduction of more short-term, forward-looking features may give acquirers greater flexibility in responding to events that occur during signing and closing. While the introduction of these definitional elements may not be appropriate or realistically obtainable in most deals, the foregoing decisions make the case for their consideration. 

On the other hand, targets should focus on whether they have the ability to force a buyer to close upon the satisfaction of all conditions precedent to closing and/or to pay a significant reverse termination fee. As the foregoing cases show, targets may enter into agreements with the expectation that they have the ability to force the acquirer to close if all closing conditions are met, but are later disappointed.