Smartphones and tablets are everywhere. Largely prompted by Apple, Samsung, and Google’s consumer-centric marketing strategies, people are spending more and more money on the latest and fastest mobile devices, upgrading them almost constantly, and integrating them into every part of their lives. A large part of that integration is work-related. Employees use their own devices to manage work calendars, view and respond to e-mail, take notes at meetings, and almost anything else they would ordinarily do at their in-office workstation. Allowing employees to bring their own devices to work is no longer a trend; it has become a business necessity. As a result, an increased number of personally owned devices are making their way onto company networks, and it is undeniable that the bring-your-own-device (BYOD) phenomenon is here to stay.
BYOD presents companies with a myriad of new risks and challenges, and lawyers need to understand the issues involved in order to provide quality advice to clients as it relates to information management. The most important thing every corporate attorney and outside counsel advising clients on information governance and BYOD needs to understand is this: the biggest risk with BYOD is data loss. An effective BYOD program and policy should emphasize security and contain clear instructions on what behaviors and activities are permitted on personally owned devices that have access to corporate information systems. However, most companies do not have the information architecture, hardware infrastructure, or resources to protect and secure all the data flowing through networks filled with different operating systems, applications, and devices – many of which, by the way, are widely dispersed and access internal corporate data via unsecure Internet connections. In order to fill this gap, companies are turning to Mobile Device Management (MDM) service providers to equip themselves with software tools and security solutions to protect the devices and data on their networks. Installing MDM software can help mitigate a lot of the technical risk associated with allowing employees to access company data on their own devices. For example, it is common for MDM solutions to allow a company to encrypt data on mobile devices, remotely lock and wipe devices, know the location of the device in real time, enforce a PIN policy, access personal data and contacts, and track user activity. While these capabilities address many of the security risks associated with BYOD, they also create problems related to employee rights and privacy.
Monitoring privately-owned devices creates a significant policy dilemma for companies and it raises a lot of legal questions for attorneys. If your client monitors too much, it can be seen as invading employee privacy, and in some parts of the world, may even be breaking the law. If it does not monitor and control enough, it places the company’s data at a huge risk. Balancing these two seemingly opposing interests is the single greatest challenge to successfully implementing a BYOD program, and it is the role of legal counsel and in-house lawyers to make sure this implementation is done within the law, transparently, and without exposing the company to unnecessary legal risk. So, as an attorney, when a company you represent or work for informs you that it is interested in investing in technical solutions such as MDM to address security risk factors associated with BYOD, you should be prepared to respond that along with a technical solution, and in fact, ahead of it, it will be necessary to create a comprehensive BYOD policy that is transparent, easy to understand, and sufficiently detailed to help protect the company from unwanted regulatory scrutiny and litigation and to avoid the privacy pitfalls that can arise with the rollout of a BYOD program.
As briefly described above, MDM software gives companies a lot of power to control and manipulate the devices their employees use to access corporate data. Before they deploy any type of MDM, counsel should advise their clients to create a training program to educate employees about the scope and capabilities of the software. Every single person employed by your client should consent to MDM software installation before installation and should understand exactly what information is collected, how the MDM software is used, which capabilities are enabled, what happens during an incident, and what the employees’ expectations are upon termination of employment. Security incident procedures must also be spelled out in your client’s BYOD policy. For example, the BYOD policy must clearly explain what will happen if an employee reports a missing smartphone. Will the device be auto-locked? Will the company attempt to locate it using geo-location? Will the device be wiped completely? Will the employee’s access rights be restricted? To avoid confusion and provide a framework for incident response, all these procedures should be spelled out in writing in the BYOD policy and provided ahead of time so employees do not encounter any unexpected results or surprises. Lawyers will have to work hand-in-hand with the CIO and the IT department to ensure that the BYOD policy accurately reflects and considers all of the capabilities of the MDM solution being deployed.
There are also several notices that must be incorporated into an effective BYOD policy. For example, employees must be made aware of all “passive” or “background” security measures in effect on their devices. If your client is going to track user activity on its employees’ devices, they must be told exactly what is being tracked and how that information is being used and stored by your client. If the client is tracking the location of the device via MDM software or other means, the BYOD policy must also describe how location data is used and who has access to it and why. The best and most transparent way to increase monitoring of activity on privately-owned devices is to provide notice and ask for permission. When drafting a BYOD policy, it is “smart lawyering” to explain each process in detail and ask for specific consent.
Consent is a key component to any successful BYOD policy and BYOD program because it empowers your client to govern and monitor the activity of its employees’ privately-owned devices without appearing to be secretive or deceptive. Here is a good rule of thumb: advise your clients never to install anything on any employee’s personally-owned device without obtaining consent first. If a new feature is added that changes the way monitoring occurs, revise the BYOD policy and have employees acknowledge that they understand the changes. If (not really if, but when) it is discovered that your client has been engaged in any clandestine activity or secret monitoring of an employee’s privately-owned device, it will almost certainly lead to conflict, disapproval, and possibly litigation. For example, in a case that went all the way to the U.S. Supreme Court, a California police officer sued his police department after he discovered that they had collected and reviewed personal text messages he sent from an employer-issued device. The Court, in City of Ontario, California v. Quon, ruled that the Fourth Amendment rights of a government employee had not been violated when the contents of his personal text messages – which were sent from a government-issued device – were reviewed in the course of an investigation. However, the Court expressed restraint in saying that its decision was deliberately narrow because “a broad holding concerning employees’ privacy expectations vis-à-vis employer-provided technological equipment might have implications for future cases that cannot be predicted.” Further, the Court stipulated for purposes of its discussion that Quon had a reasonable expectation of privacy in the text messages sent on the government-issued device. The implications of this reasoning for purposes of BYOD are significant because it is fair to assume that if a reasonable expectation of privacy exists on a government-issued device, then at least the same or an increased expectation of privacy will exist for a device the employee personally owns. In addition to the Supreme Court chiming in on digital privacy in the workplace, several state legislatures have passed laws requiring employers to notify employees when monitoring their electronic communications. See Del.Code Ann., Tit. 19, § 705 (2005); Conn. Gen.Stat. Ann. § 31-48d.
The threat of “spillage” or information leaking out of the confines of the company’s protected network is another significant challenge with BYOD. In order to prevent spillage, IT departments want to have the option and capability to wipe devices or destroy data at any time. Lawyers must caution clients against such broad control of and access to personally-owned devices because wiping or destroying data on any device with or without the consent of the owner is a very risky proposition. For example, if wiping a device deletes the owner’s media library containing thousands of dollars worth of movies and music, is your client then responsible for the loss of property? What if a device is reported lost, gets wiped, and then is found the next day in a safe location? Is your client responsible for helping recover all of the wiped personal information? As employees become more aware of their own risks associated with BYOD, it will become more difficult for companies to implement security solutions that grant them widespread control over their devices. Companies will be forced to make uncomfortable compromises and lawyers will have to play a lead role in helping them decide what their risk tolerance is for both the loss of corporate data and the possibility of violating their employees’ privacy.
One countermeasure that can be employed to reduce the risks associated with device control and device-wide wipes is “sandboxing.” Sandboxing is a form of software virtualization (via MDM software) that allows programs to run in an isolated virtual environment on a device. MDM software can then manage the sandboxed portion of the device only and encrypt and wipe data inside the sandbox as necessary. For sandboxing to be effective, the data in the sandbox must stay in the sandbox, but unfortunately, that is not always the case. Two close cousins of BYOD – BYOA (bring your own app) and BYOC (bring your own cloud) – are making it increasingly difficult for companies to employ sandboxing methods to safeguard data. BYOA includes all of the “wild” apps on your client’s employees’ devices. These apps are impossible to control and it would be extremely difficult – both legally and logistically – to know, let alone regulate, what apps employees should and should not install on their devices. BYOC presents an even more complex problem. In many instances, people use cloud services on mobile devices without even knowing it. For example, many smartphones back up data to the cloud automatically and tons of apps operate in their own proprietary clouds or interface with multiple clouds at once. With this level of cross-pollination taking place, it is impossible to prevent at least some data from leaking onto a third-party cloud. And when your client’s corporate data is stored on or travels through a third-party cloud, you must consider it compromised.
An often-overlooked challenge with BYOD is legal discovery. If your client is engaged in litigation or involved in some other type of legal proceeding, an employee’s device may become discoverable. This presents significant legal problems. People store all sorts of private information on their mobile devices, ranging from healthcare information, financial data, search results, and contact lists to family photos, social media profiles, and personal passwords. Some of this information, such as healthcare information, is legally protected, but may nonetheless be made public during the discovery process. Something as seemingly innocuous as a missed call may reveal private information if it is discovered that the call came, for example, from a psychiatrist’s office. As you can see, the privacy concerns surrounding incidental or non-relevant disclosures as a result of discovery that involves BYOD are considerable. On the other hand, if it is the employee who is in litigation and he or she turns over a device for discovery, sensitive company information may be compromised in the process. Worse yet, if your client were to attempt to wipe a device subject to discovery, the punitive legal consequences may be significant. It is important for counsel to emphasize the dangers of BYOD in the discovery process to clients because it is very likely to be overlooked if not considered at the outset.
BYOD presents some surprising but inevitable challenges as well. For instance, no matter how hard they try, companies will never be able to ensure that only pre-approved and authorized persons have access to their employees’ devices. For example, if an employee takes his or her iPhone into an Apple store for repair, he or she has to give the device password to the technician, and in many cases has to leave the phone in the store overnight or ship it to a remote location. If your client handles financial data or healthcare data as part of its business, just leaving an iPhone at the Apple store may be considered a data breach and trigger reporting requirements. As explained above, the use of third-party apps is also problematic. For instance, many people use tools such as Siri or other personal assistant apps to send e-mails, make calendar appointments, etc. Apple stores (in the cloud) everything you tell Siri for two years. Therefore, without intending to, employees may be sharing sensitive information with unauthorized parties simply by using the common features on their phone or tablet.
Implementing a BYOD program is a choice, but failing to do so may result in decreased employee satisfaction, lower performance, increased costs, and loss of competitiveness. Many of the risks associated with BYOD can be mitigated or avoided by implementing MDM solutions and encryption solutions. But as you have just read, these solutions themselves create a series of new challenges. It is up to counsel to help their clients navigate the legal hurdles involved in implementing a BYOD program and to help them develop a BYOD policy and BYOD program that combines technology solutions with clear and comprehensive policies and procedures to help safeguard sensitive data, remain respectful of employee rights and privacy, and defend against litigation. Because the rules of the game are not clear, and because technology continues to evolve at breakneck speed, litigation is inevitable in this field and BYOD will be at the forefront of the controversy. By investing in new technology and implementing comprehensive and commonsense policies that are understandable and transparent, you can help your clients mitigate some of the exposure that has become necessary to remain competitive in the marketplace.
On July 10, 2013, the U.S. Securities and Exchange Commission (SEC) adopted rule changes eliminating the prohibition against general solicitation and advertising in private securities offerings conducted under Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 (Securities Act). The Rule 506 private placement safe harbor is the most widely used exemption from Securities Act registration and is relied upon by many private issuers (i.e., companies that issue and sell their securities, including start-up and emerging companies, EB-5 programs, private equity funds, venture capital funds, and hedge funds) in connection with their capital raising activities. The new rules, which mark a radical departure from longstanding law governing private placements and which are aimed at providing greater and more efficient access to capital markets, implement a congressional mandate under Section 201(a) of The Jumpstart Our Business Startups Act, the so-called JOBS Act.
The amendments approved by the SEC create new Rule 506(c), which provides an additional “safe harbor” exemption from registration for securities offerings marketed using general solicitation and general advertising (together, referred to as “general solicitation”), provided that:
all of the ultimate purchasers of securities are, or are reasonably believed by the issuer to be, “accredited investors” (as defined under applicable SEC rules) at the time of sale, and
the issuer takes reasonable steps to verify that each purchaser is an accredited investor.
Alternatively, private issuers may choose to forgo marketing to the general public and continue to rely on Rule 506’s existing regulatory framework.
In a companion release also issued on July 10th, the SEC adopted amendments to Rule 506 that disqualify issuers from relying on Rule 506 if certain “felons and other bad actors” participate in the Rule 506 offering, as mandated by the Dodd-Frank Act of 2010.
Market participants and consumer advocates have voiced concerns that lifting the ban on general solicitation in private offerings could adversely affect the investing public and could lead to an increase in fraudulent activity aimed at unqualified investors. In response to these concerns, and in order to enhance the SEC’s ability to monitor and evaluate changes in the private offering market and developing practices in Rule 506 offerings, the SEC also proposed a series of amendments to Rule 506 and Form D (i.e., the form filed with the SEC for claiming a registration exemption). If adopted, these amendments would impose significant new filing and disclosure requirements on Rule 506 private offerings, particularly those conducted with general solicitation. The proposed rule changes are expected to draw significant comments, including concerns about costs versus benefits, the potential chilling effect on the use of general solicitation in private offerings and the resulting frustration of the JOBS Act’s central purpose of facilitating capital formation.
The final rules and related amendments approved by the SEC will become effective on September 23, 2013 (60 days after publication in the Federal Register). The SEC has yet to issue proposed rules permitting so-called “crowd funding” offerings and transactions as mandated under the JOBS Act.
A summary of the new rules, as well as observations regarding practical implications for issuers and market participants regarding these rules, follows.
Rule Changes Permitting General Solicitation in Private Offerings
Summary of New Rule 506(c)
Rule 506 of Regulation D is a non-exclusive safe harbor rule adopted in 1982 under Section 4(a)(2) of the Securities Act, which exempts offers and sales of securities by an issuer “not involving any public offering” from the registration requirements of Section 5 of the Securities Act. Under current law, it is a requirement of most private placement exemptions from the registration requirements of the Securities Act, including Rule 506 and (in the view of the SEC’s staff) Rule 144A, that issuers are prohibited from using any form of general solicitation when conducting an unregistered offering of their securities. This restriction has been interpreted broadly to prohibit all public marketing efforts and outlets in an issuer’s capital raising activities, including, among others, publicly accessible websites and social media, media broadcasts (such as radio and television advertisements), newspaper advertisements, mass e-mail campaigns, and public seminars and meetings.
Under new Rule 506(c), issuers will be permitted to use general solicitation in private securities offerings made under Rule 506, provided that the following conditions are met:
all purchasers of securities in the offering must be “accredited investors,” either because they fall within one of the enumerated categories of accredited investors under applicable SEC rules or because the issuer reasonably believes that they do, at the time of the sale of securities, and
the issuer must take “reasonable steps to verify” that each purchaser of its securities is an accredited investor.
The SEC stated in its adopting release that whether the steps taken by an issuer to verify the accredited investor status of a purchaser are “reasonable” requires a principles-based, objective determination in the context of the particular facts and circumstances of each purchaser and transaction. This is an independent procedural requirement which must be satisfied even if all purchasers are in fact accredited investors. Factors that issuers should consider in making this determination include (1) the nature of the purchaser and the type of accredited investor that it claims to be, (2) the amount and type of information that the issuer has about the purchaser, and (3) the nature of the offering (such as the manner in which the purchaser was solicited to participate in the offering and the terms of the offering, including the minimum investment amount).
These factors are interconnected, and may require more, or less, consideration depending upon the specific facts and context. For example, an issuer that solicits new investors through a website accessible to the public or through a widely disseminated e-mail or social media solicitation would likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party, such as a federally registered broker-dealer or investment adviser. Furthermore, if the minimum investment amount in the offering is sufficiently high such that only accredited investors could reasonably be expected to meet it, and the investment is made with a direct cash investment that is not financed by the issuer or any other third party, these factors would be relevant in determining what additional steps should reasonably be taken to verify a purchaser’s accredited investor status.
Regardless of the particular steps taken, given that the issuer bears the burden of proving that the exemption from registration is available, the SEC cautioned in its adopting release that issuers should retain adequate records documenting the steps taken to verify that a purchaser is an accredited investor. In addition, the SEC stated that:
[we do] not believe that an issuer will have taken reasonable steps to verify accredited investor status if it, or those acting on its behalf, required only that a person check a box in a questionnaire or sign a form, absent other information about the purchaser indicating accredited investor status.
Thus, the relatively common practice in which prospective investors complete a suitability questionnaire, or sign a form or agreement, self-certifying as to accredited investor status, will not by itself satisfy the “reasonable steps to verify” standard, at least not for natural person investors.
“Reasonable Steps to Verify” Accredited Investor Status
In response to comments seeking specific guidance on how an issuer can reliably verify accredited investor status, the SEC included in the Rule 506 amendments a non-exclusive list of four verification methods deemed to satisfy the required “reasonable steps” standard as applicable to natural person purchasers (as long as the issuer or person acting on its behalf does not have knowledge that a potential investor is not an accredited investor):
Income Test. If the potential purchaser’s accredited investor status is premised on meeting the (accredited investor) income test – i.e., for a natural person, income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years, and a reasonable expectation of the same income level in the current year – reasonable verification can be established by reviewing copies of any IRS form that reports the person’s income (e.g., a Form W-2, Form 1099, Schedule K-1 or a copy of a filed Form 1040) for the two most recent years, and by obtaining a written representation from the person that he or she reasonably expects to meet the required income level during the current year.
Net Worth Test. If the potential purchaser’s accredited investor status is premised on meeting the (accredited investor) net worth test – i.e., for a natural person, individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of such person’s primary residence – reasonable verification can be established by reviewing certain specific documents, dated within the prior three months, and by obtaining a written representation from the person that all liabilities necessary to make a determination of net worth have been disclosed. For assets, the issuer may rely on bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments and appraisal reports issued by independent third parties; and for liabilities, a credit report from at least one of the nationwide consumer reporting agencies is required.
Third Party Confirmation. An issuer is also deemed to satisfy the verification requirement by obtaining written confirmation from one of the following persons that it has taken reasonable steps within the prior three months to verify the accredited status of the purchaser (and has determined that the purchaser is accredited): an SEC-registered broker-dealer or investment adviser, a licensed attorney, or a certified public accountant. An issuer may be entitled to rely on accredited investor verification by other persons – if the third party takes reasonable steps to verify that potential purchasers are accredited and has determined that they are accredited – so long as the issuer has a reasonable basis to rely on the verification.
Prior/Existing Investor Confirmation. For any person who purchased securities in an issuer’s Rule 506 offering as an accredited investor before the effective date of Rule 506(c) and who continues to own such securities, the issuer is deemed to satisfy the verification requirement by simply obtaining a bring-down certification from such person at the time of sale that he or she still qualifies as an accredited investor.
Private Offering Safe Harbor and “Reasonable Belief” Standard Continue
New Rule 506(c) leaves the traditional, existing safe harbor under Rule 506 unchanged, and redesignates it as Rule 506(b). Thus, issuers that do not wish to avail themselves of the opportunity to conduct their securities offerings using general solicitation may continue to offer their securities in reliance on the traditional safe harbor under Rule 506(b). Rule 506(b) permits sales of securities (with no limit as to dollar amount), without registration, to an unlimited number of accredited investors and up to 35 non-accredited investors who satisfy certain “sophistication” requirements (i.e., knowledge and experience in financial and business matters so as to be capable of evaluating the merits and risks of the prospective investment), if the required resale limitations are imposed, any applicable information requirements are satisfied and other conditions of the rule are met. If an issuer does not engage in any general solicitation, it will not be required to take reasonable steps to verify (under the new standards) the accredited investor status of its purchasers. However, as discussed further below, once a general solicitation has been made to potential investors in an offering, the issuer is precluded from relying on the Rule 506(b) safe harbor in that offering.
In addition, in its adopting release, the SEC reiterated its position that the “reasonable belief” standard in the definition of accredited investor in Rule 501 of Regulation D is unchanged by the new amendments to Rule 506. In this regard, as long as an issuer takes reasonable steps to verify that a purchaser is accredited and has (and those acting on its behalf have) a reasonable belief that the purchaser is accredited, the issuer would not lose its ability to rely on Rule 506(c) if it is later discovered that the purchaser was not in fact an accredited investor.
Changes to Form D
Issuers relying on Regulation D’s safe harbor exemptions are required to file a Form D with the SEC no later than 15 calendar days after the first sale of securities in the offering. In connection with the rule changes, Form D is being amended by adding a new check box for issuers to indicate whether they are using general solicitation under the Rule 506(c) safe harbor (or instead are relying on Rule 506(b)). Issuers may not check both boxes. In addition, Form D will be amended to require issuers claiming a Rule 506 exemption to confirm that the offering is not disqualified from reliance on the Rule 506 exemption (see the discussion below regarding the new felon and “bad actor” disqualification rules). It should be noted that the SEC, on the same day it issued its final rules, issued certain proposed amendments to Form D that would condition prospective reliance on Rule 506(c) on complying with expanded Form D filing requirements.
Rule 144A Clarification
A Rule 144A offering involves a primary offering of securities by an issuer to one or more financial intermediaries in a transaction exempt from registration under Section 4(a)(2) or Regulation S under the Securities Act, followed by the resale of those securities to qualified institutional buyers (QIBs) in reliance on Rule 144A. QIBS, in general terms, are entities, owned entirely by accredited investors, which own and invest, on a discretionary basis, at least $100 million in securities; for a registered broker-dealer, the threshold is $10 million. In order to qualify for the exemption in existing Rule 144A, offers as well as sales must be made to QIBs. Thus, under current law, it’s not clear whether issuers and sellers may permissibly offer securities under Rule 144A to investors which are not QIBs, which effectively prohibits the use of general solicitation in such offerings. An amendment to Rule 144A under the new rules confirms that securities may be offered to persons other than QIBs (i.e., they may be offered via general solicitation), as long as the securities are sold only to persons that the seller reasonably believes are QIBs.
Disqualification of Offerings Involving Felons and Bad Actors
Separately, in a companion release also issued on July 10 and as mandated under Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC also adopted rule changes adding a felon and “bad actor” disqualification provision applicable to offerings conducted under Rule 506 of the Securities Act. Under this amendment, the Rule 506 registration exemption will not be available for any securities offering, regardless of whether the offering is made using general solicitation under Rule 506(c), if the issuer or any other “covered person” (including directors, executive officers, other officers involved in the offering, general partners and managing members, 20 percent beneficial owners, promoters, placement agents, and persons compensated for soliciting investors) had a “disqualifying event” during a specified time period. The list of disqualifying events is broad, and includes certain securities-related felonies and misdemeanors, SEC cease-and-desist orders barring future violations of specified securities laws, suspensions from registration with national securities exchanges or national securities associations such as FINRA and other regulatory disciplinary actions. The rule does not apply if the issuer can show that it did not know, and in the exercise of reasonable care could not have known, that a covered person with a disqualifying event participated in the offering. In its adopting release, the SEC noted that the steps an issuer should take to satisfy the reasonable care standard – including reasonable factual inquiry into whether any disqualifications exist – will vary according to the particular facts and circumstances of the “bad actor” and the offering. Additionally, the SEC may grant waivers from disqualification under certain circumstances, including a change of control and absence of notice and opportunity for hearing. The rule applies only to disqualifying events that occur after its effective date, but disqualifying events that occurred prior to the effective date must be disclosed to investors at a reasonable time prior to the securities sale date.
Regulation S Offshore (and Concurrent) Offerings
Many private securities offerings are made concurrently (side-by-side) to the U.S. domestic market under Rule 506 or Rule 144A and to non-U.S. investors in reliance on Regulation S, a safe harbor for offers and sales of securities made outside the United States. These safe harbors are important when U.S. and non-U.S. companies, including EB-5 programs, engage in multi-country securities offerings in which the U.S. portion of the offering is conducted in accordance with Rule 506 or Rule 144A and the non-U.S. (offshore) portion is conducted in reliance on Regulation S. One requirement of a Regulation S offering is that there be no “directed selling efforts” in the United States, a concept similar in some respects to general solicitation (or “conditioning of the market” where the securities will be sold). In its adopting release, the SEC confirmed that concurrent (offshore) non-U.S. offerings that are conducted in compliance with Regulation S will not be integrated with domestic U.S. offerings that use general solicitation and are otherwise conducted in compliance with Rule 506 or Rule 144A, as amended.
Proposed Rules Regarding Form D and Exempt Offering Filing and Disclosure Requirements
In view of lifting the ban on general solicitation, the SEC, in proposed rules published for public comment on July 10, proposed a number of investor protection requirements applicable to Rule 506 private offerings, particularly those conducted with general solicitation. These provisions, in the words of the SEC, are intended to enhance the SEC’s ability to evaluate the development of market practices in Rule 506 offerings and to address concerns that may arise given that issuers are permitted to engage in general solicitation under the new rules. The proposed rule changes cover a variety of significant topics and proposed new requirements, including an expansion of the information required to be included in Form D, new “advance” and “closing” Form D filing requirements, mandated legends and disclosure requirements (particularly regarding offerings using general solicitation), disqualification from the ability to rely on Rule 506 for a failure to make compliant Form D filings and a temporary rule requiring submission of written solicitation materials (where general solicitation is used) to the SEC on a non-public basis. The SEC’s proposing release also includes a request for public comment on the “accredited investor” definition and thresholds. As noted above, the proposed rules (extensive discussion of which is beyond the scope of this article) are expected to draw significant comments, including concerns about costs versus benefits, the potential chilling effect on the use of general solicitation in private offerings and the resulting frustration of the JOBS Act’s central purpose of facilitating capital formation.
Effective Date; Limitations; No Fallback Exemption
The final rules and related amendments described above are effective on September 23, 2013 (60 days following publication in the Federal Register), and the proposed rules provide for a 60-day public comment period (which ends on September 23, 2013). Accordingly, Rule 506 and Rule 144A remain unchanged at present (until September 23), and issuers should continue to comply with the existing requirements of such rules (including Rule 506’s prohibition on general solicitation).
Importantly, the elimination of the prohibition on general solicitation under the new rules applies only to private offerings meeting the requirements of Rule 506(c), and not to other private offerings made under Section 4(a)(2) generally, under the so-called “private resale” exemption or under any other registration exemption other than Rule 144A. In this regard, issuers unable to rely upon the Rule 506 safe harbor that seek instead to qualify under the Section 4(a)(2) statutory exemption for private offerings should tread very carefully (with the advice of securities counsel), since the scope of that exemption as interpreted by the SEC and the courts is substantially more limited and less clearly defined than under Rule 506, and a failure to qualify could lead to possible SEC enforcement action and would possibly trigger rescission rights in favor of investors. As the SEC made clear in its final rules adopting release, issuers engaging in general solicitation in a securities offering in the U.S. face significant consequences if they rely on the new Rule 506(c) exemption but fail to meet the “reasonable steps to verify” accredited investor status standard; in such a case, they will not be able to rely on the statutory exemption provided by Section 4(a)(2) of the Securities Act and thus likely would be left without any exemption from – and would consequently be in violation of – the Securities Act’s registration requirements.
Practical Implications for Issuers and Market Participants
The introduction, for the first time, of the ability to engage in general solicitation in Rule 506 and Rule 144A offerings is expected to have a significant impact on the way that certain issuers approach and market their private placements. The new rules present the opportunity for issuers (including start-up and emerging companies, EB-5 programs, and private investment funds) and their advisors to reach potential investors beyond their traditional relationships and networks, and to take advantage of a wide variety of state-of-the-art, broadly-inclusive and instantaneous communication and marketing tools and platforms, including through newspaper, television and radio advertisements, and via relatively inexpensive Internet-based media. Electing to go the general solicitation route, however, will come at a price. Issuers and their advisers (and, in the case of private investment funds, their sponsors) should bear in mind the increased responsibilities for due diligence with respect to verifying accredited investor status of potential investors and assuring that offering participants and other covered persons are not felons or bad actors subject to a disqualifying event, and should keep a watchful eye on the currently proposed rules and other rulemaking initiatives as these markets and offering practices, as well as SEC enforcement priorities and actions, develop and evolve. Some practical implications for issuers and market participants to consider include:
Many issuers will likely stick with the known, existing regulatory regime (and no general solicitation) for now. Current private offering practices, designed to prevent any form of general solicitation, are well understood and practiced by sophisticated issuers, their owners, advisors (including private placement agents registered as broker-dealers), and other market participants. The SEC has made clear that issuers may continue to rely on the existing regulatory framework (redesignated as Rule 506(b)) and conduct private offerings precisely the way they are being conducted today, provided that no general solicitation is used. Complying with the final and proposed rules (and other possible rulemaking) will significantly increase regulatory burdens and costs associated with compliance – including increased due diligence, verification of accredited investor status and more robust Form D disclosure requirements. Accordingly, initially (and until the regulatory “dust” settles), it is likely that many issuers – and particularly private investment fund issuers – and their advisors will forego general solicitation flexibility in favor of conducting their offerings under the current regulatory regime (i.e., the existing safe harbor exemption under Rule 506(b)).
Taking reasonable steps to verify accredited investor status; due diligence and record keeping; third party verification services. Issuers choosing to engage in general solicitation will be required to take “reasonable steps to verify” that each purchaser of securities in a Rule 506(c) offering is an accredited investor. Having a person check a box on a questionnaire or sign a form or agreement is not sufficient to verify accredited investor status, absent other information about the purchaser. The issuer has the burden of demonstrating that its offering is entitled to an exemption from registration, and thus should retain all records evidencing its “reasonable steps to verify.” As a best practice, issuers should review with counsel their offering and subscription documents and practices, and fund sponsors and placement agents should also review their due diligence investigation protocols and private offering and other policies and procedures, including how best to document and verify that each purchaser qualifies in view of the factors discussed above. Among other things, consideration should be given to maintaining a detailed list of the steps taken and materials reviewed for each prospective purchaser. In addition, it is anticipated that a robust and dynamic “industry” of third-party verification service providers (regarding accredited investor status) may develop, and compete, to participate in and facilitate this process. Verification services will likely be offered by (among others) affiliates of placement agents, investment advisers, and other investment “matchmakers” who also compete for investment offering deal flow. Providing reliable verification regarding potential investors’ accredited investor status, via a safe, trusted, and user-friendly access point to personal and financial information, will be important, both from a compliance and marketing point of view.
Addressing investor privacy concerns. Issuers who choose to take advantage of the new general solicitation rules must request personal and private financial information from potential investors, or must find some other acceptable way to demonstrate and document that each purchaser qualifies as an accredited investor (see discussion above regarding third-party verification service providers). Requesting such information, or obtaining other verifications concerning personal financial (including income and net worth) data, will raise privacy and data security concerns and may deter potential investors from participating in Rule 506(c) private offerings.
Offerings involving felons and bad actors disqualified from using Rule 506; due diligence on covered persons and disqualifying events. In view of the new felon and “bad actor” disqualification rules, and the reasonable care exception to the rule, issuers and placement agents will need to adopt and implement due diligence and verification procedures and practices to ferret out whether the issuer, any placement agent or any other covered person is, or during the applicable look-back period was, subject to a “disqualifying event.” Registered broker-dealer firms and their employees are often subject to certain disqualifying events and thus will not be able to promote or assist with Rule 506 offerings without an SEC waiver. Issuers should consider adding appropriate additional questions to D&O questionnaires, requiring 20 percent or greater owners to complete questionnaires, and requiring placements agents, compensated finders, their personnel, and other covered persons to provide appropriate contractual representations. Judgment searches and review of broker-dealer compliance and other public records should also be conducted. Placement agents, broker-dealers and private fund advisors should adopt and implement new and more robust protocols and procedures in light of the rule changes, including (1) making sure their “houses are in order” (and that they, their affiliates and personnel are not subject to a “disqualifying event”), and (2) reviewing and revising, with their counsel, their due diligence requests and activities, disqualification protocols, form of placement agent agreement and other documents to address and conform to the requirements of the new rules.
Potential unintended consequences of general solicitation offerings. For issuers choosing to take advantage of the new general solicitation rules, careful consideration should be given to what information should be included in the marketing effort and what impact, positive or negative, the general solicitation may have on the image or credibility of their company and management team, or on the company’s customers, vendors, or employees, or its ability to attract accredited investors. Information accessible on an issuer’s website in advance of and during a private offering is deemed to be part of the general solicitation. Once marketing information is “out there,” despite confidentiality notices and precautions, the publicity (and related communications) may take on a life of its own, whether or not the subject offering is ultimately successful.
Antifraud rules continue to apply. The new rules do not incorporate any exemption from traditional anti-fraud rules under the securities laws, including under Section 10(b) of and Rule 10b-5 under the Securities Exchange Act of 1934 (and related sanctions for making false or misleading statements in connection with securities offerings). Issuers and their agents should carefully review and consider the form, content, and distribution of all marketing, advertising, and solicitation information and materials, however communicated or accessible (including via website and social media outlets). Issuers should expect the SEC to be vigilant in surveying the market for examples of improper conduct to target for enforcement action.
Having a high degree of confidence in the success of an offering sold solely to accredited investors before any general solicitation. Once an issuer commences any general solicitation activities, if it is later unable to meet the requirements of Rule 506(c) (including the “reasonable steps to verify” accredited investor status standards and assuring that all purchasers are accredited investors), it may be left without any exemption from the Securities Act’s registration requirements, and thus be unable to pursue or close any private offering of securities for some time. In addition, start-up, early stage, and other issuers that may need frequent access to private investment capital will need to be careful to avoid possible “integration” of offerings conducted within a six-month period – for example, when an offering to friends, family and known persons (including non-accredited investors and without general solicitation, under the traditional Rule 506(b)) is planned to be conducted concurrently with or following one or more offerings to other investors (using general solicitation, under new Rule 506(c)).
Regulatory “Soup” – watch for additional related, perhaps significant, private offering reforms. In embarking upon this new era of securities offering reform, the SEC will monitor closely the impact of its rule changes, and developing market practices, in the private, exempt offering arena. The proposed rules discussed above signal the SEC’s desire, while implementing congressional mandates, to craft “speed bumps” and safeguards for the protection of investors (including by requiring new, rather extensive filing and disclosure requirements in offerings sold entirely to accredited investors). In addition, for startup and early stage companies seeking to raise capital in relatively small amounts from a wide audience, the SEC has yet to issue proposed rules to permit “crowd funding” offerings and transactions (as mandated under the JOBS Act). Issuers and their advisors will need to assess carefully the new rules, proposed rules, and future rulemaking efforts – and the associated costs, burdens, potential liabilities, and other consequences – as they consider and plan for their capital raises and related offering alternatives.
The balance of power has shifted from the investment managers who create private equity funds to the pension plans and other folks with money that invest in the private equity asset class.
Investors now have the upper hand in negotiating fund agreements, and they are itching to exert their newfound bargaining power. Many are unhappy with the high fees and poor performance of their existing investments; and annoyed by the governance transgressions and shoddy reporting practices of the problem child in which they have invested.
The ILPA Principles
The publication by the Institutional Limited Partners Association (ILPA) of recommended best practices for structuring private equity funds (ILPA Principles) is an effort by the leading industry organization to shift negotiating leverage in favor of investors.
The ILPA Principles recommend a significant retooling of the key terms in the limited partnership agreements used to establish private equity funds, all in an effort to more closely align managers’ pay with performance. This alignment is the value driver in the private equity business model. Given proper incentives, fund managers can lead in economic recovery by doing what they do best—restructuring underperforming businesses by motivating management, imposing cost efficiencies, and divesting noncore assets.
The ILPA Principles provide guidance on recommended deal terms in three distinct areas: management fees and profit sharing, governance and conflicts of interest, and reporting obligations.
Management Fees and Profit Sharing
The first major area in which the ILPA Principles make detailed recommendations is with respect to management fees, transaction fees, and carried interest. These are the three ways that fund managers are compensated under the private equity model. Under the original “2 and 20” model, managers receive a 2 percent management fee on committed capital and 20 percent of the profits made on investments.
Management Fees. One of the big issues this year is management fee percentages. Management fees have fallen in recent years as a percentage of assets under administration and are now being pushed into the 1.5 percent range. Nevertheless, they can be extremely lucrative to fund managers because of the economies of scale in operating a larger fund. Allowing managers to profit from management fees in advance of generation of economic return to investors distorts incentives, encouraging managers to maximize fund size rather than perform.
The ILPA Principles state that management fees should be set on the basis of a disclosed fee model that reflects the manager’s budgeted expenses to cover professional and staff salaries, rent, and operating and overhead expenses.
Management fees should step down significantly (50 percent) after the investment period or after the manager closes a successor fund, with fees from that point on calculated on invested rather than committed capital.
Transaction Fees. Transaction fees are another problem area addressed by the ILPA Principles. Fund managers typically provide an array of services to portfolio companies. These services can generate significant advisory fees to directors, consultants, and advisors.
In recent years, there has been a clear shift in the market away from a 50-50 sharing of these transaction fees between general partners and limited partners, with 80-100 percent now being credited against management fees. The ILPA Principles approve of this trend. They recommend that 100 percent of transaction fees go to the fund as this reduces the conflict inherent in managers working for companies in which the partnership they are managing holds an investment.
Carried Interest. Profit-sharing formulas are the principal tool used in private equity funds to align interests and drive incentives. Typically, the manager receives its profit participation through a “carried” interest share of fund profits, so called because the manager is not required to pick up a corresponding share of the fund’s costs. The mechanics governing payment of the carried interest are set out in something called a distribution “waterfall,” which describes the sequence in which proceeds from the sale of portfolio companies are distributed between the general partner and the limited partners.
The “Return All Capital First” Approach. The ILPA Principles recommend a “return all capital first” approach to carried interest waterfalls. In this model, common in Europe, the general partner does not receive payout of its carried interest until investors have received back all of their contributions, including the amount invested in both realized and unrealized investments, together with management fees and other expenses of the fund.
In addition, the ILPA Principles recommend that carry should not be paid on ordinary income generated by portfolio companies. Also, it should be calculated net of withholding tax regardless of whether investors are eligible for offsetting tax credits.
The ILPA Principles further suggest that carried interest should be streamed predominately to the professional staff responsible for the success of the fund, who should be prohibited from transferring those interests.
The U.S. House of Representatives recently passed legislation that, if also passed in the Senate, would hit the pocketbooks of fund managers by taxing carried interest as ordinary income. In response, managers are negotiating “gross up” provisions to hold them whole or are trying to insert language allowing them to restructure their funds if tax laws change. Sensibly, the ILPA Principles recommend that all such efforts to pass on the economic effect of tax law changes to limited partners be resisted.
The Deal-by-Deal Approach. In North America, the current market standard for payment of carried interest is the manager-friendly deal-by-deal waterfall. The general partner’s carried interest is paid out on a deal-by-deal basis as soon as the fund begins generating profitable exits from investments.
This approach has two problems. First, the early payment of carry takes money off of the table and is a drag on investor returns. Second, it creates the need to include complicated claw-back provisions in the limited partnership agreement.
Claw Back. Where the deal-by-deal carry waterfall is used, the ILPA Principles recommend that the limited partnership agreement include detailed claw-back provisions requiring the general partner to pay back profit distributions if losses subsequently arise from the sale of portfolio companies or from asset write-downs.
The ILPA Principles include detailed recommendations for such claw-back clauses:
all realized portfolio losses and all write-downs on unrealized investments should be recovered before any distributions;
all fees and expenses should be recovered before any distributions, not just a portion of total expenses equivalent to the proportion that such distribution is of total invested capital;
there should be significant carried interest escrows (30 percent or more);
there should be joint and several liability of the fund’s management team and their family trusts for the claw-back repayment obligation;
paybacks should occur within two years of the date that the liability arises;
paybacks should be gross of taxes, even if the manager is left in a negative cash position because a refund is not available or there is a mismatch of capital gains and ordinary income; and
the fund’s independent auditors should certify all carried interest calculations.
Management Investment. Another way to align manager and investor interests is to require that the management team have significant “skin in the game.” Accordingly, the ILPA Principles suggest that managers should make a significant (3.5-5 percent) investment of their own money in each fund that they manage.
The ILPA Principles suggest that this “management profits” interest should be paid in cash rather than by way of set-off against management fees. Given that this approach is tax inefficient compared to waiving management fees, it is unlikely that the ILPA approach will find favor among managers.
Improving Fund Governance
The second major thrust of the ILPA Principles is in the area of fund governance and accountability. These are topics very much on the minds of fund investors.
Too frequently in the past, portfolio managers have chosen to invest in funds managed by the hottest fund managers without paying sufficient attention to how the fund is governed and deals with conflicts of interest.
In the current economic environment, this has changed. Investors are looking for ways to say no to funding proposals. With increasing frequency, they are deciding not to reinvest in a manager’s new funds (so-called re-ups) for reasons other than a poor performance track record: for example, because they are unimpressed by the fund’s governance and reporting practices.
Conflicts of Interest. Fund agreements too frequently fail to address conflicts of interest in a comprehensive fashion. For example, many agreements require only that the general partner disclose conflicts of interest at the end of each year rather than seek advance consent to conflicts prior to their occurrence.
This can result in the indignity for an investor of standing by and watching helplessly as a less-than-scrupulous manager abuses the fund by cherry-picking the best investment opportunities for itself or for its successor funds, or by using the fund to prop up companies held by other funds managed by the manager. The ILPA Principles recommend that all conflict-of-interest and self-dealing transactions be predisclosed and preapproved by the fund’s limited partner advisory committee.
The Role of LP Advisory Committees. The ILPA Principles recommend an enhanced role for limited partner advisory committees, or LPACs. In 2010, expect a continuation on the trend toward greater reliance on LPACs made up of representatives of the “big dogs”—the largest investors in a fund.
Key responsibilities of an LPAC include oversight of conflicts of interest and the valuation of investments. Other duties may include waiving certain investment restrictions and approving new management hires.
The ILPA Principles provide useful guidance for best practices with respect to the formation of LPACs and meeting protocols that every LPAC should be adopting.
Fiduciary Duties. The ILPA Principles are premised on the notion that limited partnership agreements should reinforce rather than dilute the fiduciary duties of general partners to limited partners. Self-dealing and conflicts of interest should not be tolerated. Unfortunately, the language in fund agreements has often fallen short.
The ILPA Principles recommend that investors push back against inappropriate terms such as provisions that allow the general partner to reduce all fiduciary duties to the fullest extent allowed by law. They also recommend that general partner behavior constituting “gross negligence, fraud or willful misconduct” be excluded from the protections of indemnification and exculpation clauses, even if the governing law would permit it.
Style Drift. The ILPA Principles recommend that investors guard against style drift (managers digressing from their investment strategies) by clearly and narrowly outlining the investment strategy of the fund. The investment strategy should encourage time and industry diversification and set specific concentration limits. Deviations from the investment strategy should be permitted only if the LPAC consents.
No-Fault Divorce Terminations. Many fund agreements permit termination of a manager “for cause” only by some extremely high majority (e.g., 85-95 percent) following a nonappealable judicial decision. This is often unworkable. It may be difficult to prove cause even where the manager’s conduct is egregious; and it may be impossible to assemble a required majority of outraged limited partners.
The ILPA Principles recommend that the limited partners, by simple majority (and not by the super majority, which is the current market standard), should have the right to suspend or terminate the commitment period. Two-thirds majority in interest of limited partners should have the right to remove the general partner or terminate the fund under the “no fault divorce” provisions of the limited partnership agreement without cause; for example, if they do not see the returns they expected.
Key Man Provisions. The experience and performance track record of a manager’s professional team are among the most important factors considered by investors in deciding to invest in a private equity fund. Yet it is not uncommon for key management personnel to leave a fund manager, particularly if the fund is underwater and management feels that there is little prospect of ever earning their carried interest.
The ILPA Principles recommend that the result of the departure of a key person should be severe: the automatic suspension of the commitment period, which becomes permanent unless the limited partners vote by two-thirds majority in interest within 180 days to reinstate it.
A similar result should apply in the event of a breach of fiduciary duties, material breach of the limited partnership agreement, bad faith, or gross negligence. Perhaps even more importantly, investor rights should be triggered upon a preliminary nonappealable determination, not by a final court decision.
Limits on Indemnification. Fund agreements usually contain indemnification and give back obligations requiring limited partners to return prior distributions in various circumstances. For example, in today’s buyer-friendly deal environment, private equity funds selling their portfolio companies are often required to provide exhaustive indemnities for breach of representations and warranties in the purchase agreement. Where a buyer invokes these indemnification rights, limited partners may be required to give back prior distributions.
The ILPA Principles recommend that indemnification be capped in amount and limited in duration. A typical clause would cap the obligations available at the level of remaining unfunded commitments plus 25-50 percent of distributions received for a period of two years from the date of distribution.
Extension of Fund Term.Currently, the venture funds established in the years leading up to the technology industry collapse of 2001 are reaching the end of their 10-year terms. Many are lingering on with a residual portfolio of illiquid investments in private companies that have not generated exit opportunities.
The ILPA Principles recommend that maturing funds be wound up after no more than one one-year extension. This is good advice and should encourage investors to make the tough but pragmatic decision to write off low prospect residual investments rather than continue to pay fees and expenses of maintaining losing investments.
Improving Information Flows
The third major topic addressed by the ILPA Principles relates to reporting and information flows. Bad reporting practices by fund managers are an irritation to investors in private equity funds.
A diligent and resourceful portfolio manager can usually cobble together most of the required information by asking questions at annual and quarterly meetings, at LPAC meetings, and by way of repeated special requests. This is less than ideal. Traditional limited partnership agreements do not have expansive information rights and tricky confidentiality obligations make robust information flow difficult to come by.
The ILPA Principles provide detailed recommendations on general partner reporting. Investors should be provided detailed information about all activities of the manager, including all of its consulting arrangements and other dealings with portfolio companies and information about its economic arrangements with its principals, placement agents, and third-party investors. Investors should receive regular limited partnership financial statements; quarterly schedules of fund-level leverage, including commitments; details of fund expenditures; and contact information for the other investors. Investors should receive detailed valuations of portfolio companies (along with a discussion of the valuation methodology) as well as selected financial performance information including earnings, burn rates, and debt levels on a quarterly and annual basis. Investors should receive details of fee and carry calculation with each distribution and annual internal rate of return calculations (with a description of the methodology for determining the internal rate of return).
Conclusions
Portfolio managers devote a disproportionate amount of their time and effort to the administration of investments governed by poorly negotiated or poorly drafted fund agreements. Poorly drafted economic terms drag on return performance and misalign incentives. Inadequate governance clauses and poorly drafted reporting provisions make it hard to deal with conflicts and other abuses, or to gather the information needed to assess performance.
The release of the ILPA Principles, together with the severely reduced flow of institutional money into new funds, should increase the bargaining power of limited partners in negotiating fund terms and help remedy these historical problems.
Some of the terms recommended by the ILPA Principles, particularly those dealing with fees and carry, deviate from current market norms and are unlikely to be welcomed by managers. Nevertheless, expect investors to assert their bargaining power on these issues and for fund managers with less than stellar performance records to agree to more investor-friendly terms.
Also, expect that the publication of the ILPA Principles will hasten the shift in market norms that has already been occurirng toward better governance and conflict-of-interest terms and improved reporting provisions.
The ILPA Principles rightfully point the way toward reestablishing investor confidence in private equity as an attractive asset class, for the ultimate benefit of both investors and managers.
For decades, courts around the country have struggled with whether to enforce, and how to interpret, contractual disclaimers that limit liability for fraud based on extra-contractual statements and omissions. These disclaimers – typically referred to as “anti-reliance clauses” or “non-reliance clauses” – most often take the form of a representation by one or both of the parties disclaiming reliance on statements made outside the four corners of the agreement. Sophisticated parties typically include anti-reliance clauses in negotiated agreements to establish what information they did and did not rely upon when entering into the transaction. These provisions are also used as a means to eliminate the threat of tort claims (namely, fraud) based on oral statements that are not reduced to a representation within the definitive agreements. Anti-reliance provisions are particularly important for sellers: although indemnification deductibles and caps define the scope of a party’s post-closing liability for breaches of contractual representations, the same often will not apply to tort-based claims premised on extra-contractual statements. As a result, selling parties are particularly motivated to eliminate the potential for fraud-based claims to the greatest extent possible.
In certain states (e.g., California), courts have declined to enforce such clauses based on a finding that they are against public policy. In other states (e.g., New York), courts have enforced anti-reliance clauses, but only under certain factual circumstances, and even then, such provisions are subject to strict scrutiny in determining whether they bar the specific claims alleged by the plaintiff. In Delaware, courts have held that clear anti-reliance clauses limiting fraud claims based on misrepresentations made outside of the agreement are generally enforceable, but such provisions will not bar fraud claims based on intentional misrepresentations within the agreement. Two recent decisions from the Delaware Court of Chancery, however, serve as important reminders that the Delaware courts will strictly construe non-reliance clauses and will not infer contractual limitations on the parties’ ability to bring fraud claims. In light of these recent cases, sophisticated parties to commercial agreements, including non-disclosure agreements and purchase and sale agreements, would be well-advised to take additional care when drafting anti-reliance clauses so as to give full effect to the parties’ bargain regarding the ability to rely on extra-contractual statements (or omissions therefrom) in making fraud claims.
Enforceability of Anti-Reliance Clauses
In the seminal case of Abry Partners V, L.P. v. F&W Acquisition LLC, 891 A.2d 1032 (Del. Ch. 2006), the Delaware Court of Chancery established that anti-reliance clauses are enforceable to bar fraud claims under Delaware law so long as the plaintiff clearly disclaims reliance on statements or promises made outside of the contract. The court also held, as a matter of Delaware public policy, that a party cannot fully absolve itself from liability for intentional misrepresentations within a purchase agreement.
Abry Partners involved a group of entities associated with a private equity firm that purchased all of the equity of a portfolio company indirectly owned by another private equity firm. After the closing, the buyers sought to rescind the purchase agreement based on allegedly false representations in the contract and extra-contractual statements. The sellers, however, contended that the claims were precluded because the purchase agreement contained, among other things, an anti-reliance clause and a provision purporting to make indemnification the parties’ sole remedy for misrepresentations in the agreement. Specifically, the purchase agreement contained the following anti-reliance clause:
[Buyers] acknowledge[] and agree[] that neither the [target] nor [the sellers] has made any representation or warranty, express or implied, as to the [target or its subsidiaries] or as to the accuracy or completeness of any information regarding the [target or its subsidiaries] furnished or made available to [the buyers], except as expressly set forth in this Agreement . . . and neither the [target] nor [the sellers] shall have or be subject to any liability to [the buyers] or any other Person resulting from . . . [the buyers’] use of, or reliance on, any such information or any information, documents or material made available to [the buyers] in any ‘data rooms,’ ‘virtual data rooms,’ management presentations or in any other form in expectation of, or in connection with, the transactions contemplated hereby.
In addition, the purchase agreement’s indemnification provisions capped the sellers’ liability for misrepresentations and precluded the buyers from bringing claims for rescission.
The court indicated that the anti-reliance clause would – if given legal effect – preclude the buyers’ claims. Importantly, the court stated that anti-reliance clauses are generally enforceable under Delaware law so long as they pertain only to representations outside of the agreement. The court explained, however, that a standard integration clause on its own will not bar a party from bringing suit based on fraudulent extra-contractual representations; the applicable clause must contain explicit anti-reliance language through which the party contractually promises that it is not relying upon statements outside the contract in deciding to sign the agreement. Explaining the policy basis for its holding, the court noted that if it failed to enforce such provisions, it would create a “double liar” scenario – allowing the plaintiff to prevail on its fraud claim by effectively sanctioning the plaintiff’s own fraudulent conduct (i.e., its false assertion in a written contract that it was not relying on extra-contractual representations).
Following its general discussion on the enforceability of anti-reliance clauses, the court in Abry Partners then examined the extent to which a contracting party can limit its liability for claims based on false representations within an agreement. Recognizing that Delaware has a general policy against immunizing fraud, the court held that parties may only insulate a seller from liability (or preclude rescission claims) for false statements of fact in an agreement that are not intentionally made. However, if a seller intentionally misrepresents a fact in a contract – that is, if a seller lies – Delaware’s public policy would not permit the enforcement of a contractual provision limiting the buyer’s remedy to a capped damages claim.
The Delaware Supreme Court did not address the enforceability of anti-reliance clauses under Delaware law until five years later in RAA Management, LLC v. Savage Sports Holdings, Inc., 45 A.3d 107 (Del. 2012).In RAA, the Delaware Supreme Court affirmed the dismissal of claims made by RAA Management, LLC, an investment firm, against Savage Sports Holdings, Inc., a privately-held sports equipment manufacturer. RAA, once a potential bidder for Savage, alleged that Savage fraudulently misled RAA regarding the existence of certain material liabilities and claims against Savage, and as a result, RAA incurred $1.2 million in due diligence and negotiation costs that it allegedly would not have incurred had RAA known of such matters at the outset.
In connection with the due diligence process, the parties executed a nondisclosure agreement that contained an anti-reliance clause. In the non-reliance provision, RAA expressly agreed to the following:
[RAA] understand[s] and acknowledge[s] that neither [Savage nor any of its representatives] is making any representation or warranty, express or implied, as to the accuracy or completeness of . . . any other information concerning [Savage] provided or prepared by or for [Savage], and . . . [o]nly those representations or warranties that are made to [RAA] in the [purchase agreement] when, as and if it is executed, and subject to such limitations and restrictions as may be specified [in] such [purchase agreement], shall have any legal effect.
Accordingly, because RAA terminated the negotiations prior to the execution of a definitive agreement, the Court held that the NDA’s anti-reliance clause precluded RAA’s fraud claim because such claim was based solely on extra-contractual representations. Although the Court decided RAA under New York law, its decision confirmed that the result would be the same under Delaware law and specifically noted that “Abry Partners accurately states Delaware law and explains Delaware’s public policy in favor or enforcing contractually binding written disclaimers of reliance on [extra-contractual representations].” By virtue of this decision, the Delaware Supreme Court also extended the rule in Abry Partners to anti-reliance clauses present in other commercial agreements entered into by sophisticated parties, like NDAs. The Court emphasized that the purpose of NDAs and confidentiality agreements is to facilitate due diligence and the negotiation of purchase and sale agreements, and anti-reliance clauses are particularly effective tools to limit the target company’s liability for misrepresentations made during these processes.
Recent Developments: The Dangers of Imprecise Drafting
Recent Delaware cases have provided further insight into the Delaware courts’ approach to determining the scope of anti-reliance clauses. The general rule of Abry Partners remains unchanged. Nonetheless, these decisions demonstrate the increased level of scrutiny the Delaware courts will use to determine whether an anti-reliance clause operates to bar the particular fraud claims alleged by the plaintiff. In these cases, the Delaware Court of Chancery rejected motions to dismiss fraud claims arising out of equity purchase agreements, finding that, notwithstanding the inclusion of broad anti-reliance clauses, such agreements specifically left open the possibility that certain fraud claims could be based on extra-contractual statements. Parties drafting and negotiating agreements containing anti-reliance clauses should take care to avoid the drafting missteps exemplified by these most recent decisions.
In Anvil Holding Corp. v. Iron Acquisition Co., Inc., 2013 WL 2249655 (Del. Ch. May 17, 2013), the Court of Chancery reiterated the holdings of Abry Partners and RAA, but suggested, in dicta, that a broad fraud carve-out could operate to nullify the intended effects of anti-reliance clauses. In this case, Indigo Holding Company, Inc., and Iron Acquisition Corp. purchased the outstanding securities of Iron Data Solutions, LLC. After the purchase, the buyers brought suit alleging that they had been defrauded by the sellers. Specifically, the buyers alleged that certain of the sellers, who were also members of the management team, were aware that the acquired company’s most important customer intended to change the pricing mechanism in its contract with the company and that such sellers deliberately withheld this information. As a result, the buyers claimed that the sellers breached a key representation in the purchase agreement and that the sellers knew the representation was false when made. The buyers based their claims on both the representations and warranties made within the purchase agreement and extra-contractual statements made prior to its execution.
With respect to the buyers’ claims based on extra-contractual statements, the sellers initially relied only on two provisions of the purchase agreement – a disclaimer by the sellers as to the making of any express or implied warranties except as set forth in the purchase agreement and a typical integration clause. Although the purchase agreement contained a specific anti-reliance clause, pursuant to which the buyers represented that the sellers made no representations or warranties other than those expressly set forth in the purchase agreement, the sellers did not include reference to this provision in their briefs, and the court declined to consider arguments based on the anti-reliance clause. Relying on Abry Partners, the court found that the buyers did not disclaim reliance on extra-contractual statements, and as a result, the buyers were not precluded from pursuing a fraud claim based thereon. In the court’s view, the sellers’ disclaimer, together with the integration clause, did not create the “double liar” problem where allowing the buyers to prevail on their fraud claim would sanction the buyers own fraudulent conduct in having falsely asserted that they would not rely on extra-contractual representations. In addition, and perhaps more importantly, the court also observed that the parties agreed in the purchase agreement to “reserve all rights with respect to” claims based on fraud or the bad faith of any party. The court concluded that this language provided further evidence that the parties intended to permit reliance on extra-contractual representations in establishing post-closing fraud claims.
Although the sellers’ arguments regarding the anti-reliance disclaimer were deemed waived for purposes of the motion to dismiss, the court noted, in dicta, that even if the court had considered the anti-reliance language in making its decision, the outcome may not have differed. In this regard, the court pointed to the broad fraud carve-out and cited the Delaware Supreme Court’s decision in Airborne Health, Inc. v. Squid Soap, LP,984 A.2d 126, 141 (Del. 2009). In Airborne, the Delaware Supreme Court held that when drafters specifically preserve the right to assert fraud claims, the agreement must specify whether the carve-out applies only to claims based on written representations within the agreement, as the court will not infer such a limitation.
Two weeks following Anvil, the Court of Chancery declined to dismiss a fraudulent concealment claim in another case, finding that the anti-reliance clause in the purchase agreement did not clearly disclaim reliance on pre-signing omissions by the sellers. In TransDigm Inc. v. Alcoa Global Fasteners, Inc., 2013 WL 2326881 (Del. Ch. May 29, 2013), the underlying purchase agreement contained an anti-reliance clause, but the provision only disclaimed reliance on extra-contractual representations, and was silent as to the disclaimer of reliance on extra-contractual omissions.
The dispute in TransDigm arose out of the acquisition of Linread Ltd. During the course of due diligence, the buyer inquired as to the relationships between Linread and its customers, the most important of which was Airbus. The indirect owner of Linread’s equity advised the buyer that there were no disputes or requests for price re-negotiations, notwithstanding the fact that at that time, the seller allegedly had information to the contrary. Following the execution of the purchase agreement, the buyer learned that Airbus expressed dissatisfaction with certain Linread products and that the seller’s CEO verbally offered Airbus a 5 percent discount, which was scheduled to commence following the consummation of the acquisition by the buyer. The buyer also learned that at a meeting that took place shortly before the execution of the purchase agreement, Airbus advised Linread that it was considering moving 50 percent of its business to a European competitor. In light of the foregoing, the buyer brought claims for, among other things, fraudulent concealment.
The seller, relying exclusively on the Delaware Supreme Court’s decision in RAA, premised its arguments in favor of its motion to dismiss on the purchase agreement’s express anti-reliance clause. That provision stated, in pertinent part:
[B]uyer has undertaken such investigation and has been provided with and has evaluated such documents and information as it has deemed necessary to enable it to make an informed decision with respect to the execution, delivery and performance of this Agreement and the transactions contemplated hereby. Buyer agrees to accept the [equity] without reliance upon any express or implied representations or warranties of any nature, whether in writing, orally or otherwise, made by or on behalf of or imputed to [the seller] or any of its affiliates, except as expressly set forth in [the purchase agreement].
The buyer argued, however, that its claim was not based on extra-contractual representations, but rather on the intentional and active concealment of material facts by the seller. In particular, the buyer alleged that it reasonably and justifiably relied on the lack of a negative response to its inquiries as to Linread’s business relationship with Airbus in making its decision to purchase Linread.
Denying the seller’s motion to dismiss, the court distinguished the facts in TransDigm from RAA, pointing out that under the instant facts, the buyer did not agree that the seller was making no representations as to the “accuracy and completeness” of the information provided. The buyer likewise did not disclaim reliance on extra-contractual omissions. In so holding, the court noted that the buyer reasonably could have relied on the assumption that the seller was not actively concealing information that was responsive to inquiries made with respect to Linread’s customers. The court further observed that the two cases discussed in detail in RAA both involved challenges to agreements that contained language expressly disclaiming reliance on both extra-contractual representations and omissions. SeeGreat Lakes Chemical Corp. v. Pharmacia Corp., 788 A.2d 544, 552 (Del. Ch. 2001) (stating that the buyer represented, among other things, that “[e]ach of [the sellers] expressly disclaims any and all liability that may be based on such information or errors therein or omissions therefrom”); In re IBP, Inc. Shareholders Litig.,789 A.3d 14 (Del. Ch. 2001) (noting that the buyer represented, among other things, that none of the sellers “shall have any liability whatsoever to us or our [r]epresentatives relating to or resulting from the use of [certain materials] or any errors therein or omissions therefrom”).
Conclusion
Following the Delaware Court of Chancery’s decision in Abry Partners and its subsequent confirmation by the Delaware Supreme Court in RAA, drafters of commercial agreements between sophisticated parties governed by Delaware law could be confident that clearly drafted anti-reliance clauses that disclaimed reliance on statements made outside of the agreement would be enforced by the Delaware courts and would limit the buyer’s ability to bring fraud claims based on extra-contractual representations. While neither Anvil nor TransDigm modify the holdings of those earlier decisions, these cases are important insofar as they offer helpful guidance to practitioners on the drafting of anti-reliance clauses.
The Court of Chancery’s decision in Anvil demonstrates the possible unintended consequences of a broad reservation by the parties of the right to bring fraud claims. Although sellers of equity or assets may intend to insulate themselves from post-closing claims for fraudulent misrepresentations through the inclusion of carefully drafted anti-reliance clauses, the insertion of language preserving the parties’ rights to bring fraud claims could negate such efforts. Accordingly, to the extent that sellers are unable to negotiate around the broad reservation of rights in respect of fraud, practitioners representing the selling parties should seek to include language limiting the right to bring fraud claims to claims based on the representations and warranties expressly set forth in the purchase agreement.
The TransDigm decision, on the other hand, reflects the need for vigilance in the drafting of anti-reliance language. Provisions that disclaim reliance only as to representations made outside of the purchase agreement may be insufficient to avoid claims for fraudulent concealment. To the extent the parties intend to preclude all claims based on extra-contractual statements and omissions, anti-reliance disclaimers should also include express disclaimers of reliance on the “accuracy and completeness” of the information provided and the omission of material facts outside of the agreement.
An Update of the 2004 Special Report of the Task Force on Securities Law Opinions, ABA Business Law Section*
This updated report reflects developments in opinion practice since the 2004 Special Report, including the publication on October 14, 2011 of Staff Legal Bulletin No. 19 by the SEC Division of Corporation Finance.1
I. INTRODUCTION
Section 7(a) of the Securities Act of 1933 (the “Securities Act”) requires a registration statement to contain the information specified in schedule A to the Act.2 Paragraph 29 of schedule A requires the filing of “a copy of the opinion or opinions of counsel in respect to the legality of the issue.”3 The Securities and Exchange Commission (the “SEC”) has addressed that requirement in item 601 of Regulation S-K.4 Under paragraph (b)(5) of item 601, a registration statement must include as an exhibit “[a]n opinion of counsel as to the legality of the securities being registered, indicating whether they will, when sold, be legally issued, fully paid and non-assessable, and, if debt securities, whether they will be binding obligations of the registrant.”5 Counsel to the issuer—either inside counsel or outside counsel—gives the opinion. The opinion on legality appears as exhibit 5 to a registration statement and is thus often referred to as an “Exhibit 5 opinion.” This 2013 Update examines Exhibit 5 opinions.
II. PRELIMINARY MATTERS
A. ADDRESSEES, LIMITATIONS ON RELIANCE, AND TIMING OF FILING
The Securities Act and the SEC rules under it are silent with regard to whom an Exhibit 5 opinion should be addressed. In practice, the opinion typically is addressed to the issuer.
The SEC staff (the “Staff ”) does not permit the inclusion in an Exhibit 5 opinion of any limitations on who may rely on the opinion6 and has stated that purchasers of securities in any offering to which an Exhibit 5 opinion relates are entitled to rely on that opinion without limitation.7 The Staff views any limitations on reliance (e.g., stating that the opinion is “only” or “solely” for the issuer or its board of directors) as being inconsistent with the purpose of paragraph 29 of schedule A to the Securities Act.
An Exhibit 5 opinion need not be included as an exhibit to a registration statement as initially filed but must be filed as an exhibit in order for the registration statement to be declared or become effective. Thus, the opinion often is filed with an amendment to the registration statement.8 As discussed further below, when counsel needs to include otherwise impermissible assumptions or qualifications to give an initial opinion before a registration statement becomes effective (e.g., in the case of a shelf registration statement), the Staff requires that an updated, unqualified opinion be filed not later than the closing date of each offering of securities pursuant to the registration statement.9
B. ASSUMPTIONS
The fact that the opinion must be filed before the securities are actually sold—and in the case of shelf registrations, often long before—gives rise to issues about the appropriateness of assumptions that are included in the opinion. Certain situations (e.g., the filing of shelf registration statements and the registration of rights under shareholder rights plans) require counsel to include broad and otherwise unacceptable assumptions that the Staff has deemed permissible in these limited circumstances. These are discussed in further detail below. In general, however, the Staff likely will object to any assumptions that it considers “overly broad, that ‘assume away’ the relevant issue or that assume any of the material facts underlying the opinion or any readily ascertainable facts.”10 Nevertheless, the Staff does not question the inclusion of certain standard opinion assumptions (e.g., the genuineness of signatures and the legal capacity of the signatories of documents reviewed by counsel), many of which “are understood as a matter of customary practice to apply, whether or not stated.”11 Although counsel need not expressly enumerate each of these customary assumptions for them to apply, some may choose to do so. In general, assumptions should be limited to matters that cannot be known until after the registration statement is effective, such as the terms of a particular series of debt securities or approval by directors of the price of shares being sold in a common stock offering.12
C. CONSENTS AND EXPERTISE
Rule 436 under the Securities Act requires that a written consent of counsel be filed as an exhibit to a registration statement, “[i]f any portion of the . . . opinion of . . . counsel is quoted or summarized as such in the registration statement or in a prospectus.”13 This requirement has led to speculation as to whether, by virtue of the reference in the prospectus to its having passed on the legality of the securities, counsel giving an Exhibit 5 opinion is an expert for purposes of section 7 of the Securities Act. The statute itself refers to:
any accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, [who] is named as having prepared or certified any part of the registration statement, or is named as having prepared or certified a report or valuation for use in connection with the registration statement.14
The statute does not specifically refer to lawyers, an omission that may explain why Rule 436 refers to the consent of “an expert or counsel.”15 In any event, Rule 436 requires that a consent of counsel “be filed as an exhibit to the registration statement.”16 That consent must be to the filing of the opinion as an exhibit to the registration statement and to both the discussion of the Exhibit 5 opinion and the reference to the counsel that gave it in the related prospectus.17 As a drafting matter, most lawyers include the consent in the opinion letter itself. Some also add a statement to the effect that the filing of the consent shall not be deemed an admission that counsel is an expert within the meaning of section 7 of the Securities Act. The Staff does not object to this “no admission” language. The Staff does object, however, to language affirmatively denying that counsel is an expert within the meaning of the Securities Act.18 Whether or not counsel includes the “no admission” language should have no bearing on whether counsel is or is not an expert under section 7.
Exhibit 5 opinion practice, including compliance with Rule 436, has varied when the law of multiple jurisdictions is implicated. A typical example would be the issuance of debt securities by an entity formed in a jurisdiction other than New York pursuant to an indenture governed by New York law. Unless expressly qualified, an opinion that debt securities issued under an indenture are valid and binding (a matter of contract law under the law of the jurisdiction whose law governs the indenture) is customarily understood to encompass an opinion that the indenture has been duly authorized, executed, and delivered (a matter of corporate or other entity law of the jurisdiction where the issuer was formed). If the opinion giver is able to cover both the law of the issuer’s jurisdiction of formation and the law that governs the indenture, it can cover all requisite elements of the opinion in a single Exhibit 5 opinion. If not, the opinions of two counsel will be required to cover all relevant opinion matters. There are two approaches typically used when two opinions are required. These two approaches often are referred to as the reliance approach and the separate opinion approach.
Rule 436(f ) under the Securities Act specifies that, if an opinion filed as an exhibit expressly relies on an opinion of another counsel, the consent of that other counsel need not be provided and that other counsel need not be named in the registration statement.19 Under this approach, the opinion of primary counsel covers all required matters (e.g., due authorization, execution, and delivery of the indenture as well as enforceability of the debt securities issued pursuant to the indenture), expressly relying on the opinion of other counsel for matters governed by the law of the jurisdiction where the issuer was formed. Despite the relief from filing a consent, the Staff has taken the position that a signed copy of the opinion on which primary counsel expressly relied must nevertheless be included as an exhibit to the registration statement.20
The Staff also has accepted a separate opinion approach when the law of multiple jurisdictions is involved. Under this approach, which is more consistent with typical third-party closing opinion practice, the opinion of one counsel covers all matters governed by the law of the jurisdiction where the issuer was formed (e.g., due authorization, execution, and delivery) and, assuming those matters, the opinion of another counsel covers enforceability. Under this approach, both opinions must be filed as exhibits to the registration statement and both counsel must file consents pursuant to Rule 436.21
III. PARTICULAR CLASSES OF SECURITIES
A. EQUITY SECURITIES
1. Substantive Requirements
Item 601 of Regulation S-K requires that the opinion state that the securities, when sold, will be:
The phrase “legally issued,” although taken directly from the language of the Securities Act, is not the language lawyers customarily use when giving a third-party closing opinion on equity securities. Because the Staff does not insist on the “legally issued” language, many opinion givers use “validly issued” instead.23 Thus, in Exhibit 5 opinions, many lawyers use, and the Staff has accepted,24 a formulation of an Exhibit 5 opinion with respect to equity securities to the effect that the securities have been “duly authorized and, [when sold in accordance with the provisions of the applicable purchase agreement], will be validly issued, fully paid and nonassessable.”25 This is the language normally used in third-party closing opinions, and its meaning (as well as the meaning of “fully paid and nonassessable”) is the subject of numerous bar association reports.26
Because the Exhibit 5 opinion is delivered before the securities are sold, opinion givers often cast the opinion in the future tense, stating that the securities will be validly issued, fully paid, and nonassessable upon their sale in accordance with the applicable purchase agreement or governing document. Opinion givers also sometimes condition the opinion on further action by the board or a board committee. Opinion givers should be careful about the breadth of any such assumptions. Although an opinion giver may appropriately assume that a pricing committee—if permitted by the law of the jurisdiction where the issuer was formed and its constituent documents—will take the action necessary to set the sale price within a range established by the board,27 the Staff likely will object to an assumption that all action required to be taken prior to the issuance and sale of the securities has been taken.28 In general, as discussed above, assumptions should be limited to matters that as a practical matter cannot be known until after effectiveness of the registration statement.
2. Opinions on Delaware Corporations by Counsel Not Admitted to Practice in Delaware
The Staff has indicated that it will accept an opinion in respect of the law of a jurisdiction in which the opinion giver is not admitted to practice so long as the opinion giver does not attempt to qualify the opinion by “carv[ing] out” the very laws of the jurisdiction in question.29 Counsel not admitted to practice in Delaware, for example, often give Exhibit 5 opinions on stock issued by Delaware corporations.30 Usually, such counsel includes in its opinion a so-called coverage limitation specifying that the opinion’s coverage of Delaware law is limited to the Delaware General Corporation Law.
In the late 1990s, a question arose over the scope of the law covered by opinions on stock issued by Delaware corporations where coverage of the opinion was limited to the Delaware General Corporation Law. In the registration statement review process, the Staff frequently commented that this limitation unacceptably limited the scope of the opinion because, on its face, it focused only on the Delaware corporation statute and not on the Delaware Constitution and judicial interpretations. That controversy was resolved when the Staff accepted the view that the reference to the “Delaware General Corporation Law” was an opinion drafting convention, and that the practicing bar understood that phrase to cover the Delaware General Corporation Law, the applicable provisions of the Delaware Constitution, and reported judicial decisions interpreting these laws. The Staff ’s position was further clarified in Staff Legal Bulletin No. 19, in which the Staff confirmed that it shares the view that the phrase Delaware General Corporation Law includes reported judicial decisions interpreting that law.31 The Staff now routinely accepts a coverage limitation that states that the opinion is limited to the Delaware General Corporation Law.32 However, the Staff has reiterated that it “does not accept an opinion that explicitly excludes consideration of . . . reported judicial decisions. This position applies to the corporation and other entity statutes of all jurisdictions.”33
B. DEBT SECURITIES
1. Binding Obligations
For debt securities, item 601 of Regulation S-K requires the filing of an opinion that the securities will be “binding obligations of the registrant.”34 This opinion, often referred to in the context of general opinion practice as the “remedies” or “enforceability” opinion, is stated in various ways. Perhaps the most common formulation is that the debt securities constitute valid and binding obligations of the issuer, enforceable against the issuer in accordance with their terms “except as may be limited by bankruptcy, insolvency or other similar laws affecting the rights and remedies of creditors generally and general principles of equity.”35 Minor differences in wording do not change the meaning of the opinion.36
Exhibit 5 opinions on debt securities typically refer to the debt instruments themselves rather than the indenture under which they are issued. An enforceability opinion on the debt securities covers those portions of the indenture that relate to the terms of the securities, including any terms in the indenture that further define terms in the securities, such as the terms for conversion.37
2. Governing Law
Unlike the law governing the validity of equity securities (which is the entity law of the jurisdiction where the issuer was formed), the law governing the enforceability of debt securities is generally the law chosen in the instrument under which the securities are issued. Often New York law is chosen to govern the obligations of the issuer in a registered debt offering. In the context of third-party closing opinions, when counsel for the issuer is not in a position to give an opinion on New York contract law, underwriters may be willing to accept an opinion on the enforceability of the debt as if the law of counsel’s home jurisdiction applied.38 However, that practice is not acceptable to the Staff in the context of an Exhibit 5 opinion.39 The Securities Act requires an opinion on the legality of the issue, and the Staff takes the position that anything short of an opinion on the law that actually governs the enforceability of the debt securities will not suffice.40
3. Non-Standard Exceptions
Sometimes counsel includes exceptions, in addition to the standard bankruptcy exception and equitable principles limitation, to identify issues that affect the enforceability of particular provisions of the securities being registered. When including additional exceptions, counsel should consider whether they relate to issues requiring disclosure in the prospectus. In addition, counsel should be prepared for possible Staff comments.41 If the exceptions simply make explicit what is understood as a matter of customary practice to be implicit or otherwise are not material, additional exceptions should not require prospectus disclosure.
C. OPTIONS, WARRANTS, AND RIGHTS
Rights to acquire securities, either equity or debt, are contractual rights. In that respect they are more like debt securities than equity securities.42 In the case of warrants, for example, an opinion that a warrant is validly issued, fully paid, and nonassessable would be inapt because these concepts relate to stock— not contractual obligations.
As with opinions relating to debt securities, an Exhibit 5 opinion on warrants, for example, should address their enforceability under the law chosen to govern the warrants. Typically, the offer and sale of the warrants and the securities underlying the warrants are registered at the same time. In that case, the Exhibit 5 opinion should state not only that the warrants are enforceable, but also that the underlying shares (in the case of warrants to purchase stock) have been duly authorized and, upon delivery in accordance with the terms of the warrants, will be validly issued, fully paid, and nonassessable.43
Shareholder rights plans (sometimes referred to as “poison pills”) take the form of the issuance of rights to purchase shares of an issuer’s capital stock. These rights are attached to the shares of the issuer’s common stock and are issued each time a share of common stock is issued.44 The underlying stock may be common stock or preferred stock. Although the discussion above with respect to opinions on the binding effect of rights to acquire securities applies to rights issued pursuant to rights plans, the potential use of rights plans as takeover deterrents, the associated fiduciary issues under state corporate law, and the unpredictable facts and circumstances that may have an effect on whether such rights are binding in any given situation created uncertainty as to whether counsel could give an unqualified Exhibit 5 opinion with respect to these rights.
Following discussions with representatives of the ABA Business Law Section, the Staff has provided guidance regarding the assumptions that it considers permissible in Exhibit 5 opinions on rights issued pursuant to shareholder rights plans. The Staff has stated that it will not object if an Exhibit 5 opinion stating that such rights are binding obligations includes language to the effect that:
[1] the opinion does not address the determination a court of competent jurisdiction may make regarding whether the board of directors would be required to redeem or terminate, or take other action with respect to, the rights at some future time based on the facts and circumstances existing at that time;
[2] board members are assumed to have acted in a manner consistent with their fiduciary duties as required under applicable law in adopting the rights agreement; and
[3] the opinion addresses the rights and the rights agreement in their entirety, and it is not settled whether the invalidity of any particular provision of a rights agreement or of rights issued thereunder would result in invalidating such rights in their entirety.45
IV. PARTICULAR TYPES OF OFFERINGS
Opinion practice varies, depending not only on the type of securities being offered, but also on the type of offering. A signed Exhibit 5 opinion—not simply an unsigned form of opinion—must be on file in order for the registration statement to be declared or become effective.46
A. SHELF OFFERINGS
Shelf offerings under Rule 415 permit issuers to offer and sell securities long after a registration statement becomes effective.47 Moreover, in the case of universal shelf registrations, the class or classes and types of securities to be offered and sold may not be known on the effective date. Exhibit 5 opinion practice has evolved to accommodate shelf offerings.
1. Shelf Registrations for Common Stock
When an issuer registers common stock to be issued from time to time in the future, the opinion should state that the shares have been duly authorized. The remainder of the opinion, however, often requires assumptions that various actions will be taken before the shares are issued. In addition to the assumptions that apply whenever shares are being issued in the future, such as the issuer’s receipt of the required consideration, the opinion giver typically will need to assume expressly that the board of directors adopts resolutions approving the issuance and sale of the common stock at a specified price or pursuant to a specified pricing mechanism.
If the opinion is filed prior to effectiveness of the registration statement and the only substantive assumptions are that specified actions required to set the sale price of the shares will be taken and that the consideration for their issuance and sale will be received, no further opinion will be required when the shares are issued so long as the specified actions are permitted by the law of the jurisdiction where the issuer was formed and the issuer’s constituent documents.
Some issuers filing a shelf registration statement for common stock register a specific number of shares rather than an aggregate dollar amount. If the issuer decides to register an aggregate dollar amount of common stock, the opinion giver should expressly assume that no more than a specified number of shares, based on the then current market price, will be issued and sold under the registration statement and should confirm that the number of shares so specified is authorized and available under the issuer’s charter. If the issuer ultimately wishes to sell more shares than were covered by the original opinion or the opinion includes other substantive assumptions, a new unqualified opinion should be filed at the time of the sale as described below.
2. Universal Shelf Registrations
Universal shelf registrations permit issuers to register an aggregate dollar amount of securities, designating by class the various types of securities (e.g., common stock, debt securities, convertible debt securities, preferred stock, and warrants) that may subsequently be issued, without allocating such aggregate dollar amount among the several types of securities. In addition, following the adoption of securities offering reform in 2005,48 a universal shelf registration statement filed by a well-known seasoned issuer (a “WKSI”)49 may omit altogether any specific amount of securities registered, thus registering an unspecified and indeterminate aggregate initial offering price or number of securities.50 An Exhibit 5 opinion for a universal shelf registration statement thus requires more assumptions than even a shelf registration for a particular class of security. The board of directors typically will not have approved the terms of the debt securities or preferred stock at the time of effectiveness of the shelf registration statement. In the case of common stock, the issuer may not have sufficient authorized shares to permit an opinion that, were the issuer to elect to sell the entire aggregate dollar amount of securities registered as common stock at current market prices (or, in the case of universal shelf filed by a WKSI, were the issuer to elect to sell any common stock whatsoever), the stock to be sold has been duly authorized.51 Assumptions and qualifications, therefore, are necessary, and the Staff has not objected to opinions that include appropriate assumptions.
3. Filing Updated Opinions
Shelf registration was not contemplated at the time Congress enacted the legality opinion requirement. Permitting assumptions in Exhibit 5 opinions is necessary for the shelf registration process to work. Consistent with a position it had previously taken in its telephone interpretations, in Staff Legal Bulletin No. 19 the Staff permits the filing, before a shelf registration statement is declared or becomes effective, of an Exhibit 5 opinion that includes assumptions regarding the future issuance of the securities being registered that “would not generally be acceptable in connection with a non-shelf offering.”52 In Staff Legal Bulletin No. 19, however, the Staff, again consistent with its previous position, conditioned inclusion of those assumptions on the filing of “an appropriately unqualified opinion . . . no later than the closing date of the offering of the securities covered by the registration statement.”53
Thus, in connection with a shelf registration statement, counsel for the issuer typically files more than one opinion: an opinion before the registration statement becomes effective and subsequent opinions for each takedown. The initial opinion is highly qualified and contains broad assumptions intended to address the different securities being registered for subsequent issuance. The subsequent opinions, which are filed no later than the closing date for the offering to which they relate, address the particular securities being issued and take the form of a traditional unqualified Exhibit 5 opinion.
In filing an updated opinion, an issuer can make an exhibit-only filing pursuant to Rule 462(d), which provides for the immediate effectiveness of post-effective amendments filed solely to include exhibits.54 Alternatively, for shelf offerings conducted by an issuer under Rule 415(a)(1)(x), which must be registered under Form S-3 or F-3,55 the opinion may be incorporated by reference into the registration statement through a Form 8-K or 6-K filing.56
B. ACQUISITIONS AND EXCHANGE OFFERS
Acquisitions and exchange offers that involve the offer and sale of securities are registered on Form S-4. These registration statements require an Exhibit 5 opinion on the securities being issued in the acquisition. Often the issuance of the securities being registered requires the approval of shareholders, whether as a requirement of state corporation law or a securities exchange. Because an opinion must be on file before the registration statement is declared effective, as with shelf registrations, these opinions may be based on an express assumption that the required shareholder approval will be received.57 As with a qualified opinion filed prior to the effectiveness of an initial shelf registration statement, any such qualified opinion must be supplemented by an unqualified opinion filed by post effective amendment or on Form 8-K or Form 6-K, as out-lined above, no later than the closing date of the exchange offer.58
_____________
* The Task Force included members of the Legal Opinions Committee and the Subcommittee on Securities Law Opinions of the Committee on Federal Regulation of Securities of the American Bar Association Business Law Section. This Updated Report is being issued by the Subcommittee on Securities Law Opinions. Keith F. Higgins served as reporter for the 2004 Report and Andrew J. Pitts served as reporter for this 2013 Update.
8. If there is a long delay between the initial filing of the registration statement and the effective date, the Staff previously required that an updated opinion be filed before declaring the registration statement effective. Recently, Staff members have indicated that the Staff no longer requires the filing of an updated opinion solely because of the passage of time. This position is based on the recognition that under section 11 of the Securities Act the opinion must be correct at the time the registration statement becomes effective regardless of when the opinion is dated or filed. Therefore, should the opinion cease to be correct, for example as a result of a change in the law, after it is filed and before the registration statement becomes effective, counsel would have to file an updated opinion even if an update is not requested by the Staff.
9. See infra Part IV.A.3. The Staff formerly asked counsel to remove language from the opinion stating that counsel had no duty to update the opinion, but Staff members recently indicated that the Staff had changed this practice and will no longer ask for that language to be removed.
10. SLB 19, supra note 1, § II.B.3.a. The Staff has specifically noted that counsel may not assume conclusions of law relevant to the opinion, e.g., that the issuer is “legally incorporated; has sufficient authorized shares; is not in bankruptcy; or has taken all corporate actions necessary to authorize the issuance of the securities.” Id.
11. Id. § II.B.3.a n.32 (citing, e.g., TriBar Opinion Comm., Third-Party “Closing” Opinions: A Reportof the TriBar Opinion Committee, 53 BUS. LAW. 592, 615 (1998) (§ 2.3(a)) [hereinafter TriBar 1998 Report]). Many bar association reports describe opinion practice in particular states. By following the approach taken for third-party closing opinions, opinion givers should be able to rely on the substantial body of literature describing customary practice regarding those opinions.
20. SLB 19, supra note 1, § II.B.1.e. The Staff further notes that in such a situation, while primary counsel’s opinion cannot then “assume” the matters for which it is relying on the other counsel’s opinion, it may nevertheless “note that [primary counsel’s] opinion as to these matters is subject to the same qualifications, assumptions and limitations as are set forth” in the other counsel’s opinion. Id. § II.B.1.e. n.21.
22. 17 C.F.R. § 229.601(b)(5) (2013). The Staff outlines its understanding of the meanings of each of “legally (or validly) issued,” “fully paid,” and “non-assessable” in detail in SLB 19, supra note 1, § II.B.1.a.
23. In the case of a corporation, shares must be duly authorized to be validly issued, and the opinion as to due authorization is subsumed in the “validly issued” opinion. The Staff also has provided guidance on the meaning of these concepts and the form of the Exhibit 5 opinion when the issuer is not a corporation but rather a limited liability company, limited partnership, or statutory trust. See SLB 19, supra note 1, § II.B.1.b. With respect to limited liability companies, the Staff has indicated that it will accept the form of opinion set forth in TriBar Opinion Comm., Supplemental TriBar LLCOpinion Report: Opinions on LLC Membership Interests, 66 BUS. LAW. 1065, 1072 n.43 (2011).
25. See DONALD W. GLAZER ET AL., GLAZER AND FITZGIBBON ON LEGAL OPINIONS: DRAFTING, INTERPRETING AND SUPPORTING CLOSING OPINIONS IN BUSINESS TRANSACTIONS § 10.1, at 409–10 n.3 (3d ed. 2008).
26. See, e.g., TriBar 1998 Report, supra note 11, at 648–52 (discussing third-party closing opinions). The Staff has noted that “[i]f counsel does not opine that the securities will be legally issued, the Division [of Corporation Finance] will not accelerate the effectiveness of the registration statement. On the other hand, if counsel opines that the securities are not fully paid or are assessable, the effectiveness of the registration statement may be accelerated so long as the disclosures about partial payment or assessability are adequate.” SLB 19, supra note 1, § II.B.1.a.
27. For example, this practice is usually followed when, in reliance on Rule 430A, the registration statement is declared effective before pricing occurs. See generally 17 C.F.R. § 230.430A(a) (2013) (indicating that a registration statement that omits the public offering price may be declared effective); see also SLB 19, supra note 1, § II.B.3.a.
28. Unless, as discussed below, the opinion is being given in the context of a shelf registration of securities for future sale and a subsequent unqualified opinion will be filed in connection with each specific offering. See supra Part II.B; see also infra Part IV.A.
29. SLB 19, supra note 1, § II.B.3.b. In general, the Staff does not require that counsel be admitted to practice in the jurisdiction whose law is covered by the opinion, but it will object if an opinion states that counsel is not qualified to opine on the law of the covered jurisdiction.
31. Id. § II.B.3.c. In 2000, the Staff had revised its procedures to require counsel to confirm to the Staff in writing that reference to the “Delaware General Corporation Law” included not only the statutory provisions, but also all applicable provisions of the Delaware Constitution and reported judicial decisions interpreting that law. With the publication of Staff Legal Bulletin No. 19, however, that requirement was eliminated. In addition, in 2004, the specific provision of the Delaware Constitution addressing the due issuance of stock of Delaware corporations was repealed.
32. Similarly, opinions on Delaware limited liability companies and limited partnerships that are limited to the Delaware Limited Liability Company Act or the Delaware Revised Uniform Limited Partnership Act are now routinely accepted by the Staff.
34. 17 C.F.R. § 229.601(b)(5) (2013). When debt securities are guaranteed, counsel must also give an opinion that each guarantee will be the binding obligation of the applicable guarantor. SLB 19, supra note 1, § II.B.1.e.
35. TriBar 1998 Report, supra note 11, at 622–23 (noting the bankruptcy exception and equitable principles limitation to an “enforceability” opinion). The bankruptcy exception and equitable principles limitation are standard exceptions that are understood to apply even when not stated expressly. Id. at 623. These exceptions do not require prospectus disclosure, and the Staff does not object to their being stated expressly. SLB 19, supra note 1, § II.B.1.e.
37. Furthermore, the Staff has noted that “counsel need not expressly state in the opinion that the agreement or instrument pursuant to which the debt security or guarantee is issued, such as an indenture, is enforceable in accordance with its terms, although the opinion may include such language.” SLB 19, supra note 1, § II.B.1.e.
38. TriBar 1998 Report, supra note 11, at 635 n.98.
40. See id. The Staff permits counsel to exclude federal law (including the federal securities laws) and state securities laws from the coverage of the opinion. Id. § II.B.3.c. See also supra Part II.C. Because the opinion need only cover the legality of the issue under state law, such exclusions are not required whether or not the Exhibit 5 opinion contains a statement that the opinion is limited to applicable state corporation law (e.g., the Delaware General Corporation Law).
41. Counsel should keep in mind that “boilerplate” exceptions that do not relate to the securities being offered are likely to be questioned by the Staff.
42. This is the case even though an option, warrant, or right fits the definition of “equity security” in Rule 405 under the Securities Act. 17 C.F.R. § 230.405 (2013).
43. SLB 19, supra note 1, § II.B.1.e. In the case of warrants to purchase debt securities, the opinion on the underlying securities would track the opinion required to be given in respect of debt securities.
44. The rights only become separable from the issuer’s common stock and exercisable under specified circumstances, typically involving the acquisition by a third party of beneficial ownership of a specified percentage of the issuer’s common stock. Delaware courts generally have tested the validity of rights under shareholder rights plans under the Delaware General Corporation Law rather than as a matter of traditional contract law. See, e.g., Leonard Loventhal Account v. Hilton Hotels Corp., No. Civ. A. 17803, 2000 WL 1528909 (Del. Ch. Oct. 10, 2000), aff ’d sub nom. Account v. Hilton Hotels Corp., 780 A.2d 245 (Del. 2001); Moran v. Household Int’l, Inc., 500 A.2d 1346 (Del. 1985). In addition, the corporation statutes of many states contain a provision that expressly permits the issuance of rights under shareholder rights plans.
50. Securities Offering Reform, supra note 48, at 44771, 44779; see also 17 C.F.R. § 230.430B(a) (2013) (indicating the types of information that may be omitted from a shelf registration statement when it is declared effective or, in the case of an automatic shelf registration statement, when it becomes effective).
51. This problem can be solved, for example, by assuming that, after the sale of shares of common stock under the registration statement, the total issued shares will not exceed the number of authorized shares in the issuer’s certificate or articles of incorporation, an assumption to which the Staff does not object in the context of a shelf offering. SLB 19, supra note 1, § II.B.2.a. n.25.
57. An assumption will not be necessary, however, if shareholder approval is needed solely to satisfy listing requirements because the shares would still be validly issued even if shareholder approval is not obtained.
58. SLB 19, supra note 1, § II.B.2.d. The Staff ’s position appears to be that the requirement to file an unqualified opinion by closing applies in any situation in which an initial and necessarily qualified opinion has been filed prior to the effectiveness of any type of registration statement (e.g., an acquisition shelf registration statement with respect to which an initially filed opinion necessarily assumed that the number of shares to be offered and sold will not exceed the number of shares authorized in the issuer’s certificate or articles of association, and that the board will adopt resolutions in appropriate form and content authorizing the issuance and sale of the shares). Id.
There may be legal professionals who expect that the 2010 Amendments to UCC Article 9 (the Amendments) will finally do away with all those pesky non-uniform filing requirements that states have enacted over the years. Unfortunately, that won’t happen. While the Amendments do provide many welcome revisions, very few states have used the enactment process to replace non-uniform filing provisions with the official text from Part 5 of Article 9.
The remaining non-uniform filing requirements pose risks for UCC filers because they are not always obvious. This article identifies by state a sampling of non-uniform departures from the official text of Article 9 that will not be affected by enactment of the Amendments. This article also offers some suggestions to avoid the potentially costly traps non-uniform versions of Article 9 create for those who file UCC records.
Florida
A non-uniform addition to Fla. Stat. § 679.512(1)(a) requires that all amendments provide the names of the debtor and secured party of record. The filing office refuses to accept an amendment that omits the party names under Section 679.516(2)(c) on the grounds that the record fails to correctly identify the initial financing statement in compliance with Section 679.512(1)(a).
Ordinarily, a rejected amendment poses little risk for the secured party. The filer will simply resubmit a corrected version after receiving the rejection notice. Unless, of course, the filing office rejects a time-sensitive record, such as a continuation statement submitted at the end of the six-month window. In that case, the secured party could be at risk. Consequently, a UCC filer should always include the party names when filing an amendment in Florida. The party names can be provided either on the amendment form, space permitting, or on an attached exhibit.
Georgia
The official text of UCC § 9-515(a) provides the general rule that a financing statement is initially effective for five years. There are some exceptions, however. If the record indicates that it is filed in connection with a public-finance or manufactured-home transaction, then Section 9-515(b) provides that it is effective for 30 years. Likewise, if the record indicates that the debtor is a transmitting utility, then Section 9-515(f) makes it effective until terminated.
Some states omitted either public-finance or manufactured-home transactions from the scope of Section 9-515(b). Georgia, however, omitted the official text of subsections (b) and (f) entirely from Ga. Code Ann. § 11-9-515. As a result, all financing statements filed in Georgia are initially effective for a five-year period, no exceptions.
If a secured party sets its continuation tickler based on the assumption that Georgia law follows the uniform effective periods, it will not be reminded to file a continuation statement at the correct time and the record will lapse.
Georgia’s version of Article 9 also creates a trap for the unwary UCC filer when the collateral includes growing crops. Georgia law treats growing crops in the same manner as timber to be cut, as-extracted collateral and fixtures. In other states there are no special requirements for financing statements that cover growing crops.
Under Ga. Code Ann. § 11-9-501(a)(1)(A), however, the proper place to file a financing statement covering growing crops is the same office where a mortgage would be recorded on the affected real property, not the regular UCC index. Likewise, a financing statement that covers growing crops must satisfy the additional Section 11-9-502(b) content requirements for records that cover real-estate-related collateral. Unless a financing statement covering growing crops located in Georgia is filed in accordance with Section 11-9-501(a)(1)(A) and Section 11-9-502(b), then the secured party may find itself with an unperfected security interest.
The Amendments may bring one significant Georgia statutory deviation back into uniformity with the official text. Under current Section 11- 9-502(c), a record of a mortgage cannot be effective as a financing statement filed as a fixture filing. The bill introduced in Georgia this year to enact the Amendments replaces current Section 11-9-502(c) with the uniform text from UCC § 9-502(c). However, the legislation, as introduced, will not change the other non-uniform provisions described above.
Idaho
Perfecting a security interest in any farm products requires special care in Idaho. If a security interest includes farm products as collateral, non-uniform Idaho Code Ann. § 28-9-502(e) imposes additional requirements for the sufficiency of the financing statement.
Under the official text of UCC § 9-502(a), a financing statement is sufficient if it provides just three pieces of information: the name of the debtor, name of the secured party, and an indication of the collateral. There are no special rules for the sufficiency of a financing statement that cover farm products.
In Idaho, however, Section 28-9-502(e) applies the federal requirements for an “Effective Financing Statement,” as defined in 7 U.S.C. § 1631(c)(4) of the Food Security Act, to the sufficiency of a UCC financing statement that covers farm products. Under this non- uniform provision, a written financing statement covering farm products is sufficient if it provides the names and addresses of the parties, is signed or authenticated by the debtor, and includes the debtor’s Social Security Number (SSN) or other unique identifier selected by the secretary of state. Moreover, the record must describe the farm products by category and identify the locations by county where the farm products are produced or located.
To further complicate matters, the content requirements differ for records filed electronically and those submitted on written forms. For example, the debtor must sign or otherwise authenticate a written UCC record that covers farm products. The same record submitted electronically, however, would not require the debtor’s signature or authentication.
Indiana
A non-uniform provision added to Ind. Code § 26-1-9.1-502 imposes a unique duty on the secured party following the filing of a financing statement. Subsection (f) requires the secured party to furnish a copy of a financing statement to the debtor within 30 days of the file date. The provision also places the burden of proving compliance with this requirement squarely on the secured party.
It is significant that the text of Section 26-1-9.1-502(f) does not limit the secured party’s responsibility to providing the debtor with a copy of just an “initial financing statement.” Instead, subsection (f) uses the broader term “financing statement.” The official text of Article 9 and Ind. Code § 26-1-9.1-102(a)(39) both define “financing statement” to include any filed record related to the initial financing statement. Consequently, this provision arguably requires the secured party to send the debtor a copy not just of the initial financing statement, but also any related amendments filed at a later date.
A secured party’s failure to send a copy of the filed record to the debtor will not make the record ineffective. Nevertheless, there are potential costs if the secured party overlooks this requirement. A secured party that fails to comply with subsection (f) is subject to the penalties set forth in Ind. Code § 26-1-9.1-625. To play it safe, a prudent UCC filer should promptly send the debtor a copy of any UCC record filed in Indiana by a method that provides proof of delivery.
Louisiana
The risk of filing office error generally falls on those who search the UCC records. A secured party is protected against a filing office indexing error by UCC § 9-517. Likewise, UCC § 9-516(d) partially protects the secured party when the filing office wrongfully refuses to accept the record, except in Louisiana.
Louisiana omitted subsection (d) when it enacted La. Rev. Stat. § 10:9-516. Consequently, a record wrongfully rejected by a Louisiana filing office through no fault of the secured party is nevertheless ineffective against other creditors.
To avoid the risk caused by the omission of UCC § 9-516(d) in Louisiana, filers should assume that a wrongfully rejected record is ineffective. The UCC filer must respond promptly to any notice of rejection from a Louisiana filing office and do what it takes to get the record filed.
South Dakota
Prior to 2001, several states required financing statements to include the SSN of an individual debtor. By early 2012, only South Dakota still required an individual’s SSN by statute for all financing statements. It was widely hoped that South Dakota would use the Amendments legislation as an opportunity to finally eliminate the SSN requirement. That did not happen. When it enacted the Amendments in March 2012, South Dakota retained the SSN requirement for sufficiency in S.D. Codified Laws § 57A-9-502(a)(1).
UCC filers must continue to provide an individual debtor’s SSN on any financing statement submitted in South Dakota or the filing office will reject the record. Moreover, the SSN is a requirement for sufficiency under S.D. Codified Laws § 57A-9-502(a)(1). A record without the SSN may not be effective even if the filing office accepts it. The safest course of action, therefore, is to ensure that all financing statements submitted to a South Dakota filing office provide the individual debtor’s SSN.
Wyoming
In 2013, Wyoming enacted a significant non-uniform amendment to the Article 9 financing statement duration and effectiveness rules. The new law amends Wyo. Stat. Ann. § 34.1-9-515(a) to provide that financing statements filed after July 1, 2013, will be effective for 10 years. In addition, the filing of a continuation statement after July 1, 2013, will extend the effectiveness of the related financing statement for an additional 10-year period.
The reasoning behind this non-uniform departure from the official text of UCC § 9-515(a) is that a growing number of finance transactions now extend beyond five years. A 10-year effective period for financing statements reduces the risk that a lender would inadvertently miss the continuation deadline and become unperfected. It also saves lenders the cost of filing continuation statements because nearly all transactions will conclude within that 10-year period.
A 10-year effective period for UCC financing statements should reduce the number of instances where a record inadvertently lapses because the secured party missed the continuation deadline. Whether this benefit outweighs the added costs of a longer effective period remains to be seen. It will take several years before the lenders and debtors feel the full impact of the increased transaction costs.
Conclusion
The states listed above are by no means the only jurisdictions that enacted UCC Article 9 with non-uniform filing requirements. Perhaps someday, every state will finally adopt the full official text of the Article 9 filing provisions. Until then, non-uniform filing requirements will continue to create risk for secured parties and their legal counsel. The best way to limit that risk is never to assume that the filing requirements are entirely uniform. The UCC filer must carefully review the statutory requirements prior to filing in a particular state.
At the outset of any relationship, be it professional or personal, the parties to the relationship are not interested in discussing how it will end. For various reasons, many investors in limited liability companies (LLCs) seek to exit those companies by seeking judicial dissolution of the LLC. Based on recent case law in Delaware, however, members of an LLC should not take comfort in, or rely upon, the statutory provisions of the Delaware Limited Liability Company Act (DLLCA) as an “exit mechanism.” Although Section 18-802 of the DLLCA provides a possible exit mechanism for members of an LLC, recent case law has shown that the Delaware courts are loath to dissolve an LLC merely because of changed circumstances, including bad economic conditions or a failure by the LLC to perform as anticipated. (Although the focus of this article is Delaware limited liability companies, the discussion with respect to exit mechanisms is applicable to LLCs formed in other jurisdictions as well.)
The DLLCA (Section 18-1101(b) of the Delaware Limited Liability Company Act) and relevant case law(Ross Holding & Mgmt. Co. v. Advance Realty Group LLC, 2010 WL 3448227, at *5 (Del. Ch. Sept. 2, 2010)) make clear that LLCs are creatures of contract and provide the members with substantial flexibility to tailor a business relationship in a manner that best suits their needs. Given the contractual flexibility provided by the DLLCA, members of an LLC and counsel drafting the limited liability company agreement (LLC Agreement) should be careful to include terms in the LLC Agreement that will provide the parties with an exit mechanism that meets the goals and objectives of the members. Depending on the purpose for which the LLC is being formed and the tenor of the negotiations between the parties to the LLC Agreement, it may be desirable for the members to rely on the statutory exit mechanism provided by the DLLCA. In the event the parties will rely on the statutory exit mechanism, the nature of this statutory exit mechanism should be explained to the members prior to entering into the LLC Agreement to ensure they understand the limits of the exit mechanism provided by the DLLCA. This article highlights the importance of addressing the issue of exit mechanisms in an LLC Agreement and provides a brief description of possible exit mechanisms that could be included in an LLC Agreement.
The DLLCA Default Provisions
In the event an LLC Agreement does not contain an exit mechanism, the members’ ability to exit the LLC will be governed by the default provisions of the DLLCA. Under Section 18-603 of the DLLCA, a member of an LLC does not have the right to withdraw from an LLC unless the LLC Agreement specifically provides such right. Therefore, unless a member has the right to resign under the LLC Agreement, a member cannot resign or withdraw from the LLC until it has been dissolved and wound up pursuant to its LLC Agreement or the DLLCA. Under Section 18-801 of the DLLCA, an LLC shall be dissolved (1) as provided in its LLC Agreement, (2) upon the requisite vote of members of the LLC, (3) at any time the LLC has no members, unless the LLC is continued as provided in the DLLCA or (4) upon an entry of a decree of judicial dissolution under Section 18-802 of the DLLCA.
The typical multi-member LLC Agreement is drafted in such a way that the LLC is dissolved solely upon a vote of the members (which vote often requires the consent of multiple members) or upon a judicial dissolution pursuant to Section 18-802 of the DLLCA. Thus, a typical multi-member LLC Agreement will not allow a member to unilaterally withdraw or cause the dissolution of the LLC. Therefore, if a member of an LLC governed by such an LLC Agreement determines, for any number of reasons, that it wants to exit the LLC, neither the LLC Agreement nor the DLLCA would provide the member with attractive options to exit the LLC. Such member may either (1) negotiate with the other members of the LLC for an exit acceptable to such member or (2) petition the Court of Chancery of the State of Delaware for the judicial dissolution of the LLC. The foregoing options may not be appealing to the member desiring to withdraw because none of the options can be taken unilaterally by such member.
With respect to the first option, negotiating an exit with the other members, the member that desires to withdraw will need to persuade the other members, or the LLC, to purchase its interest (which may not be a viable option for the LLC or the other members); or, such member will need to persuade the other members to dissolve the LLC. Presumably, the other members will only agree to either of the foregoing options if it makes business sense for them to do so at that time. Therefore, the member that desires to withdraw will have little influence over its power to withdraw. In the event that such member is unable to persuade the other members to purchase its interest or dissolve the LLC, such member may seek judicial dissolution of the LLC pursuant to Section 18-802 of the DLLCA.
Under Section 18-802 of the DLLCA, “on application by or for a member or manager the Delaware Court of Chancery may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement.” At first blush, the statutory exit mechanism provided in Section 18-802 of the DLLCA may appear to be a reasonable option for parties to rely upon instead of having the difficult discussion at the formation of the LLC about how members may exit the LLC. But the case law applying and interpreting Section 18-802 of the DLLCA makes clear that such reliance may not be justified. The Delaware Court of Chancery has made clear that the remedy of judicial dissolution is an extreme remedy that should be used sparingly, and even if a petitioner is successful in proving the requisite elements under Section 18-802 of the DLLCA, as described by the court, it is still within the court’s discretion to grant judicial dissolution. In re Arrow Inv. Advisors, LLC, 2009 WL 1101682, at *2 (Del. Ch. Apr. 23, 2009).
Under Section 18-802 of the DLLCA, the case law shows that the Delaware Court of Chancery will grant judicial dissolution if either (1) the purpose for which the LLC was created no longer exists or can no longer be achieved (i.e., “frustration of purpose”) or (2) a deadlock exists. With respect to a petition for judicial dissolution due to “frustration of purpose,” the petitioner will need to show that it is not reasonably practicable for the LLC to carry on its business in conformity with its LLC Agreement because the defined purpose of the LLC can no longer be fulfilled. With respect to a judicial dissolution due to a deadlock, the Delaware Court of Chancery has found that the following factors are relevant (although no one factor is dispositive): (1) is there a deadlock?, (2) does the governing document provide a means of navigating around the deadlock?, and (3) whether due to the LLC’s financial position, is there still a business to operate? See Fisk Ventures v. Segal, 2009 WL 73957 (Del. Ch. January 13, 2009). Thus, due to the difficulty of obtaining a decree of judicial dissolution, Section 18-802 of the DLLCA may offer cold comfort to a member that wants to exit an LLC. The expense of a full trial litigating judicial dissolution will not be attractive to a member, particularly when the outcome – even if the member is successful in proving the “requisite elements” required under Section 18-802 of the DLLCA – is within the Court of Chancery’s broad discretion. Thus, this article recommends that counsel and his or her client consider including an appropriate exit mechanism in a multi-member LLC Agreement. A well drafted exit mechanism will save the parties money and time, should one of the parties wish to withdraw from the LLC.
Exit Mechanisms
Section 18-1101(b) of the DLLCA states that “[i]t is the policy of the [DLLCA] to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” Further, the Delaware Court of Chancery has stated that LLC Agreements are creatures of contract; therefore the options available to members of an LLC in crafting exit mechanisms are vast. In drafting the exit mechanism provisions, counsel should understand the goals and objectives of the client and try to identify the circumstances that might cause the client to want to withdraw from the LLC. The reasons for wanting to withdraw from an LLC are limitless, but some of the reasons that typically crop up are listed below:
Purpose. A member may want to withdraw from an LLC because the defined purpose of the LLC can no longer be fulfilled. For example, the defined purpose of an LLC may be frustrated if the company was formed to develop and market technology that has since become obsolete. However, if the purpose clause is broad and the client does not have authority to veto a decision to cause the LLC to enter into a different area of business, such member may find itself stuck in an undesirable line of business.
Member Breach. A member may want to withdraw from an LLC because of a breach of the LLC Agreement by another member. Or, even if the other member has not technically breached the LLC Agreement, a member may want to withdraw because the other member has failed to perform as expected and has not lived up to the benefit of the bargain made by the members.
Disagreement on Strategy. A member may want to withdraw from an LLC because the parties cannot agree on the LLC’s strategy. Often when this occurs, a deadlock will result if management is split equally and decisions require the consent of the other members.
Lock in Gains. A member may want to withdraw because the LLC has been successful and it wants to lock in and realize the gain on its investment.
Understanding the reasons why a member would want to withdraw from an LLC will enable counsel to draft appropriate exit mechanism provisions. Further, this exercise will help align the exit triggers with the exit mechanisms. Certain exit mechanisms may not match an exit trigger. For example, the parties to an LLC Agreement may not want to provide a breaching party with a “put” right upon its breach of the LLC Agreement, which could have the effect of rewarding the breaching member for its misconduct.
One indirect way to address exit mechanisms is for counsel drafting the LLC Agreement to ensure that the defined purpose clause in the LLC Agreement accurately reflects the objectives and purposes for the LLC. Members entering into a multi-member LLC Agreement should consider whether a broad or narrow purpose clause should be included in the LLC Agreement. A broad purpose clause will typically state that the LLC is formed for the purpose of engaging in any lawful act or activity for which Delaware limited liability companies can be formed. A broad purpose clause like the one described in the preceding sentence will make it difficult for a petitioner to obtain a judicial dissolution of the LLC for “frustration of purpose.” Thus, if the purpose for which the LLC is being created is narrow and limited, the defined purpose clause in the LLC Agreement should also be narrow and limited. Further, provisions should be added to the LLC Agreement to prohibit the LLC from operating for a different purpose, or amending the purpose clause, without unanimous member consent.
As noted above, possible exit mechanisms in an LLC Agreement are limited only by the imagination of the drafter, but a few options are as follows: (1) a right to terminate the LLC upon the occurrence of a specified event, (2) a right to “put” interests to the LLC or the other members upon the occurrence of a specified event, (3) a right of a member or the LLC to “call” interests in the LLC upon the occurrence of a specified event, (4) a buy-sell provision which gives the parties the right to either be a buyer or seller of the LLC interests upon the occurrence of a specified event, or (5) a right to sell all of the LLC interests in the company (or just the exiting member’s interest) upon the occurrence of a specified event. As previously noted, care should be taken by the drafter to correctly match an exit mechanism with an exit trigger to ensure that the parties to the LLC Agreement are incentivized to maximize the value of the enterprise consistent with their duties and obligations under the LLC Agreement.
Termination
Under Sections 18-801(a)(i) and (a)(ii) of the DLLCA, an LLC is dissolved upon the time specified in its LLC Agreement or upon the happening of events specified in the LLC Agreement. Thus, the parties to an LLC Agreement may want to provide that the LLC terminates upon the occurrence and/or non-occurrence of certain events specified in the LLC Agreement. Such a provision, with clear and objective triggers, will be helpful if the parties to the LLC Agreement disagree upon the strategic direction of the LLC. The range of triggers that might cause a termination of the LLC are limitless, but whatever the trigger is, the drafter of the LLC Agreement should take care to ensure the trigger is clear and objective in order to avoid litigation as to whether the trigger event in fact has occurred.
Put or Call Rights
Members of an LLC may want to include put or call rights with respect to their LLC interests in the LLC Agreement. Again, care should be taken by the drafter to ensure that the put or call right is correctly aligned with the appropriate trigger to create incentives that are desirable to the LLC and its members. Pursuant to a put right, the holder of such right will have the ability to cause the LLC, or the other members, to purchase its LLC interest upon the occurrence of certain events. A put right enables a member to monetize its LLC interest and withdraw upon the occurrence of certain events. In drafting the put right, and certain other exit mechanisms described below, the drafter of the LLC Agreement should carefully consider how the LLC interests will be valued and how the purchase of such LLC interests will be financed.
Similar to the put right, a member or the LLC may be granted a call right, which would give a member or the LLC the right to purchase another members’ interest in the LLC upon the occurrence of certain events. This right may be attractive to a member that no longer wishes to be in business with the other member due to that member’s breach, or some other reason. A call right would enable the holder of the call right to purchase a member’s interest upon certain trigger event(s). The valuation issues described above should also be considered with respect to a call right.
Buy-Sell Provision
Members of an LLC may want to include a buy-sell provision in the LLC Agreement. In using this type of exit mechanism, a member will set a price at which it would be willing to buy or sell its LLC interests. The other member then has the right to either buy or sell at the offering member’s suggested purchase price. This right will allow members to terminate their relationship, presumably at a fair price. The purchase price should be fair because the initiating member will presumably suggest a fair price because it will not know at the outset whether it will be a buyer or seller.
Sale Rights
Another exit mechanism that the members may want to include in the LLC Agreement is the right to sell the LLC or the right of the exiting member to sell its interest in the LLC to a third party. Typically, a multi-member LLC Agreement will contain transfer restrictions that prohibit a member from transferring its interest in the LLC to a third party without the consent of the other members. But the parties to an LLC Agreement may want to consider adding a provision that allows a member to sell the LLC or its interest in the LLC to a third party. If the sale right provision will permit the exiting member to cause the sale of the LLC as a whole, then the LLC Agreement will also need to contain a drag-along provision to force the other members to sell their LLC interests in the LLC to the third party.
Additional Provisions
In addition to the foregoing exit mechanisms, the parties may also want to consider adding dispute resolution provisions to resolve any disputes among the members, including disputes over valuing the LLC interests in connection with any of the exit mechanisms described above. This would be particularly important in an LLC with two members in which management is split equally and decisions require the consent of the other member. The drafters of the LLC Agreement should specify whether the exit mechanisms set forth in the LLC Agreement are intended to trump the default provisions of the DLLCA or simply supplement those provisions. Thus, the parties should consider whether members should retain the right to seek judicial dissolution in spite of the negotiated exit mechanisms set forth in the LLC Agreement.
Conclusion
The foregoing discussion is not meant to suggest that an inordinate amount of energy, time, or expense should be devoted to drafting the exit mechanisms contained in an LLC Agreement. But rather, the purpose of this article is to suggest that as part of the process of negotiating and drafting an LLC Agreement, the members should consider how the parties will exit the LLC. In spite of the foregoing suggestion, the author recognizes that at times it may be preferable for members of an LLC to not address termination or exit provisions at the outset, because it would be better to address those issues at the time a member wishes to exit the LLC based on the circumstances as they exist at that time. Nevertheless, the parties to the LLC agreement should realize the consequences of that decision and the risk that the parties may not be able to agree as to acceptable exit terms; and furthermore, reliance on the judicial dissolution provision in the DLLCA may not be warranted, considering the lack of success that parties have had petitioning the Delaware Court of Chancery for judicial dissolution. Although counsel representing an investor in an LLC should not assume the failure of the LLC or future discord among members of the LLC, he or she should carefully educate the client as to the risks involved and the possible ways to resolve such risks.
In December 2012, the Iowa Supreme Court issued a controversial ruling in a sex discrimination case brought under Iowa law. In Nelson v. Knight, the court held 7–0 that a male employer may fire a female employee, though she did nothing wrong, because his wife was concerned about their relationship. Although critics maligned the decision as manifestly unfair, it is consistent with the case law. But one can envision fact patterns that might lead to a different outcome.
Nelson was a stellar dental assistant for Knight for 10 years. At some point they began texting about such innocuous matters as their children’s activities. Nelson (age 32) said she saw Knight (age 53) as a father figure and never sought an intimate relationship. Knight’s wife learned of the texts, however, and demanded that he fire Nelson. He did so, in part because of that demand, but also because he said he wasn’t sure he could avoid trying to have an affair with her otherwise.
Iowa law, on this point, is modeled after Title VII of the 1964 Civil Rights Act, which prohibits employers with at least 15 employees from discriminating against an employee because of his or her sex. To have a viable disparate treatment claim, a plaintiff must prove that he or she suffered an adverse employment action (e.g., termination or a promotion denial), and that sexual identity was a motivating factor in the action. A claim for disparate impact discrimination lies where an employer has a facially neutral practice that has a disproportionately negative impact on a specific gender and is not justified by business necessity.
Nelson advanced a straightforward “but-for” argument: she would not have been fired but for her gender. Knight said she was fired because of the perceived threat to his marriage. Nelson countered that the threat would not have existed had she not been female. After reviewing cases holding that an employer does not violate Title VII by firing a female employee involved in a consensual relationship that has triggered jealousy, although the relationship and jealousy presumably would not have existed had the employee been male, the court upheld the district court’s decision to grant summary judgment for Knight.
The ruling has been criticized on a number of grounds. One is that it sends the message that men cannot be held accountable for their sexual desires and women have to monitor and control their bosses’ urges; if these urges get out of hand, women can be legally fired. In the end, however, the court found a distinction between an isolated personnel decision based on personal relations (assuming no coercion or quid pro quo), even if the relations would not have existed had the employee been of the opposite sex, and a decision based on gender itself. The court also stressed that Knight hired Nelson and also replaced her with a woman, which indicates that sex did not motivate the termination decision.
The Knight court relied on Tenge v. Phillips Modern Ag. Co., where a business owner fired a valued employee at the urging of his wife. The difference was that Tenge “came on” to the owner so there were grounds for the wife’s suspicion of an intimate relationship. Noting that sexual favoritism – treating an employee better than the opposite sex because of a consensual relationship with the boss – does not violate Title VII because any benefits of the relationship are due to the employee’s sexual conduct, not gender, the court implicitly reasoned that treating an employee unfavorably due to such a relationship is legal.
In Platner v. Cash & Thomas Contractors, Inc.,which was also cited, an employer fired a female employee who worked on the same crew as his son after the son’s wife became jealous of her. Concluding that the owner was faced with an escalating family conflict that he resolved by firing a non-relative instead of his son, the court found that Platner was fired, not because of her gender, but because of favoritism for a close relative. Nepotism is unfortunate, said the court, but it does not violate Title VII.
All of these courts stressed, as others have, that Title VII is not a general fairness law and an employer does not violate it by treating an employee unfairly as long as he or she does not act because of the employee’s protected status. This echoes U.S. Supreme Court Justice Scalia’s admonition in a 1998 sexual harassment case that Title VII is not a general workplace civility code. It is also consistent with the approach taken in a 2010 age discrimination case, where the U.S. Supreme Court held that a plaintiff can prevail only if he or she proves that age was not just a motivating factor in his or her termination, but the sole, or but-for, cause.
Nelson did not claim sexual harassment, although Knight engaged in questionable conduct, e.g., telling her that if she saw his pants bulging, she would know her clothing was too revealing, and saying, regarding her infrequent sex life, that it was like having a Lamborghini in the garage and never driving it. Sexual harassment is a form of sex discrimination. It may be quid pro quo, where a tangible employment action is conditioned on the granting of sexual favors, or a hostile environment, where an employee is subjected to conduct that is unwelcome and sufficiently severe or pervasive to alter the conditions of one’s employment. Possibly, Nelson did not assert this claim because there was no evidence of an explicit or implicit quid pro quo or conduct that was non-consensual, unwelcome, severe, or pervasive in nature. Different facts, however, could support such a claim.
The outcome might also be different if one fires several female employees because his wife was jealous of them; then, one might infer that gender, not the relationship, was the cause of the terminations. This could fit into the disparate impact category. One could also run afoul of the gender stereotyping theory, which establishes that sex discrimination occurs if an employer evaluates employees by assuming or insisting that they match the stereotype associated with their group.
Recent case law is replete with examples of courts reading the “because of sex” language with increasing exactitude, largely due to the fear of making a Title VII case out of every arbitrary or unfair employment decision. The Knight case is consistent with this approach. What happened seems unfair, for had Nelson not been female Knight wouldn’t have had the feelings he had and she wouldn’t be out of a job. It is also, arguably, unsound business practice to fire a top-flight employee for the reasons Knight offered. In the end, however, the case reinforces the fact that unfair is one thing and illegally discriminatory is quite another.
An entrepôt during its colonial era, Hong Kong has retained its strategic position as a trading hub in Asia and a gateway to China. With constant reinforcement of the “one-country, two-systems” principle, which is set to continue until 2047, the uncertainties that surrounded the 1997 handover have largely been removed, and while its long-term future may be uncertain, Hong Kong continues to have one of the most stable, effective, and certain legal systems in the world. With over 250 million tons of goods passing through it each year, and its proximity to China’s Pearl River Delta, one of the world’s worst intellectual property (IP) piracy and counterfeiting hotspots, Hong Kong is strategically important for all IP owners.
Under the “one-country, two-systems” principle, Hong Kong’s constitution, the “Basic Law,” specifically provides that Hong Kong should, on its own, develop appropriate policies and afford legal protection for IP rights. Therefore, despite being part of China, Hong Kong and China have separate legal systems. IP rights registered in Hong Kong will not be automatically protected in mainland China, and vice versa.
What Is Intellectual Property?
IP rights are proprietary rights granted to protect original products of creation. They are intended to encourage and reward creativity and fair competition in the marketplace. IP rights can be relied upon to prevent others from using one’s trademark, patented invention, copyright work, or design without consent. IP is territorial in nature and exists for set periods of time.
Hong Kong has had an English legal system for over 150 years, which was retained on the 1997 handover to China. The courts still rely on a great deal of English case law, and proceedings (whether administrative or judicial) can be conducted in either English or Chinese. Although its English legal system makes Hong Kong an ideal stepping stone for doing business in China, IP owners will need to pay extra attention to a number of issues that are unique to this city that stands between the East and the West.
Trademarks
What Is a Trademark?
A trademark can be a word, phrase, symbol, shape, color, sound, smell, or a combination of these used to identify a product or service. It functions as a badge of origin, helping consumers distinguish the products and services of one trader from those of another. In other words, a trademark helps consumers answer the questions “Who makes this product?” and “Who provides this service?” Word marks in Hong Kong can be in any language or dialect, and can be in Latin or Chinese characters. They can be transliterated between English and Chinese based on how they sound, or based on their meaning or some description of their characteristics or aspiration, or a combination of the two.
How Are Trademarks Protected in Hong Kong?
Trademarks that are used, or intended to be used, in Hong Kong can be registered with the Hong Kong Intellectual Property Department (IPD). The IPD does not differentiate between local and foreign proprietors.
Trademarks are registered in relation to particular goods or services. The Nice Classification, which is used internationally, sets out 45 classes of goods and services. In the majority of cases, an application will only be considered if the applicant is using or intending to use the mark on, or in relation to, the goods or services for which registration is sought. The system is a “first to use” system. Rights to a mark are determined on the basis of first use rather than registration. While an unregistered mark will be capable of protection, enforcement and commercialization will be easier and more satisfactory if the mark is registered.
Is My Trademark Registrable?
A trademark is not registrable if it is:
Merely descriptive (e.g., “Lavender Soap” for lavender-scented soap) or not sufficiently distinctive – unless you can show that the mark has acquired distinctiveness through extensive use;
Contrary to public policy or likely to deceive or confuse the public; or
Applied for in bad faith.
The trademarks examiner will also search the IPD’s register for any conflicting prior applications or registrations. The examiner will object to an application if the subject mark is too similar to a mark that is already on the register.
How Long Does Registration Take?
If the application is straightforward, the IPD is usually able to register the mark within six months of the date of filing. If the examiner raises objections, or third parties formally oppose the application, then the registration process will generally take longer.
An Examination Report is usually issued two months after the application is filed. The report informs the applicant whether the trademark applied for satisfies the requirements for registration. If no objections are raised by the examiner, the mark will be published in the Hong Kong Intellectual Property Journal. Third parties are then given three months from the date of the publication to lodge objections. If none is raised, the application will be entered onto the register, and the registration will take effect from the date the application was filed.
If a third party files an opposition, and the applicant either subsequently withdraws its application or is not successful at an inter-party hearing, the applicant may have to pay the opponent’s costs of the opposition.
Do I Have to Use My Trademark?
In general, yes. If a registered mark has not been used for a continuous period of three years without a valid reason, the registration may be challenged by third parties and revoked, in full or in part.
However, in some cases it may be possible to show that an international mark is “exceptionally well known” within Hong Kong, even though it is not used here. It can then be registered defensively in order to prevent misappropriation by third parties.
How Long Does a Trademark Registration Last?
With continued use, trademarks can last indefinitely, but must be renewed every 10 years.
What Rights Do I Receive upon Registration?
A registered trademark gives the registrant exclusive rights to prevent others from:
Using a mark identical to the registrant’s mark on or in relation to identical goods or services;
Using a mark identical or similar to the registrant’s mark on or in relation to identical or similar goods or services, where there is a likelihood of confusion on the part of the public; and
Using a mark identical or similar to the registrant’s mark in relation to identical, similar, or dissimilar goods or services if the use takes unfair advantage of or is detrimental to the distinctive character or reputation of the registrant’s mark – but only if the registrant’s mark is “well known.”
If a trademark is unregistered, it may still enjoy legal protection. This can be achieved by bringing a passing-off action. In order for a passing-off action to be successful, a plaintiff needs to show:
Goodwill or reputation in its mark;
A misrepresentation by the defendant causing confusion to consumers; and
Damages.
This is likely to involve extensive civil litigation, and is clearly more burdensome and difficult than merely being able to point to a registration. A registered trademark grants prima facie exclusivity and saves the mark owner a lot of trouble in the long run.
What If I License My Trademark?
Licensing trademarks is an important part of manufacturing, sale, distribution, merchandising, and franchising of goods.
The license should be registered with the IPD; otherwise the licensee will not be entitled to claim damages in an infringement action.
Patents
What Is a Patent?
A patent gives its owner (properly called a “patentee”) the exclusive right, for a limited period, to prevent others from exploiting the invention without permission. In exchange for this right, the applicant must disclose to the public how to carry out the invention in order to promote further advancement in the field.
Patents in Hong Kong are granted to the first person to file an application, rather than necessarily the first person who created the invention. Therefore, inventors can lose out if they do not patent quickly enough. Patents are territorial rights: a Hong Kong–registered patent confers exclusivity only within Hong Kong. Like other forms of property, patents can be bought, sold, and licensed.
Is My Invention Patentable?
To be patentable, an invention must:
Be new; that is, it must never have been made public in any way, anywhere in the world, before the “priority date” (the date the patent application is filed, or up to one year prior to that date where a suitable “priority document” has been filed somewhere else in the world);
Involve an inventive step over what was known at the priority date – i.e., it must not be obvious to someone with good knowledge and experience of the subject (known as a person skilled in the art); and
Be capable of industrial application; that is, it must take some practical form and be capable of being made or used in some kind of industry. So, while the invention need not be technically or commercially beneficial, impossible or futuristic inventions like perpetual motion machines are not allowed.
There are also some things that are specifically excluded. These include scientific discoveries, scientific theories or mathematical methods, aesthetic creations, schemes or methods for performing a mental act or playing a game, presentations of information, methods of treatment of humans or animals, and new animal or plant varieties.
How Do I Obtain a Patent in Hong Kong?
Patents in Hong Kong are essentially re-registrations of foreign patents. There is no substantive examination performed by the IPD. The grant of a standard patent in Hong Kong is based on the registration of a patent granted by one of three “designated patent offices”:
The State Intellectual Property Office, People’s Republic of China (PRC).
The European Patent Office, in respect of a patent designating the United Kingdom.
The United Kingdom Patent Office.
The whole process will usually take between three and five years. Hong Kong also has a “short-term” patent for which there is no substantive examination. The applicant need only comply with formalities and submit a search report obtained from one of the designated patent offices. A grant of a short-term patent is therefore much quicker and cheaper than for a full-invention patent; however, anyone can see the search report, which will not necessarily be favorable to your client.
How Long Does Patent Protection Last?
Standard patents in Hong Kong are protected for a maximum period of 20 years. Short-term patents are granted for a maximum period of eight years.
What Rights Do I Receive?
Once a patent has been granted, the patentee is entitled to take legal action against others who infringe upon the monopoly granted with respect to the invention. In this way, the patentee can prevent the unlicensed manufacture, use, importation, or sale of a product incorporating the patented invention. This right can be used to develop a business based on the invention, or it can be assigned or licensed to another person or company.
Once Granted, Is My Patent Safe?
Not necessarily. A patent may be attacked during its life for a variety of reasons, including that the invention is not new, that it is obvious, or that it does not have industrial applicability. In particular, since short-term patents are not substantively examined, they are more likely to be challenged and it is up to the patentee to prove their validity.
There are, however, some limits on the patentee’s rights. For instance, private acts done for noncommercial purposes and experiments into the subject matter of the patent will not count as infringements.
Registered Designs
What Is a Registered Design?
Registered designs – the equivalent of design patents in the PRC – are registered monopoly rights that protect the appearance of the whole or part of a product. Product features such as lines, contours, colors, shapes, texture, material, and ornamentation can be protected by design registration.
There is no provision for the protection of unregistered designs in Hong Kong.
How Do I Apply?
A completed application must be submitted to the IPD accompanied by representations of the product that clearly illustrate the features to be registered. The representations may be design drawings or just photographs of the product.
To qualify for protection, a design must:
Be new; that is, it must not be the same as any design that has already been made available to the public; and
Concern the aesthetic appearance of the product to which it is applied. Designs that are primarily functional will not be registrable.
What Rights Do I Receive?
Registered designs are protected for a maximum period of 25 years. The registration is renewable for five-year periods.
The owner of a registered design has the exclusive right to prevent others from using (including making, selling, and importing) goods made to the same or substantially the same design, and also to stop them from producing tools used for making such goods. The owner cannot, however, restrain infringing acts that are carried out for noncommercial, educational, or research purposes.
Copyright
What Does Copyright Apply To?
Copyright protects a wide variety of original works, including those embodied in books, photographs, paintings, sculpture, music, drama, records, films, CDs, videos, architecture, computer software, broadcasts, and the typographical arrangements of published works. Copyright can apply even where the work is computer generated.
Do I Need to Register Copyright?
Copyright arises automatically in Hong Kong when an eligible, original work is made. There is no need or provision for any form of registration. Because of this it can be difficult to prove ownership and is, therefore, important to keep proper records.
Under the Berne Convention, works protected by copyright in other Berne member states are automatically protected in Hong Kong.
What Does Copyright Provide?
Copyright does not protect against the independent development of the same ideas; it protects only against actual copying. In the case of complex works, it may be possible to infer copying from the quantity and exactness of the various copied features.
Also note that, in general, copyright will only protect the expression of an idea, not the idea itself. The extent to which this applies, however, depends on the detail of the idea, how it has been set out, and how much of it has been copied.
A copyright owner is able to prevent the unauthorized use of its work, such as the making of copies of the whole or substantial parts of the work, use of the work on the Internet, or translation or adaptation of the work.
There are other rights related to copyright that creators may enjoy in parallel with copyright. For instance, “moral rights” include the right to be identified as the author of a work and to object to its derogatory treatment.
How Long Does Copyright Protection Last?
In Hong Kong, copyright protects literary, dramatic, musical, or artistic works for the author’s lifetime plus 50 years thereafter. Sound recordings and broadcasts are protected for 50 years from the year of first publication and films are protected for 50 years from the year in which the last principal director, author, or composer dies. Typographical arrangements of published works are protected for 25 years from the year of first publication.
Confidential Information
Confidential information, such as industrial and commercial secrets and know-how, is by its very nature highly sensitive. In some cases, confidential information can be the most valuable asset of a business – witness the formula for Coca-Cola.
Unlike the other rights, rights in confidential information will usually derive from confidentiality agreements (often known as NDA or nondisclosure agreements) rather than from legislation. In this context, any misuse or misappropriation of the information will be actionable as a breach of contract.
However, an action for breach of confidence per se can arise where a third party discloses certain identifiable information that it has received in circumstances that imposed an obligation of confidence.
Businesses with confidential information as assets should take the necessary steps to protect this information. These may include:
Ensuring that staff do not disclose any information to persons who do not “need to know,” whether inside or outside the workplace;
Imposing nondisclosure obligations for a period after the employees resign from and leave the business; and
Requiring possible business partners to sign an NDA prior to disclosure.
In a nutshell, do not rely on implied confidentiality. It is safer to buttress confidential information with contractual obligations; breach of contract will be easier to establish and contractual damages will often be higher than those awarded for breach of confidence.
Remedies include damages, injunctions (it is important to contain the confidential information before its further release), account of profits, delivery up of all materials containing confidential information (i.e., handing them over to the owner), or destruction of such materials under oath.
Domain Names
All domain names ending in “.hk” are governed by the Hong Kong Internet Registration Corporation Ltd.; international domain names such as “.com” are governed by the Internet Corporation for Assigned Names and Numbers (ICANN). Both organizations operate a dispute resolution service to resolve cases of squatting (unauthorized use of a third party’s mark in the domain name) and misleading domain names, without having to turn to litigation. Usually, squatting amounts to passing-off (see above at “Trademarks”), but in the vast majority of cases, using the dispute resolution service is quicker and cheaper than going to court (although there is no provision for the recovery of costs).
In each case, the governing body may order the transfer of a domain name if:
It is identical or confusingly similar to the complainant’s Hong Kong trademark;
The registrant has no rights or legitimate interest in the domain name; and
The domain name was registered and is being used in bad faith.
Enforcement
Registration of IP rights can have a deterrent value in itself, but to derive the full benefit of IP rights, it is necessary to enforce them.
In Hong Kong, IP owners often learn of infringements through investigations by their own employees or by sightings referred by their lawyers, consultants, or investigators. After learning of the infringement, it is normally best to conduct an investigation to determine how bad the problem is and who is responsible for it. A good investigation will reveal the following:
Who and where the infringer is;
Whether the infringer manufactures and/or sells the goods;
The volume of infringing goods produced/sold; and
The possible location of the goods.
A low-key and low-cost first step in enforcing IP rights is simply to write to the infringer setting out the case, and demanding that it cease the infringing activity. The letter will normally also request an undertaking not to infringe further. The signed undertaking can be relied on if the infringer recommences infringing activity in the future. The downside is that unless written very carefully, such a letter, if unjustified, can constitute an actionable threat that will enable the recipient to commence proceedings for damages.
If, however, the infringer does not provide a positive response, or if the infringing activities continue, it may be necessary to enforce IP rights through the courts.
Damages awarded by the courts will rarely compensate the plaintiff in full for the damage suffered or for the full costs of the legal action. In many cases, it may be more advantageous for IP owners to seek to resolve the dispute by negotiation. In any particular case, the best approach should be carefully considered and determined in consultation with legal or other professional advisers.
Conclusion
In Hong Kong, trademarks, patents, designs, and domain names can be registered, whereas copyright does not require registration. It is necessary to determine the necessary scope of protection as products and services often embody a number of IP rights.
Registration of IP rights in Hong Kong is territorial in that they do not extend to China, and vice versa.
Every year since 1995, Hong Kong has been voted the world’s freest economy by the Heritage Foundation and the Wall Street Journal’s Index of Economic Freedom. It also has one of the lowest tax rates in the world. According to the Paying Taxes 2013 study conducted by PricewaterhouseCoopers and the World Bank Group, Hong Kong is the fourth-easiest place in the world to pay taxes, just behind three countries in the Middle East. Hong Kong is ideally located in the heart of Asia and serves as a gateway to and from Mainland China. Moreover, Hong Kong signed the Closer Economic Partnership Agreement (CEPA) with Mainland China and is treated more favorably than other foreign investors in many aspects. These advantages make Hong Kong an attractive place for foreign investors.
Hong Kong is an important location for U.S. interests. According to the U.S. Department of State, as of 2012, there are some 1,400 U.S. firms, including 840 regional operations (315 regional headquarters and 525 regional offices), and over 60,000 American residents in Hong Kong. According to the U.S. Department of Commerce, as of February 2013, Hong Kong is the United States’ seventh-largest trading partner in terms of imports from the United States, while Mainland China is third.
This article gives an overview of the major issues that U.S. investors should consider when setting up a company in Hong Kong.
The Companies Ordinance (the CO) is the main piece of legislation governing companies in Hong Kong. The CO is being completely rewritten, and the new CO will come into force in the first quarter of 2014. Where changes will be brought about by the new CO regarding the issues discussed in this article, the new CO provisions will be introduced as well.
Types of Permitted Operations in Hong Kong
Depending on the scope of operations, foreign companies seeking to operate in Hong Kong have three alternative permitted forms of business presence.
Representative Office
A representative office is suitable for a foreign company that intends to conduct only minimal activities in Hong Kong. A representative office cannot conduct any trade, professional, or business activities or transactions in Hong Kong and cannot enter into any contracts in Hong Kong. A representative office is appropriate, for example, for acting as a liaison office without creating any binding business obligations.
Branch Office
If a foreign company establishes a place of business in Hong Kong, it will require registration as a foreign company under the CO. A “place of business” includes a place used by a company to transact any business that creates legal obligations. The foreign company is liable for the debts and liabilities of its Hong Kong branch, and a branch office cannot take full advantage of Hong Kong’s tax benefits.
Hong Kong Subsidiary
Due to the limitations of a representative office and branch office as described above, a foreign company usually favors establishing a Hong Kong–incorporated company as a subsidiary to operate in Hong Kong. This is generally the preferred type of business structure because the entity may be sued only to the extent of the limited assets of the Hong Kong subsidiary.
Classification of a Company
Under the CO, a “private company” is a company that restricts the right to transfer its shares, prohibits public subscription for its shares or debentures, and limits the number of shareholders to 50. Any company which cannot satisfy all three requirements is a public company. A public company can be listed on a stock exchange or unlisted. This article does not discuss public companies.
A company can also be classified by whether it is limited by shares or by guarantee, or is an unlimited company. This article focuses on a company limited by shares, which is the most common type and is usually referred to as a “limited company.” A company limited by guarantee in Hong Kong is usually a nonprofit organization.
The new CO makes it clear that there are five types of companies that can be set up under the CO:
A public company limited by shares;
A private company limited by shares;
A public unlimited company with a share capital;
A private unlimited company with a share capital; and
A company limited by guarantee without a share capital.
Requirements for a Hong Kong Private Company
At a minimum, a Hong Kong private limited company must have the following:
One shareholder;
One director;
A company secretary;
A registered office address in Hong Kong;
An auditor; and
A business registration certificate.
Director
A director must be at least 18 years of age, must not be an undischarged bankrupt, must not be subject to a disqualification order, must comply with any share qualification requirement, and must consent to act. There is no restriction on the nationality of a director.
A private company can have a director that is a corporation, but under the new CO, a private company must have at least one director who is a natural person (but a company that is a member of a group of companies of which a listed company is a member cannot have any corporate directors).
Company Secretary
A company secretary must be either an individual resident in Hong Kong or a company with a registered office or place of business in Hong Kong.
Business Registration Certificate
A one-stop Company and Business Registration Service has been launched by the Companies Registry and the Inland Revenue Department. Applications for both incorporation and business registration may now be undertaken simultaneously.
In addition to the business registration certificate, certain types of businesses may need additional forms of licensing. For example, a company conducting regulated financial services activity (such as asset management, dealing in securities, or advising on securities) in Hong Kong requires licenses from the Securities and Futures Commission.
Generally
There is no prescribed minimum paid-up capital. Under the new CO, the concept of nominal or authorized share capital and nominal or par value will be abolished. Instead, the articles of the company with a share capital must include a statement of capital containing some prescribed information and the initial shareholdings.
The same person can be the secretary, director, and shareholder of a company, except that the sole director of a company cannot also be the secretary of the company.
A company’s statutory records should be kept at its registered office. If they are kept at a different place, a notice must be filed with the Companies Registry.
Under the new CO, the memorandum of association will be abolished as the constitution of a company. The articles of association will be the sole constitutional document of the company. Moreover, it will no longer be compulsory for companies to have a common seal. There are new provisions for execution of documents by authorized signatories where the document would take effect as if executed under seal.
Information Available to the Public
Compared to other jurisdictions (e.g., the British Virgin Islands and the Cayman Islands), Hong Kong companies are much more transparent in terms of information that is available to the public. In addition to basic information, one can search for all the documents filed with the Companies Registry in relation to a particular company. One can also search for the registered charges of a company and disqualification orders made. Moreover, one can search for all the companies in which an individual has directorships and the particulars of that director, such as his or her identity number and residential address.
It was originally proposed under the new CO that the residential address of a director and the full identification numbers of any person would not be made available for public inspection. This new arrangement has been subject to a heated public debate over the balance between personal data privacy and information transparency. The implementation of this new arrangement has now been delayed, and will not come into force along with the other provisions under the new CO.
Establishing a Private Company
There are two ways of establishing a private company in Hong Kong: incorporating a new company or buying a shelf (or existing) company.
Incorporation involves applying to the Companies Registry, which then issues a certificate of incorporation within four working days after submission of the application by post (online applications may be processed within an hour). The newly incorporated company then needs to be activated by holding its first board meeting and a shareholders’ meeting, if necessary.
Buying a shelf company is useful when a company is urgently needed. One just needs to acquire a shelf company and then activate it by effecting a change of shareholders and directors and holding a board meeting (and a shareholders’ meeting, if necessary).
Continuing Compliance Requirements
A company should hold an annual general meeting (AGM) each year, and not more than 15 months from the previous AGM, unless everything that is required to be done at the meeting is done by written resolution and the relevant documents are provided to each member. The following matters are usually dealt with at the AGM:
Adoption of audited accounts comprised of the balance sheets, directors’ report, and auditors’ report;
Declaration of dividends;
Election of directors; and
Appointment of auditors.
The new CO provides that a company is not required to hold an AGM if it has only one member or the AGM is dispensed with by unanimous members’ consent.
Other compliance requirements include, among others, the following:
A company should keep a register of members and a register of directors and secretaries;
Various returns have to be filed with the Companies Registry within stipulated deadlines for changes in relation to the company, such as changes in directorship and secretary, registered office, share capital, etc.;
A company must file an annual return;
A company must have annual audited accounts. The CO prescribes detailed requirements regarding the types of accounts to be prepared. A directors’ report must also be prepared in conjunction with the annual accounts;
Shareholders’ or board meetings should be held as may be necessary or required under the CO. The minutes or written resolutions should be filed in a minute book and resolutions or notices should be filed with the Companies Registry as required under the CO; and
A company also needs to renew its business registration certificate before it expires and file profit tax returns for the company and the employer’s return for its employees with the Inland Revenue Department.
If a company fails to comply with these requirements, the company and every officer of the company who is in default may be liable for a fine and/or imprisonment.
Tax Issues
Profits Tax
Hong Kong adopts a territorial corporate tax system. Corporations are taxed on profits at a rate, for assessment year 2012/2013, of 16.5 percent. Profits tax is charged on Hong Kong–sourced profits and is collected by the Inland Revenue Department. The tax rate on profit derived in Hong Kong is the same for Hong Kong and foreign companies.
Specifically, domestic and foreign entities meeting the following three criteria are subject to profits tax:
The entity carries on a trade, profession, or business in Hong Kong;
The profits are from such trade, profession, or business carried on by the entity in Hong Kong; and
The profits arose in, or were derived from, Hong Kong.
A Hong Kong resident may derive profits from abroad that are not subject to Hong Kong profits tax; conversely, a nonresident may be liable for tax on profits arising in Hong Kong. The question of whether a business is carried on in Hong Kong and whether profits are derived from Hong Kong is largely one of fact. Profits arising from activities conducted abroad, even if they are remitted into Hong Kong, are not subject to profits tax.
Salaries Tax
Income received by employees from Hong Kong–sourced employment is subject to salaries tax. Subject to certain exemptions, income subject to salaries tax includes salaries, wages, commissions, tips, bonuses, allowances, perquisites, leave pay, terminal/retirement awards, contract gratuities, and noncash benefits such as housing allowances and stock-based awards.
In determining assessable income, outgoings and expenses (other than expenses of a domestic or private nature and capital expenditure) wholly, exclusively, and necessarily incurred in the production of the assessable income and depreciation allowances in respect of the plant and machinery, the use of which is essential to the production of the assessable income, are deductible. Other permitted deductions include:
Loss brought forward from previous years of assessment;
Expenses of self-education paid;
Elderly residential care expenses paid;
Home loan interest paid;
Contributions to recognized retirement schemes; and
Donations to approved charities.
Salaries tax is computed on net chargeable income at scaled rates between 2 percent and 17 percent for assessment year 2012/13. Salaries tax will not in any event exceed (i.e., is capped at) 15 percent of net income before allowances.
Double Taxation
The United States is absent from Hong Kong’s otherwise comprehensive double-taxation treaty network. However, Hong Kong adopts the territoriality basis of taxation, whereby only Hong Kong–sourced income or profit is subject to tax and non–Hong Kong sourced income or profit is, in most cases, not subject to tax. Accordingly, Hong Kong generally does not double-tax its residents. The Inland Revenue Department allows a deduction for foreign tax paid on turnover basis in respect of an income that is also subject to tax in Hong Kong.
General Tax Benefits
Dividends or overseas branch profits repatriated to Hong Kong are not subject to Hong Kong tax. In addition, dividends paid by a Hong Kong company to its shareholders are not subject to Hong Kong tax in the hands of shareholders (tax already having been paid by the company on the profits underlying those dividends), nor is there any withholding tax on dividends paid to shareholders outside Hong Kong. Capital gains are also tax-exempt. A stamp duty is imposed on certain documents such as share transfers, leases of real property, and sale of real property. There is no sales tax, value-added tax, or estate tax in Hong Kong.
For 2012/2013, a one-off reduction of 75 percent of the final tax payable under the profits tax, salaries tax, and tax under personal assessment, subject to a ceiling of HK$10,000 per case, was proposed in the 2013–14 financial budget. This reduction is pending legislative approval.
FATCA Issues
Under the new U.S. Foreign Account Tax Compliance Act (FATCA), all foreign financial services institutions have to report the activities of their U.S. clients to the U.S. Internal Revenue Service if assets in their offshore accounts reach US$50,000. FATCA was designed to catch tax evasion by U.S. taxpayers overseas. Foreign countries have until 2014 to come into compliance or risk sanctions by the U.S. government. As at this writing, Hong Kong does not have a FATCA compliance plan.
Employment Issues
Protection Under the Employment Ordinance
Irrespective of their hours of work, all employees covered by the Employment Ordinance (Chapter 57 of the Laws of Hong Kong) are entitled to basic protections, which include wages and statutory holidays. Employees who are employed under “continuous contracts” are also entitled to benefits such as rest days, paid annual leave, sickness allowance, severance payment, and long-term payment. An employee who has been employed continuously by the same employer for four weeks or more (with at least 18 working hours each week) is regarded as being employed under a “continuous contract.” The definition of “continuous contract” is currently under review.
Minimum Wage
Starting from May 1, 2013, the minimum wage rate in Hong Kong is HK$30 per hour.
Mandatory Provident Fund
In Hong Kong, all employers and their employees aged 18 to 65 must join an employment-based retirement pension scheme unless an exemption applies (e.g., if the employee earns less than HK$6,500 per month), or if the employee is an existing member of an overseas pension scheme. Mandatory contributions are calculated on the basis of 5 percent of an employee’s relevant income, up to a maximum mandatory contribution of HK$1,250 a month, with the employer matching the employee’s contribution.
Employment Visa Issues
As a general rule, any person, other than those having the right of abode or the right to land in Hong Kong, must obtain a visa before coming to Hong Kong for the purpose of taking up employment. This includes secondees from an overseas office.
Conclusion
This article gives an overview of the main issues relating to setting up a business in Hong Kong. One may also need to consider issues other than the ones discussed above, such as opening bank accounts, entering into leases for office premises, recruiting employees, arranging financing, and protecting trademarks and other intellectual property rights and establishing data protection policies.
Hong Kong has always been keen to attract foreign investment to reinforce its status as an international financial center. Government policies generally favor foreign investment. For example, Hong Kong and Mainland China regularly enter into new supplements to CEPA to give more advantages to Hong Kong. These are the advantages that Hong Kong has that foreign investors should consider when they decide where to establish their business.
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