Coming at a time of tightening credit markets, cryptocurrency business bankruptcies are making big headlines for their sudden entries into bankruptcy courts following rapid declines in the value of digital assets. From July 2022 to January 2023, there have been several bankruptcies filed by crypto brokerages, exchanges, and lenders, resulting in a significant evaporation of value. All signs suggest that more crypto bankruptcies are coming, so investors should understand the potential impact of digital assets held or invested in an exchange.

What Is Causing the Crypto Bankruptcies?

The reasons for these bankruptcies vary, including alleged fraud in the case of FTX Trading Ltd. However, the start of a broader crypto sell-off in the market began in May 2022 with the collapse of the Terra Luna coin and the related “stablecoin” TerraUSD.^[1] Within a few days, Terra Luna and TerraUSD both lost substantial value, leading many crypto investors to begin seeking to withdraw their digital assets from various crypto exchanges and brokerages.^[2] This led to the failure of crypto hedge fund Three Arrows Capital (or 3AC), which had significant exposure to Terra Luna.^[3] Numerous future Chapter 11 filers had loaned money to 3AC, including BlockFi (a cryptocurrency lender), Celsius Network (a cryptocurrency lender), and Voyager Digital (a cryptocurrency brokerage). In particular, Voyager Digital loaned $665 million to 3AC; and when 3AC defaulted on the loan, Voyager filed for Chapter 11.^[4] In May 2022, investors withdrew over $1 billion from the Celsius Network platform due to what the CEO of Celsius referred to as a generalized “distrust of cryptocurrency.”^[5] Over the course of 2022, the value of Bitcoin dropped approximately 65 percent.^[6]

What has followed is a wave of digital asset freezes, followed shortly thereafter by a wave of Chapter 11 bankruptcies in the United States. Celsius Network froze its platform for trading digital assets on June 12, 2022, and then filed for Chapter 11 on July 13, 2022.^[7] Voyager Digital froze its trading on July 1, 2022, and then filed for Chapter 11 on July 5, 2022.^[8] FTX Trading Ltd. (a cryptocurrency exchange and hedge fund) froze its platform for trading on November 8, 2022, and then filed for Chapter 11 on November 11, 2022.^[9] The FTX trading freeze had a serious impact on BlockFi, which had $355 million of assets at FTX.^[10] BlockFi also made loans to Alameda Research, an FTX affiliate and hedge fund, which defaulted on approximately $680 million in collateralized loan obligations.^[11] BlockFi limited customer withdrawals on November 10, 2022, and then filed for Chapter 11 on November 28, 2022.^[12] Genesis Global Capital (a cryptocurrency lender) froze customer redemptions on November 16, 2022, and then filed for Chapter 11 on January 20, 2023.^[13] Similar to other crypto bankruptcy filers, Genesis loaned significant amounts to 3AC and Alameda Research, both of which filed insolvency proceedings in 2022.^[14]

Most of these Chapter 11 filings occurred with little preplanning, which is rare in contemporary large Chapter 11 filings. Customarily, large companies will conduct weeks or months of planning and negotiations with its creditors prior to filing for bankruptcy, which typically helps to shorten the bankruptcy process and ensure greater certainty as to results. Instead, each of these crypto businesses has largely free-fallen into bankruptcy court, without a go-forward plan, following a rapid decline in value.

The FTX Collapse

The FTX bankruptcy caused significant disruption in the broader market for cryptocurrencies due to its size and perceived stability before its collapse. Sam Bankman-Fried, the majority owner of FTX and its affiliates, was arrested on December 12, 2022, for various alleged crimes connected to his operation of FTX, including wire fraud, securities fraud, and money laundering. Among the allegations by prosecutors is that Bankman-Fried diverted billions of dollars of customer funds for his personal use and to make investments. Bankman-Fried pleaded not guilty to the charges. On December 21, 2022, Caroline Ellison, the CEO of Alameda Research, and Gary Wang, FTX’s cofounder and chief technology officer, each pleaded guilty to charges that they helped Bankman-Fried in a years-long scheme to defraud investors.^[15]

At 4:30 a.m. on November 11, 2022 (the day that FTX filed for bankruptcy), Bankman-Fried resigned his CEO role, and all corporate powers and authority were delegated to John J. Ray III, including the power to appoint independent directors and commence the Chapter 11 cases.^[16] Ray appointed five restructuring experts as independent directors of each of the five business silos that FTX operated prebankruptcy.^[17] Ray has significant restructuring experience, having worked as a chief restructuring officer or CEO on other large corporate failures, such as Enron and Residential Capital.

In the first-day affidavit filed by FTX with the bankruptcy court, Ray stated that he has never seen such a failure of corporate controls and such a complete absence of trustworthy financial information.^[18] Ray indicated that he has no confidence in the financial statements produced while Bankman-Fried was in control of FTX,^[19] that FTX did not have an accounting department,^[20] and that FTX did not have a centralized cash-management system throughout its corporate structure.^[21] Under its former leadership, FTX did not keep appropriate books and records, or even security controls, for its digital assets, and Bankman-Fried and Wang controlled nearly all access to digital assets in FTX.^[22] Ray has engaged forensic analysts to assist in identifying FTX assets on the blockchain, and cybersecurity professionals to identify any unauthorized transactions.

As a sign of just how volatile these crypto bankruptcies can be, FTX filed for bankruptcy a mere twenty-three days after it sought and received bankruptcy court approval to purchase the digital assets of Voyager Digital for $1.4 billion.^[23] That sale fell through and, as of December 19, 2022, BAM Trading Services Inc. (known as Binance.US) was selected as the winning bidder for Voyager Digital’s assets.^[24] The deal with Binance.US is valued at $1 billion, and Voyager estimates that the sale will allow its customers to recover approximately 51 percent of the value of their digital asset deposits at the time Voyager filed for bankruptcy.^[25]

When a Crypto Exchange Files Bankruptcy, What Happens to the Digital Assets?

When a company files for bankruptcy, a bankruptcy estate comprised of “all legal or equitable interests of the debtor in property as of the commencement of the case” is created by law.^[26] Any and all property of the estate can be used to satisfy claims of creditors or pay expenses of the company in bankruptcy. The questions that should logically follow are these:

• What happens to the digital assets deposited by customers/investors in a crypto company when the crypto company files for bankruptcy?
• Are these digital assets property of the estate?

On January 4, 2023, Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York determined the answers to these questions in part in the Celsius Network bankruptcy. Judge Glenn determined that Celsius’s terms of use unambiguously established that customer funds deposited in “Earn” accounts at Celsius were property of the Celsius bankruptcy estate and were not property of Celsius’s customers.^[27] The Earn account was a product offered by Celsius through which customers could earn interest on digital assets that they deposited in such accounts.^[28] When Celsius filed for Chapter 11 in July 2022, there were 600,000 Earn accounts holding approximately $4.2 billion in digital assets.^[29] There also were approximately $20 million in stablecoins in the Earn accounts.^[30]

Celsius and the official committee of unsecured creditors took the position that the Earn accounts were property of the estate, and, as such, Celsius should be permitted to sell certain stablecoins in the Earn accounts to fund operating expenses and costs of the Chapter 11 case.^[31] The Earn account holders argued that they owned the digital assets in the Earn accounts and that such funds should be returned to them.^[32]

The Court determined that ownership of the digital assets in the Earn accounts was a “contract law issue.”^[33] Per Celsius’s “Terms Version 8,” a clickwrap contract governed by New York law, Celsius held “all right and title to such Eligible Digital Assets, including ownership rights” in the digital assets deposited in the Earn accounts.^[34] The customers participating in the Earn accounts overwhelmingly accepted the clickwrap contract terms or an earlier version of those terms.^[35] The Court held that the terms of use formed a valid, enforceable contract between Celsius and its Earn account holders and that the terms unambiguously transferred title and ownership of the Earn account assets to Celsius.^[36] As such, the Court ruled that the Earn account assets, including the stablecoins held therein, were property of the bankruptcy estate of Celsius and could be sold by Celsius to provide liquidity for the Chapter 11 proceedings.^[37]

Importantly, the Court did not determine that holders of digital assets in the Earn accounts would receive nothing at all, but rather determined that the account holders will be considered unsecured creditors and will receive in-kind distributions under a to-be-confirmed Chapter 11 plan filed by Celsius, or under the Bankruptcy Code’s distribution waterfall in the event of a liquidation.^[38] This means that the Earn account holders will have to wait a significant period—potentially years—for a recovery from the Celsius bankruptcy.

The Court also did not determine the ownership of assets in Celsius’s “Custody Program,” “Withhold Accounts,” or “Borrow Program,” or whether individual account holders have valid defenses between themselves and Celsius.^[39] By contrast with the Earn accounts, the terms of use for the Celsius Custody accounts stated that title to digital assets held in such accounts “shall at all times remain with you and not transfer to Celsius.”^[40] Based on the ruling on the Earn accounts, this suggests that the Custody accounts may not be property of the Celsius bankruptcy estate, and the assets therein may be returned to account holders.

On December 7, 2022, Judge Glenn ruled that a small group of Celsius customers, whose deposits were never commingled with other Celsius funds or in interest-bearing accounts, could recover their digital assets.^[41]

While these decisions do not resolve all ownership issues that could arise with respect to digital assets in a crypto exchange, they do provide preliminary guidance for how an investor may protect itself in prudently storing digital assets based on the terms of use of an exchange.

Conclusion

As distress in the cryptocurrency market continues, investors should remain vigilant regarding the effects of bankruptcy on both their possession of digital assets in an exchange and the ultimate ownership of digital assets.

1. Krisztian Sandor & Ekin Genç, The Fall of Terra: A Timeline of the Meteoric Rise and Crash of UST and LUNA, CoinDesk (updated Dec. 22, 2022). ↑

2. MacKenzie Sigalos, From $10 Billion to Zero: How a Crypto Hedge Fund Collapsed and Dragged Many Investors Down with It, CNBC (updated July 12, 2022). ↑

3. Id. ↑

4. Id. ↑

5. Declaration of Alex Mashinsky, Chief Executive Officer of Celsius Network LLC, in Support of Chapter 11 Petitions and First Day Motions ¶ 35, In re Celsius Network LLC, No. 22-10964 (Bankr. S.D.N.Y. July 14, 2022) (Doc. No. 23). ↑

6. Bitcoin, CoinDesk (last visited Jan. 20, 2023). ↑

7. Decl. of Alex Mashinsky, In re Celsius Network, No. 22-10964, Doc. No. 23, at 6. ↑

8. Declaration of Stephen Ehrlick, Chief Executive Officer of the Debtor, in Support of Chapter 11 Petitions and First Day Motions, In re Voyager Digital Holdings, Inc., No. 22-10943, Doc. No. 15, at 24 (Bankr. S.D.N.Y. July 6, 2022). ↑

9. Danny Nelson & Nikhilesh De, FTX US Temporarily Froze Crypto Withdrawals, Adding to Chaos of Bankruptcy Proceedings, CoinDesk (updated Nov. 14, 2022). ↑

10. David Hollerith, BlockFi Calls Bankruptcy Filing ‘the Antithesis of FTX’ in First Court Hearing, Yahoo! (Nov. 29, 2022). ↑

11. Declaration of Mark A. Renzi in Support of Debtors’ Chapter 11 Petitions and First-Day Motions ¶ 96, In re BlockFi Inc., No. 22-19361 (Bankr. D.N.J. Nov. 28, 2022) (Doc. No. 17). ↑

12. Id. ¶ 97. ↑

13. Crypto Lending Unit of Genesis Files for U.S. Bankruptcy, Reuters (Jan. 20, 2023). ↑

14. Caitlin Ostroff, Alexander Saeedy & Vicky Ge Huang, Crypto Lender Genesis Considers Bankruptcy, Lays Off 30% of Staff, Wall St. J. (updated Jan. 5, 2023). ↑

15. Tory Newmyer & Shayna Jacobs, Two Bankman-Fried Colleagues Plead Guilty to Fraud, Wash. Post (updated Dec. 21, 2022). ↑

16. Declaration of John J. Ray III in Support of Chapter 11 Petitions and First Day Pleadings ¶ 44, In re FTX Trading Ltd., No. 22-11068 (Bankr. D. Del. Nov. 17, 2022) (Doc. No. 24). ↑

17. Id. ¶ 47. ↑

18. Id. ¶ 5. ↑

19. Id. ¶¶ 18, 23, 28, 36. ↑

20. Id. ¶ 58. ↑

21. Id. ¶ 50. ↑

22. Id. ¶ 65. ↑

23. Crystal Kim, Binance Wants to Buy the Voyager Assets FTX Won, Axios (Nov. 17, 2022). ↑

24. Rohan Goswani, Binance.US to Acquire Bankrupt Crypto Exchange Voyager’s Assets for $1 Billion, Weeks After Planned FTX Deal Failed, CNBC (updated Dec. 19, 2022). ↑

25. Dietrich Knauth, Voyager Gets Initial Approval for $1Bln Binance Deal amid National Security Concerns, Reuters (Jan. 10, 2023). ↑

26. 11 U.S.C. § 541(a)(1). ↑

27. Memorandum Opinion and Order Regarding Ownership of Earn Account Assets, In re Celsius Network LLC, No. 22-10964, at 4 (Bankr. S.D.N.Y. Jan. 4, 2023). ↑

28. Jeremy Hill, Celsius Owns Coins Held in Interest-Bearing Accounts, Judge Says, Bloomberg (Jan. 4, 2023). ↑

29. Crystal Kim, Bankruptcy Judge Rules That Earn Account Assets Belong to Celsius, Axios (Jan. 4, 2023). ↑

30. Id. ↑

31. Memorandum Opinion and Order Regarding Ownership of Earn Account Assets, supra note 27, at 5. ↑

32. Id. ↑

33. Id. ↑

34. Id. at 6. ↑

35. Id. ↑

36. Id. at 30. ↑

37. Id. ↑

38. Id. ↑

39. Id. at 31. ↑

40. Terms of Use, Celsius (rev. Sept. 29, 2022). ↑

41. Dietrich Knauth, Celsius Bankruptcy Judge Orders Return of Some Crypto Assets to Customers, Reuters (Dec. 7, 2022). ↑

In 2022, the Office of Foreign Assets Control (OFAC) announced numerous settlements with cryptocurrency exchanges. These settlements serve as “fair warnings” to all cryptocurrency service providers who are “U.S. persons” or who offer services to U.S. persons. The term “U.S. persons” is defined in 31 C.F.R. §560.314 as “any United States citizen, permanent resident alien, entity organized under the laws of the United States or any jurisdiction within the United States (including foreign branches), or any person in the United States.”

This article focuses on these “fair warnings” as they have accumulated from prior settlements and from OFAC’s published guidance on compliance requirements that have been public for some time.

This article uses two late 2022 OFAC settlement announcements—with West-Coast-based Bittrex, Inc. and Payward, Inc. d/b/a Kraken—to make clear that OFAC was adhering to a previously announced requirement on providers of financial services. Specifically, OFAC requires more than verification of identity at onboarding and periodic checking of customers against OFAC’s Specially Designated Nationals (SDN) list. Additionally, providers should employ lifetime-of-the-transaction and in-process geolocation checking in their interdiction screening. Geolocation screening in lifetime-of-the-relationship and in-process transactions raised the stakes for providers to block or reject transactions that would violate the sanctions regimes OFAC enforces.

The last part of this article walks through other fair warnings provided by settlements agreed to since March 2015 or other public guidance. Before discussing the two late 2022 settlements or the fair warnings, it may help to have the foundation of the March 2015 settlement OFAC made with PayPal, Inc.

A. OFAC’s Early Foray into In-Process Transactions in Newer Electronic Payments and Services: PayPal, Inc. (March 2015)

OFAC claimed new territory when it announced its settlement with PayPal, Inc. on March 25, 2015.^[1] OFAC maintained that PayPal “did not screen in-process transactions in order to block or reject prohibited transactions.” The settlement highlighted, among other things, two types of deficiencies in PayPal’s sanctions compliance program. In the first, PayPal’s automatic interdiction filter failed to identify at least one customer as a potential SDN when OFAC made the SDN designation because its automatic interdiction filter was not “working properly.” PayPal’s agents “dismissed” on at least five occasions one customer’s SDN match and proceeded with transactions. On one other occasion, the filter “flagged” this customer’s account, but a PayPal agent again dismissed the match despite receiving additional information that showed a date of birth and place of birth identical to the SDN. These failures resulted in 136 transactions with a single individual on the SDN list that violated the “Weapons of Mass Destruction Proliferators Sanctions Regulations.”^[2] The March 2015 settlement also addressed violations by PayPal of other U.S. sanctions regulations, and PayPal agreed to pay civil penalties totaling $7,658,300.^[3]

B. The Late 2022 Settlements

1. Bittrex, Inc.

Bittrex, Inc. is a private company based in Bellevue, Washington. Bittrex provides both virtual-currency-exchange and hosted-wallet services. OFAC’s settlement announcement explained that from March 2014 to December 31, 2017, Bittrex operated more than 1,700 accounts, processed 116,421 virtual-currency-related transactions, and transacted $263,451,600.13 in violation of law and OFAC regulations.

Bittrex apparently showed “some understanding” of OFAC regulations by August 2015, months after OFAC settled with PayPal. However, until October 2017, Bittrex had no internal controls to screen customers or transactions for connections to sanctioned jurisdictions. OFAC described other failings in Bittrex’s compliance efforts, including:

• not screening IP address or physical address information that customers were in sanctioned jurisdictions;
• not paying attention to customers providing Iranian passports or identifying themselves as being in Iran at account opening;
• not scrutinizing customers or transactions for nexus to sanctioned jurisdictions; and
• failing to have any sanctions compliance program from March 2014 to February 2016. Ouch!

OFAC cited the absence of any sanctions compliance program for two years as one of three aggravating factors in determining the civil monetary penalty of more than $24 million. Among the penalty-mitigating factors was the “swiftness” with which Bittrex responded to OFAC’s Apparent Violations notice.

2. Kraken

On November 28, 2022, OFAC announced a settlement^[4] with Kraken for violations of the Iranian Transactions and Sanctions Regulation.^[5] Kraken’s parent, Payward, Inc., is based in San Francisco.

Based on IP address data, Kraken continued to deal with customers who had opened accounts outside of sanctioned jurisdictions and subsequently transacted business with Kraken from Iran, a sanctioned jurisdiction. The violations occurred between October 14, 2015, and June 29, 2019. Kraken’s violations began six months after the PayPal settlement was announced.

OFAC cited Kraken’s failure to employ geolocational in-process and after-onboarding screening as an “aggravating factor” in its penalty calculations. OFAC had concluded that Kraken had “reason to know based on available IP addresses that transactions appear to be” emanating from Iran. Ouch.

The settlement confirms that it is not sufficient to screen customers at onboarding or account opening or to perform daily checks to identify new entries on OFAC’s SDN list. Because customers may transact from sanctioned jurisdictions after establishment of accounts, daily monitoring needs to track IP addresses that are the source of transaction requests and instructions to identify transactions coming from jurisdictions that are on the sanctioned lists.

In the settlement, Kraken also agreed to implement more analytical tools such as “multiple blockchain analytics tools” (MBAT). These tools are geolocation controls including Internet Protocol (IP) address-blocking systems. MBAT may be a term or service not familiar to everyone. Prominent providers of MBAT include brand-name commercial providers such as Chainalysis and CipherTrace. MBAT tools assist with the basic identification and nationality verification requirements OFAC has implemented. Kraken has agreed to do more, including screening for OFAC’s “50 Percent Rule,” which requires detailed reports on beneficial ownership of assets and blocking of clients’ access to accounts and assets.

C. Fair Warnings Specifically Related to Crypto Entities’ Compliance Programs

OFAC’s settlements with Bittrex and Kraken are examples of enforcement actions presaged by prior enforcement actions and other OFAC guidance. These actions might still be cited as “regulation by enforcement” to the extent that prior enforcement actions frame the standards being enforced against each company. For example, OFAC made its focus on newer financial products and services clear beginning with its enforcement action against PayPal, Inc. in March 2015. These issues and statements of regulatory approach are described in section A of this article.

Since PayPal’s March 2015 settlement, managers updating and maintaining suitable interdiction-filtering procedures and programs had further fair warnings of OFAC’s approach and should have implemented screening of clients who may move to sanctioned jurisdictions, or who may be sanctioned by OFAC after accounts are opened. Kraken’s transactions mentioned in the settlement announcement all came later than OFAC’s action against PayPal, Inc.

The Bittrex and Kraken settlements provide at least five specific “fair warnings” about sufficient sanctions controls programs’ components, including warnings about (1) geolocation/IP address tools, (2) efficacy of controls, (3) being involved with facilitation of violations, (4) use of blockchain analytical tools, and (5) the totality for components of a proper sanctions compliance program. Let’s look at each.

1. Fair warning about geolocation tools. Kraken agreed to deploy tools such as the automated interdiction-compliance filters that commercial banks, securities firms, and insurance companies use to manage the day-to-day issues of account maintenance over the course of the provider’s relationship with its customers. For Kraken, this meant adding geolocation in-process transaction screening.

2. Fair warning about efficacy of controls. In addition to settlement announcements, OFAC has issued its 2021 “Sanctions Compliance Guidance for the Virtual Currency Industry” (2021 Guidance).^[6] OFAC mentions two actions, both involving money laundering and one of which involved “facilitating” Russian ransomware actors. OFAC urged the virtual currency industry to “implement effective sanctions compliance controls to mitigate the risk of sanctioned persons and other actors exploiting virtual currencies to undermine U.S. foreign policy interests and national security.”

3. Fair warning about facilitation of violations. The OFAC 2021 Guidance also reminded actors that “for some sanctions programs, U.S. persons, wherever located, … are prohibited from facilitating actions on behalf of non-U.S. persons if the activity would be prohibited by sanctions regulations if directly performed by a U.S. person or within the United States.”

   Virtual currency compliance programs, OFAC advised, should include “sanctions list and geographic screening,” among other measures. Details on “internal controls” in the 2021 Guidance include providers making more active use of users’ IP addresses. Additional details suggest controls via IP addresses that prevent persons in comprehensively sanctioned jurisdictions, such as Iran or Syria, from accessing providers’ platforms. OFAC expects that entities will “ensure [they are] utilizing all available information for sanctions compliance purposes.”

4. Fair warning on blockchain analytic tools and ongoing screening. The 2021 guidance document also suggests that virtual currency companies “consider conducting a historic lookback of transactional activity after OFAC lists a virtual currency address on the SDN list to identify connections to listed addresses.” Providers are encouraged to use blockchain analytic tools to identify and manage sanctions risks. OFAC also mentioned “ongoing sanctions screening and risk-based re-screening” to account for updated customer information, changes in OFAC’s SDN lists, or changes in regulatory requirements.

   In 2018, OFAC included known virtual currency addresses as identifying information for persons on its SDN list and allowed searches of those addresses using the “ID #” field in it Sanctions List FAQs 562,^[7] 563,^[8] and 594.^[9] OFAC provided more detail in its FAQs, some of which it updated in association with its 2022 press release announcing its settlement with Kraken.

5. Fair warning about components of a functional sanctions compliance program. OFAC also published on May 2, 2019, “A Framework for OFAC Compliance Commitments.”^[10] The Framework covers foreign entities that conduct business in or with the United States or U.S. persons or that use goods or services exported from the United States. The Framework identifies five aspects of a sanctions compliance program: management commitment, risk assessment, training, internal controls, and testing/auditing. Additionally, OFAC has published and codified “Economic Sanctions Enforcement Guidelines.”^[11]

Admittedly, some of the guidance that OFAC issued came after the violations covered by Kraken’s November 2022 settlement. Adding the Kraken settlement and OFAC’s FAQs updated at the time of the Kraken settlement to the universe of OFAC’s guidance provides important benchmarks for providers in the virtual currency industry.

D. A Generally Applicable Fair Warning on Voluntary Self-Disclosure of Possible Violations

OFAC seldom reveals how it becomes alerted to possible sanctions violations. It often is alerted by the entity itself through a procedure known as “voluntary self-disclosure.”^[12] Companies that self-disclose violations can negotiate much lower civil penalties. Self-disclosure requires robust and risk-based internal screening and policies to deter and detect violations of sanctions regimes. The voluntary self-disclosure must reach OFAC before OFAC learns of a violation from another source, such as a bank or freight forwarder.

In the cases of Bittrex and Kraken, OFAC did not mention self-disclosures, which signals that another entity or government had alerted OFAC or its sister agency, the Financial Crimes Enforcement Network (FinCEN) of possible violations.

Accordingly, one more generic “fair warning” should be on the fair warnings list: If you identify violations, get started on your self-disclosure promptly. Or, to be more blunt: fess up when you mess up!

E. Conclusion

As the tools available to those intending to circumvent sanctions laws and their enablers improve, OFAC has expanded the range of tools it expects entities subject to OFAC’s strict liability regimes to employ. This requires U.S. person subject to OFAC’s risk-based compliance expectations to reassess their compliance tools and procedures. Although the Federal Aviation Administration may use a thirty-year-old software to run a notice to pilots before take-off, providers of financial products and services subject to OFAC’s jurisdiction should not fail to update their systems that can detect and prevent transactions with sanctioned individuals and entities or sanctioned nation-states. Finally, providers should make voluntary self-examination and self-disclosure protocols key parts of their OFAC compliance programs.

All rights reserved. © Sarah Jane Hughes 2023.

Sarah Jane Hughes is the University Scholar and Fellow in Commercial Law at the Maurer School of Law, Indiana University in Bloomington, Indiana. Before joining the faculty as a visiting professor in 1989, Ms. Hughes was an Attorney-Advisor at the Federal Trade Commission focusing on retail payments, consumer credit protection (including the enforcement of the Truth-in-Lending Act and the FTC’s trade regulation rule Preservation of Consumers’ Claims and Defenses), and financial privacy issues. Read her full bio here.

1. Available at https://home.treasury.gov/system/files/126/20150325_paypal_settlement.pdf. ↑

2. 31 C.F.R. §544. ↑

3. Available at https://home.treasury.gov/system/files/126/20150325_paypal_settlement.pdf. ↑

4. Available at https://home.treasury.gov/system/files/126/20221128_kraken.pdf. ↑

5. 31 C.F.R. § 560.204. ↑

6. Available at https://home.treasury.gov/policy-issues/financial-sanctions/recent-actions/20211015. ↑

7. Available at https://home.treasury.gov/policy-issues/financial-sanctions/faqs/562. ↑

8. Available at https://home.treasury.gov/policy-issues/financial-sanctions/faqs/563. ↑

9. Available at https://home.treasury.gov/policy-issues/financial-sanctions/faqs/594. ↑

10. Available at https://home.treasury.gov/system/files/126/framework_ofac_cc.pdf. ↑

11. 31 C.F.R. Part 501, App. A. ↑

12. OFAC FAQ 13 (December 4, 2020), available at https://home.treasury.gov/policy-issues/financial-sanctions/faqs/13. ↑

The last few years had started to see a convergence between crypto and banking, with Bitcoin appearing to rapidly grow mainstream. That momentum hit a wall with the spectacular crypto market failures of 2022, including the collapse of the crypto exchange FTX. In response to the significant volatility and the exposure of vulnerabilities in the crypto sector that resulted, the federal prudential bank regulators (the Board of Governors of the Federal Reserve System [Fed], the Federal Deposit Insurance Corporation [FDIC], and the Office of the Comptroller of the Currency [OCC]) have recently taken coordinated moves to, with an increasingly firmer hand, delineate the types of risks related to the crypto sector that banks should be aware of—and, in certain instances, that do not belong in the banking system, in their view.

The policy lines being drawn are critical because banks continue play a dominant role in mainstream, day-to-day financial activities. A bank’s expansion into crypto activities or offerings underpinned by distributed ledger technology (DLT), particularly in partnership with a fintech company, could amplify adoption of these technologies. A fintech company offering crypto services or a DLT-based platform may find its own scale, reach, and reputation in augmented by partnering with a bank. If done carefully and cautiously, these partnerships could also help safely integrate certain crypto and DLT-based innovations into more mainstream uses. What that could look like and the supervisory expectations around such offerings are starting to take shape, as reflected by recent actions by the federal prudential regulators. As the Biden Administration has emphasized, these actions reflect “the imperative of separating risky digital assets from the banking system.” Even still, not all crypto and DLT-based activities are off the table.

We are at an important turning point in the industry, with riskier crypto enterprises failing and banking regulators stepping up to make their expectations clearer. It is important for fintech companies that partner with or are looking to partner with banks to offer crypto or DLT-based services, investors in these companies, and their legal advisers to stay abreast of where the prudential overseers are beginning to draw a red line with respect to crypto activities and the opportunities for responsible innovation that remain.

Recent Crypto Developments

The Fed, FDIC, and OCC had jointly announced in November 2021 that they conducted a series of interagency “policy sprints” focused on crypto, but only recently have they started to paint clearer boundaries for the types of crypto activities that banks may engage in. These recent announcements include their joint statement on crypto-asset risks to banking organizations, issued January 3, 2023; the Fed’s policy statement to promote a level playing field for all banks with a federal supervisor, regardless of deposit insurance status, issued on January 27, 2023; and the Fed’s announcement of its denial of the application by Custodia Bank, Inc. to become a member of the Federal Reserve System, also made on January 27, 2023.

Here are some practical takeaways for fintech companies that are partnering with or are looking to partner with banks in connection with crypto- or DLT-based offerings:

1. Banks are not barred from providing crypto custody services: The Fed explicitly stated that it is not taking off the table for its supervised banks the ability to provide safekeeping services, in a custodial capacity, for crypto—if conducted in a safe and sound manner and in compliance with consumer protection, anti-money laundering, and anti-terrorist financing laws. The OCC has previously concluded that a national bank may provide crypto custody services on behalf of customers.

2. Banks are unlikely to be holding crypto assets for their own account (“as principal,” such as for investment or market-making activity): The joint statement noted that holding as principal crypto-assets that are underpinned by an open, public, or decentralized blockchain is “highly likely to be inconsistent with safe and sound banking practices.”

   The Fed went further in its policy statement, noting that it would “presumptively prohibit” its supervised banks from holding most crypto as principal.^[1] Overcoming this presumption will be no small feat, as the Fed’s policy statement includes a litany of safety and soundness concerns.

3. There is a path for banks to issue “dollar-denominated tokens” underpinned by DLT: A bank seeking to issue a dollar token would need to demonstrate, to the satisfaction of its supervisor, that it has controls in place to conduct the activity in a safe and sound manner, and it must receive a supervisory nonobjection.

   It seems highly unlikely that a bank would receive a greenlight to issue tokens underpinned by an open, public, or decentralized blockchain. Additionally, where the bank does not have the ability to obtain and verify the identity of transacting parties, and therefore may not have a sufficient risk management framework to mitigate money laundering and terrorism financing risks, supervisors are highly likely to conclude that its activities are inconsistent with safe and sound banking practices.

   These guardrails still leave room for innovation. For example, the New York Innovation Center, a division of the Federal Reserve Bank of New York established in partnership with the Bank for International Settlements Innovation Hub, announced its participation in a proof-of-concept project with a number of major banks to explore the feasibility of an interoperable network of digital central bank liabilities and commercial bank digital money using a shared, permissioned DLT.

4. The purely crypto-centric bank business model is likely to be a relic of history: The agencies have expressed significant safety and soundness concerns with business models that are concentrated in crypto activities or have concentrated exposures to the crypto sector. At the same time, crypto companies are not being shunned from the banking system; banks are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.

More generally, the prudential regulators’ crypto actions are a reminder that banks are a “special” type of entity, and the banking system is bounded by a shifting federal regulatory perimeter. That is, banks are supervised and highly regulated institutions, and there are important guardrails with respect to the crypto-related activities they can engage in.

Unique Aspects of Bank-Fintech Partnerships

As a threshold matter, banks are limited in the activities they can engage in by “legal permissibility”—that is, before a bank can engage in new activities of any kind, including crypto-related activities, it must ensure that the specific activity is permissible under applicable banking law and regulation. In addition, prudential oversight means that banks have to operate with safety and soundness in mind, as well as have appropriate measures and controls in place to manage risks. Banks must also ensure compliance with all relevant laws, including those related to anti-money laundering/countering the financing of terrorism and consumer protection. The Fed, FDIC, and the OCC have each instructed their supervised banks to follow specific notice requirements if they are seeking to engage in crypto-related activities.

A bank-fintech partnership in offering crypto or DLT-based services can yield unique benefits when executed safely and within these guardrails. A fintech company that partners with a bank could leverage the bank’s resources, infrastructure, and regulatory compliance experience to safely offer crypto services to a larger audience. A bank might rely on the fintech company for back-end technology services or front-end user interfaces to support the crypto services it can offer to its banking customers. Robust integration of crypto functionality and DLT with traditional banking systems, with sound risk controls and consumer education, would also make it safer and easier for the general public to use these technologies.

Takeaway

We are entering a new chapter in the evolution of crypto, DLT, and the businesses around them. Crypto is not vanishing any time soon, and technologies like DLT continue to present a unique and potentially promising opportunity for fintech companies and banks to collaboratively upgrade the outdated underpinnings of our financial system. Rather than keeping innovation out of the banking system, the industry and its regulators would do better to figure out the best way to integrate it safely and incrementally. The bank-fintech partnerships that are most advanced in addressing legal uncertainties, mitigating risk, and building strong compliance infrastructures will be best positioned for success. Critical to that success is good legal counsel on how to intelligently navigate the novel and evolving regulatory issues raised by crypto and DLT.

1. The Fed also noted that the OCC has gone so far as to require a national bank to divest crypto held as principal that it acquired through a merger with a state bank: “Specifically, the OCC conditioned its recent approval of the merger between Flagstar Bank, FSB and New York Community Bank into Flagstar Bank, NA on the divestiture of holdings of ‘Hash,’ a crypto-asset, after a conformance period, as well as a commitment not to increase holdings of any crypto-related asset or token ‘unless and until the OCC determines that . . . Hash or other crypto-related holdings are permissible for a national bank.’” See also OCC Conditional Approval Letter No. 1299, at 9 (October 27, 2022). ↑

The Rule of Law is “a durable system of laws, institutions, norms, and community commitment” based on “four universal principles”: “just law”; “open government”; “accessible and impartial justice”; and “the government as well as private actors are accountable under the law.”^[1] The cornerstone of that system in this country is the United States Constitution.

“There is a story, often told, that upon exiting the Constitutional Convention Benjamin Franklin was approached by a group of citizens asking what sort of government the delegates had created. His answer was: ‘A republic, if you can keep it.’”^[2] I came across no record of Franklin elaborating on this provocative statement. But what I take away from it is that we can only keep our republic if we are willing and able to do the hard work it takes to maintain it. In writing about Franklin’s statement, Professor Richard Beeman concludes: “If there is a lesson in all of this it is that our Constitution is neither a self-actuating nor a self-correcting document. It requires the constant attention and devotion of all citizens.”^[3] The focus of this piece is the aspect of the above definition of the Rule of Law that pertains to community commitment.

Franklin’s views did not always carry the day during the Constitutional Convention. In fact, he observed: “I confess that there are several parts of this Constitution which I do not at present approve, but I am not sure I shall never approve them. For having lived long, I have experienced many instances of being obliged by better information, or fuller consideration, to change opinions even on important subjects, which I once thought right, but found to be otherwise.”^[4] However, as discussed below, Franklin’s statement about “A republic, if you can keep it” does reflect a shared concern and understanding of the Founders.

Moreover, that concern is a continuing one on the part of thoughtful commentators, and empirical evidence demonstrates that there is substantial cause for concern today. The beneficial effects of civic education are not only desirable but necessary for our well-being as a nation. Consequently, as members of the legal profession, we should engage in and promote civic education that will support and strengthen the Rule of Law. Doing so is one of the ways we can deliver on the solemn promise we made when we took an oath to support and defend the Constitution and laws of the United States of America.

Other Founders Shared Franklin’s Concern

“[W]hat the American Founders did not do—could not do—was guarantee the success of their creation. Franklin and the other Founders knew that their experiment depended on future generations, which meant the education of future citizens.”^[5] “Shortly after the Constitution was signed, Jefferson wrote from Paris: ‘Wherever the people are well informed, they can be trusted with their own government.’”^[6] In his first inaugural address, George Washington stated: “The preservation of the sacred fire of liberty, and the destiny of the Republican model of Government, are . . . staked on the experiment entrusted to the hands of the American people.”^[7] “For his part, John Adams observed that ‘liberty cannot be preserved without a general knowledge among the people.’”^[8] It is telling that on May 19, 1821, Adams wrote to Jefferson: “A free government is a complicated piece of machinery, the nice and exact adjustment of whose springs, wheels, and weights, is not yet well comprehended by the artists of the age, and still less by the people.”^[9]

In a piece titled “Civic Illiteracy and the Rule of Law,” in which he recounts the story about Franklin’s statement when exiting the Constitutional Convention, Judge Don R. Willett writes that “[t]he survival of freedom depends on people, not parchment.”^[10] Willett goes on to direct our attention to the very beginning of the Constitution, reminding us that “We the People of the United States” is “supersized on the page for all the world to see.”^[11] Thus while the words “civic education” may not have been used, the necessity of it is something that has been recognized since the founding of our nation.

A Similar Concern Today about the Need for Civic Education; We Should be Very Concerned

In his 2019 year-end report, Chief Justice John Roberts, Jr. called on us to live up to our responsibilities with respect to civic education. He wrote: “Civic education, like all education, is a continuing enterprise and conversation. Each generation has an obligation to pass on to the next, not only a fully functioning government responsive to the needs of the people, but the tools to understand and improve it.”^[12]

Others have highlighted the consequences of neglecting civic education. In “Civic Illiteracy: A Threat to the American Dream,” Michael Ford wrote: “The effects of civic illiteracy take their toll over time, and while Americans are almost defiantly indifferent about their lack of civic understanding, the consequences to our basic rights and freedoms and the general health of our republic could be dire. The American Dream, which requires the rule of law and civic understanding to protect the freedoms and opportunities we value, could be deeply damaged.”^[13] A report by the Educating for American Democracy Initiative describes our country’s situation as standing “at a crossroads of peril and possibility.”^[14] Peril because “[i]n recent decades, we as a nation have failed to prepare young Americans for self-government, leaving the world’s oldest constitutional democracy in grave danger, afflicted by both cynicism and nostalgia, as it approaches its 250th anniversary.”^[15] Possibility because “[o]ur civic strength requires excellent civic and history education to repair the foundations of our democratic republic” and we are capable of doing something about this situation.^[16]

The consequences of civic illiteracy will be felt sooner than we might suspect. For “the middle and high school students of today will be tomorrow’s jurors, judges, court staff, lawyers, litigants, and journalists.”^[17] And tomorrow is just around the corner.

In a 2018 lecture on civic education, Judge Robert A. Katzmann lamented that “[u]nfortunately, the Constitution’s ideals—and the way our system of government puts them in action—are lost on millions of Americans. Surveys show many have only a dim idea of how our government makes and applies laws. Most could not pass the test administered to prospective citizens.”^[18] Also unfortunately, there is considerable evidence to support that statement.

In April of 2020, the National Center for Education Statistics released the results of the 2018 National Assessment of Educational Progress (NAEP) civics assessment. This civics assessment was first given in 1998 and has been administered every four years since 2006 to fourth-, eighth-, and twelfth-grade students. The results from the 2018 tests show that “about 24 percent of eighth-grade students performed at or above the NAEP Proficient level on the civics assessment, which was not significantly different from the 23 percent of students performing at this level in 2014, the previous assessment year. There was no significant change in the percentage of students performing at this level compared to 1998, the first assessment year.”^[19] Studies show that the situation does not improve as students progress through high school. “Considerable evidence exists that appallingly large numbers of students would not pass the exam of basic civic knowledge required for naturalization. . . . By contrast, 92 percent of immigrants passed on their first try.”^[20]

Nor does the situation improve as people move into adulthood. A national survey conducted by Xavier University’s Center for the Study of the American Dream revealed “that one in three native-born citizens failed the civic literacy test, based on the INS passing score of 6 out of 10 correct answers. This pass rate is 32 percent less than the average immigrant passing rate. In and of itself, these numbers don’t appear alarming because we have heard them before. However, our persistence in civic unawareness is no comfort simply because it is consistent.”^[21]

Nor do we do better when presented with a relatively simple set of questions. The Annenberg Public Policy Center conducts an annual survey assessing Americans’ civic knowledge. During the period from 2006 through 2019, the percentage of people who could name the three branches of government remained below 40 percent.^[22] Then, apparently as an unanticipated consequence of the pandemic, when the 2021 survey was taken 51 percent of the participants involved could name all three branches; this was up from the previous all-time high of 39 percent in 2020.^[23] While that is an improvement, that is still a perturbingly low percentage, and post-pandemic our performance is likely to regress. This modest improvement does not undermine the accuracy of the statement that “We the People’s civic illiteracy is staggering.”^[24]

Some of the Important Benefits of Civic Education

By our actions (or inaction) today we help create our nation’s citizenry of tomorrow. They will either have the knowledge, skills, and values that serve to support and strengthen the Rule of Law, or they will not. But there is no question but that they will definitely be in need of such knowledge, skills, and values, because it is no simple task to maintain a properly functioning system of laws and institutional norms.

Professor Beeman, writing about the Founders, observed that “they had not yet worked out fully the question that has plagued all nations aspiring to democratic government ever since: how to implement principles of popular majority rule while at the same time preserving stable governments that protect the rights and liberties of all citizens.”^[25] Similarly, Professor Robert B. Talisse has written about the fact that “[d]emocracy imposes a substantial moral burden on citizens.”^[26] He observes that as a consequence of the fact that “[d]emocracy is self-government among equals . . . , democracy runs on political disagreement.”^[27] Thus, “democracy requires us to see our fellow citizens as our political equals, people who do not merely get an equal say in political decision-making but are entitled to an equal say. This of course is easy among those that agree. But there’s no easy way to regard our political opponents as equal citizens with an equal entitlement to political power.”^[28]

Our system of laws and institutional norms has flaws because we, the human beings who designed that system, are flawed. Civic education can help counteract cynicism about and disillusionment with the legal system and the Rule of Law by helping people embrace the idea that living in a democracy means that you do not always get your preferred outcome, as well as understand that the fact that our legal system does not function perfectly is no reason to abandon that system instead of working to improve it. Civic education provides students and adults the opportunity to “observe and come to grips with the real-life complexities of doing justice.”^[29]

Also, members of the legal profession can and should be exemplars of “the importance of civility and civil discourse,” and engaging in civic education is an opportunity for us to model and teach about that.^[30] Civic education is an opportunity to “provide students with the skills to communicate effectively with others, even when they disagree.”^[31]

Law professors Linda McClain and James Fleming wrote an essay in the Boston University Law Review about why “civic education is crucial to remedying what Jack Balkin, in The Cycles of Constitutional Time, diagnoses as ‘constitutional rot’ in the United States.”^[32] They observed that civic education “helps to equip people for forms of democratic participation (including in social movements) necessary to the health of constitutional democracy.”^[33] They explained that civic education “aspires to inculcate civic virtues and develop capacities for responsible constitutional self-government, for example:

• tolerance and respect for others who are different from ourselves;
• reciprocity in our relationships with others, including those with whom we disagree;
• mutual forbearance and trust . . . ;
• a willingness to meet people halfway (rather than to insist on our own way); and
• a disposition and capacity to give reasons (rather than merely to make assertions).”^[34]

So I hope we can all agree that “[w]hen civics education is taught effectively, it can equip students with the knowledge, skills, and disposition necessary to become informed and engaged citizens.”^[35]

One of the Things You Can Do

At the Business Law Section’s Spring Meeting in Seattle (April 27 to 29) we will be supporting Reading Partners Seattle by (i) donating to students books on topics related to Rule of Law, and (ii) arranging for some Section members to visit a school to read and talk about topics related to the Rule of Law.

This activity is being organized by the Pro Bono Committee and the Rule of Law Working Group, and you will learn more about it in the next issue of Business Law Today.

1. World Justice Project, What is the Rule of Law?, https://worldjusticeproject.org/about-us/overview/what-rule-law (last visited 2/14/23). ↑

2. Richard R. Beeman, Ph.D., Perspectives on the Constitution: A Republic, If You Can Keep It, National Constitution Center, https://constitutioncenter.org/education/classroom-resource-library/classroom/perspectives-on-the-constitution-a-republic-if-you-can-keep-it (last visited 2/14/23). ↑

3. Id. ↑

4. ConstitutionFacts.com, https://www.constitutionfacts.com/?section=funZone&page=famousQuotes.cfm (citing Benjamin Franklin, 1787) (last visited 2/14/23). ↑

5. Matthew Spalding, Ph.D., EDO70302b: A Republic If You Can Keep It (Jul. 3, 2002), https://www.heritage.org/political-process/commentary/ed070302b-republic-if-you-can-keep-it (last visited 2/14/23). ↑

6. Don R. Willett, Civic Illiteracy and the Rule of Law, 106 Judicature, Vol. 1, at 12, https://judicature.duke.edu/articles/civic-illiteracy-and-the-rule-of-law/ (internal citation omitted) (last visited 2/14/23). ↑

7. Id. at 11. ↑

8. Robert A. Katzmann, Civic Education and the Federal Courts, Thomas E. Fairchild Lecture, 2019 Wis. L. Rev. 397, at 400, https://wlr.law.wisc.edu/wp-content/uploads/sites/1263/2020/02/Katzmann-Final.pdf (citing John Adams, A Dissertation on the Canon and Feudal Law No. 3, Bos. Gazette (Sept. 30, 1765)) (last visited 2/14/23). ↑

9. ConstitutionFacts.com, https://www.constitutionfacts.com/?section=funZone&page=famousQuotes.cfm (citing John Adams to Thomas Jefferson, May 19, 1821) (last visited 2/14/23). ↑

10. Don R. Willett, Civic Illiteracy and the Rule of Law, 106 Judicature, Vol. 1, at 11, https://judicature.duke.edu/articles/civic-illiteracy-and-the-rule-of-law/ (last visited 2/14/23). ↑

11. Id. at 12. ↑

12. Chief Justice John G. Roberts, Jr., 2019 Year-End Report on the Federal Judiciary, U.S. Sup. Ct. (Dec. 31, 2019), https://www.supremecourt.gov/publicinfo/year-end/2019year-endreport.pdf (last visited 2/14/23). ↑

13. Michael Ford, Civic Illiteracy: A Threat to the American Dream (Apr. 30, 2012), HuffPost, https://www.huffpost.com/entry/civic-literacy_b_1457635 (last visited 2/14/23). ↑

14. Educating for American Democracy (EAD), Educating for American Democracy: Excellence in History and Civics for All Learners, iCivics (Mar. 2, 2021), https://www.educatingforamericandemocracy.org/wp-content/uploads/2021/02/Educating-for-American-Democracy-Report-Excellence-in-History-and-Civics-for-All-Learners.pdf (last visited 2/14/23). ↑

15. Id. ↑

16. Id. ↑

17. Rebecca Fanning, Involve, Inform, Inspire: Through Robust Civics Education Offerings, Federal Courts and Judges Teach the Next Generation About the Judiciary, 106 Judicature, Vol. 1, at 14 (2022), https://judicature.duke.edu/articles/involve-inform-inspire/ (last visited 2/14/23). ↑

18. Robert A. Katzmann, Civic Education and the Federal Courts, Thomas E. Fairchild Lecture, 2019 Wis. L. Rev. 397, at 399, https://wlr.law.wisc.edu/wp-content/uploads/sites/1263/2020/02/Katzmann-Final.pdf (last visited 2/14/23) ↑

19. Achievement-Level Results, The Nation’s Report Card, NAEP Report Card: Civics, https://www.nationsreportcard.gov/civics/results/achievement/ (last visited 2/14/23). ↑

20. Robert Holland & Don Soifer, What If Students Can’t Pass Immigrants’ Citizenship Test? (Sept. 28, 2014), Lexington Institute, https://www.lexingtoninstitute.org/what-if-students-cant-pass-immigrants-citizenship-test/ (last visited 2/14/23). ↑

21. Michael Ford, Civic Illiteracy: A Threat to the American Dream (Apr. 30, 2012), HuffPost, https://www.huffpost.com/entry/civic-literacy_b_1457635 (last visited 2/14/23). ↑

22. See Annenberg Public Policy Center, Americans’ Civics Knowledge Increases During a Stress-Filled Year (Sept. 14, 2021), https://www.asc.upenn.edu/news-events/news/americans-civics-knowledge-increases-during-stress-filled-year (last visited 2/14/23). ↑

23. See id. ↑

24. Don R. Willett, Civic Illiteracy and the Rule of Law, 106 Judicature, Vol. 1, at 12, https://judicature.duke.edu/articles/civic-illiteracy-and-the-rule-of-law/ (last visited 2/14/23). ↑

25. Richard R. Beeman, Ph.D., Perspectives on the Constitution: A Republic, If You Can Keep It, National Constitution Center, https://constitutioncenter.org/education/classroom-resource-library/classroom/perspectives-on-the-constitution-a-republic-if-you-can-keep-it (last visited 2/14/23). ↑

26. Robert B. Talisse, Democracy’s Burden (Aug. 23, 2020), Culturico, https://culturico.com/2020/08/23/democracys-burden/ (last visited 2/14/23). ↑

27. Id. ↑

28. Id. ↑

29. Rebecca Fanning, Involve, Inform, Inspire: Through Robust Civics Education Offerings, Federal Courts and Judges Teach the Next Generation About the Judiciary, 106 Judicature, Vol. 1, at 15 (2022), https://judicature.duke.edu/articles/involve-inform-inspire/ (last visited 2/14/23). ↑

30. Robin L. Rosenberg, Beth Bloom, & Hayley Lawrence, Critical Life Skills Through Courtroom Experiences, 106 Judicature, Vol. 1, at 34 (2022). ↑

31. Id. ↑

32. Linda C. McClain & James E. Fleming, Civic Education in Circumstances of Constitutional Rot and Strong Polarization, Abstract, 101 B.U. L. Review 1771 (2021). ↑

33. Id. at 1776-77. ↑

34. Id. ↑

35. Sarah Shapiro & Catherine Brown, The State of Civics Education (Feb. 21, 2018), American Progress, https://www.americanprogress.org/article/state-civics-education/ (last visited 2/14/23). ↑

This article is part of a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.

Delaware recently enacted significant amendments (the 2022 Amendments) to the General Corporation Law of the State of Delaware (the DGCL), enhancing Delaware’s corporate governance regime for directors and officers, while also expanding stockholder rights. However, one of the most significant changes to the DGCL—the authorization of exculpatory charter provisions for officers—has been the subject of litigation in recent cases involving public companies with dual classes of common stock. In addition, the major proxy advisory firms have begun issuing policy guidelines, signaling that management will need to make a strong case for the adoption of the proposals by stockholders to garner institutional stockholder support in some cases. Nevertheless, there are several reasons for public companies to remain optimistic about officer exculpation and the other changes to the DGCL effected by the 2022 Amendments. Beyond authorizing exculpatory charter provisions for officers, the 2022 Amendments have important implications for stock issuances and option grants, stockholder meetings, appraisal rights, and the conversion or domestication of Delaware corporations to other entities. 

Exculpatory Provisions for Officers

Section 102(b)(7) of the DGCL (Section 102(b)(7)) now permits Delaware corporations to include exculpatory provisions in their certificates of incorporation to limit or eliminate the personal liability of executive officers of the corporation for monetary damages for breaches of the fiduciary duty of care in direct but not derivative proceedings. Under the 2022 Amendments, a Section 102(b)(7) provision may exculpate as an “officer” any person who (i) is the president, chief executive officer, chief operating officer, chief financial officer, chief legal officer, controller, treasurer, or chief accounting officer, and officers performing similar functions; (ii) is or was identified in the corporation’s public filings with the United States Securities and Exchange Commission as one of the corporation’s most highly compensated executive officers; or (iii) has consented to service of process in Delaware by written agreement. Like directors, officers may not be exculpated for breaches of the duty of loyalty; actions or omissions in bad faith; knowing violations of law; and in connection with transactions from which any such officer derived an improper personal benefit. However, unlike directors, officers may not be exculpated for monetary damages incurred in derivative proceedings.

The amendments to Section 102(b)(7) respond to an increase in litigation asserting violations of the fiduciary duty of care against an officer of a corporation as a means to avoid a dismissal of the complaint at the motion to dismiss stage by reason of the application of a Section 102(b)(7) exculpatory provision to the corporation’s director defendants.
 
Because exculpatory provisions for officers must be included in a corporation’s certificate of incorporation, board and stockholder approval will be required to expand Section 102(b)(7) coverage to officers. Many public companies have protected their director exculpatory provisions with supermajority provisions, raising issues for counsel as to whether a supermajority vote is necessary to revise the provisions to cover officers. However, in many cases, a Section 102(b)(7) exculpatory charter provision covering officers can be added to a certificate of incorporation with a simple majority vote.

While many issuers have already successfully adopted amendments to their certificates of incorporation that add exculpatory provisions for officers with the support of the proxy advisory firms, recent policy guidelines issued by Institutional Shareholder Services (ISS) and Glass Lewis signal that management will need to provide a compelling rationale for the adoption of such provisions to their stockholders to garner institutional investor support in the future. The ISS and Glass Lewis guidance states that management proposals to adopt officer exculpation provisions will be reviewed on a case-by-case basis by such firms, with ISS suggesting that it would focus on whether the proposals purport to eliminate monetary liability for breaches of fiduciary duty other than the fiduciary duty of care. Glass Lewis’s guidelines take a more negative stance, stating that the firm would generally recommend voting against officer exculpation proposals.^[1] It remains to be seen how these policy guidelines will impact exculpatory officer provisions submitted for stockholder action during proxy season in the spring. Key institutional investors, such as BlackRock and State Street Global Advisors, have not yet adopted voting policies specifically addressing exculpation proposals.

Public companies with dual classes of common stock also need to be careful about the votes sought from stockholders to implement such proposals given claims by stockholders holding a class of non-voting common stock that the implementation of the proposals requires a class vote under Section 242(b)(2) of the DGCL (Section 242(b)(2)). Section 242(b)(2) affords stockholders of a class with a separate class vote on charter amendments that alter or change “the powers, preferences, or special rights of the shares of such class so as to affect them adversely” even if such stockholders hold non-voting stock. Stockholders holding non-voting, public company stock are taking the position in various lawsuits^[2] that the elimination of their ability to bring direct actions for breach of fiduciary duty against officers alters or changes “the powers, preferences, or special rights of the shares of such class so as to affect them adversely” and therefore their approval is required to implement officer exculpation.^[3] While existing case law provides strong arguments that the position taken by the plaintiffs in the actions is without merit, public companies with multiple classes of common stock should consider either waiting to adopt Section 102(b)(7) provisions until after the litigation has been resolved or subjecting the approval of any such proposals to a separate class vote of each outstanding class of common stock.

Stock, Options, and Other Rights to Purchase Stock

Sections 152, 153, and 157 of the DGCL have been amended to harmonize the rules governing the board’s ability to delegate to persons or bodies other than a board committee (such as officers or a sales or placement agent) the authority to issue stock under Section 152 of the DGCL and to make grants of rights or options to purchase stock under Section 157 of the DGCL. 

Specifically, the 2022 Amendments to Section 157 of the DGCL expand the board’s power to delegate the authority to issue options or other rights to purchase stock using the framework that applies to the delegation of issuance of stock under Section 152 of the DGCL. 

With respect to grants of rights or options to purchase stock, the board resolutions must establish (i) the maximum number of rights or options that may be granted, and the maximum number of shares issuable upon exercise thereof, (ii) a time period during which such rights or options, and during which the shares issuable upon exercise thereof, may be issued, and (iii) a minimum amount of consideration (if any) for which such rights or options may be issued and a minimum amount of consideration for the shares issuable upon exercise thereof. Assuming the board sets these broad parameters, the board may delegate to any person or body the authority to determine the precise timing of the grants, the exercise price, and the number of options or rights to be granted, as well as the other terms of the grants, such as the vesting schedule or expiration date. Under the prior version of Section 157 of the DGCL, the board could not delegate to any officer the authority to determine any of the terms of the grants other than the total number of options or rights to be awarded to officers and employees other than such officer subject to a cap set by the board. 

In addition, the consideration paid for options or rights to purchase stock may be set by reference to a formula provided in the board resolution, such as by reference to the trading price of the company’s stock. Amended Section 157 of the DGCL also eliminates the requirement that the terms of a right or option be set forth or incorporated by reference in a written instrument, paving the way for electronic forms of rights and options.

The DGCL limitations on a corporation’s ability to delegate the power to grant rights and options to officers and others do not apply to board committees. Properly empowered board committees may exercise the full power and authority of the board to make grants of rights and options to purchase stock. It was common practice prior to the 2022 Amendments for the board to constitute the chief executive officer as a one-person board committee (provided such person was also a director) for the purposes of making grants under equity compensation plans. Given the complexity of the new delegation rules under amended Section 157 of the DGCL, many corporations are continuing the practice of delegating the authority to make grants of equity awards to a one-person board committee.

Stockholder Meetings and Notices

The 2022 Amendments effect a number of changes that facilitate stockholder meetings, including by eliminating some impediments to virtual meetings. During the pandemic, many public corporations held their meetings virtually but found it difficult to comply with Section 219 of the DGCL, which required that the stockholder list be available on the virtual meeting platform or at the corporation’s principal place of business for a period of at least ten days prior to the meeting, as well as during the whole time of the meeting. The 2022 Amendments eliminate the requirement that a corporation make the list of stockholders available for inspection during the stockholders’ meeting.

The 2022 Amendments also clarify that a notice of a meeting of stockholders may be given in any manner permitted by Section 232 of the DGCL, which specifies that notice of a meeting may be given by electronic transmission, including by e-mail, and generally deems such notice to be given when directed to a stockholder’s electronic mail address. Other amendments to Section 222 of the DGCL facilitate the adjournment of a meeting due to a technical failure such as a crash of the virtual meeting platform. In such event, the meeting may be adjourned to another time and virtual space not only by oral announcement during the meeting but also by virtual display on the meeting platform or in advance, as specified in the original meeting notice.

Appraisal Rights

The 2022 Amendments to the DGCL modify Section 262 of the DGCL in a number of important respects. Under the 2022 Amendments, (1) beneficial owners may demand appraisal rights in their own names without having to cause the record owner (i.e., Cede & Co., in most cases) to demand appraisal rights on their behalf, (2) stockholders will now be able to exercise appraisal rights in connection with the conversion of the corporation to another entity or a foreign corporation unless the market-out exception applies (which generally denies appraisal rights for holders of public company stock in certain all-stock mergers), and (3) domestications under Section 388 of the DGCL no longer give rise to appraisal rights. The decision to make appraisal rights available in connection with the conversion of Delaware corporations to other entities was made in tandem with amendments to reduce the voting threshold necessary to effect such a conversion from unanimous to majority stockholder approval.

Corporations may now include in a notice of appraisal rights information directing stockholders to a publicly available electronic copy of Section 262 of the DGCL, including the website maintained on behalf of the State of Delaware, in lieu of including a copy of Section 262 of the DGCL. The revisions are intended to help reduce the unintentional inclusion of outdated versions of the appraisal statute in notices of appraisal rights. If a corporation mistakenly includes an outdated copy of Section 262 of the DGCL in a notice of appraisal rights, stockholders have the right to bring a breach of fiduciary duty claim against the corporation’s directors and are generally entitled to quasi-appraisal rights as a remedy for breach of such fiduciary duty. The 2022 Amendments will help to eliminate these risks.

SPACs

In response to the increased popularity of special purpose acquisition companies (SPACs) as a vehicle to take a private company public through a business combination with a public shell company, amendments have been made to the dissolution provisions of the DGCL. A SPAC typically includes in its certificates of incorporation a provision authorized by Section 102(b)(5) of the DGCL, limiting the corporation’s existence to a specific period during which the SPAC seeks to effect an initial business combination. However, prior to the 2022 Amendments, the DGCL did not require a SPAC to file any document with the secretary of state of the State of Delaware confirming that its existence had ceased. Under new Section 275(f) of the DGCL, the SPAC must file a certificate of dissolution with the secretary of state within ninety days of the date on which the corporation’s existence ceased. However, a SPAC’s failure to file a certificate of dissolution does not operate to extend the corporation’s existence.

1. Glass Lewis, 2023 Policy Guidelines — United States. Institutional Shareholder Services, United States Proxy Voting Guidelines. ↑

2. See, e.g., Dembrowski v. Snap, Inc., C.A. No. 2022-1042. (Del. Ch. Nov. 17, 2022); Karen Sbroglio v. Snap, Inc., C.A. No. 2022-1032 (Del. Ch. Nov. 16, 2022); Electrical Workers Pension Fund, Local 103, IBEW v. Fox Corp., C.A. No. 2022-1007 (Del. Ch. Nov. 4, 2022). ↑

3. See 8 Del. C. § 242(b)(2). ↑

Exemptions from registration have long been a cornerstone of the U.S. federal securities laws that have helped facilitate capital formation among private companies. The line drawing required to effectuate these exemptions has evolved over time and requires a delicate balance of the tensions between investor protection and capital formation. In the last decade, significant legislative and regulatory developments have expanded access to capital for private companies, particularly early stage businesses.

Significantly, the Jumpstart Our Business Startups Act (JOBS Act), enacted April 5, 2012, effected profound changes to U.S. federal securities laws and ushered in sweeping changes for the conduct of IPOs, in addition to other accommodations for private and public companies. Under the JOBS Act, the Securities and Exchange Commission (SEC) allowed for general solicitation and general advertising in private placements conducted pursuant to Rule 506 under Regulation D (provided that all purchasers are “accredited investors”) and in Rule 144A placements (provided that all purchasers are qualified institutional buyers).

The JOBS Act also increased the number of record holders of a class of equity securities that triggers an issuer’s obligation to register and become a reporting company under the Securities Exchange Act of 1934 from 500 holders to either 2,000 persons or 500 persons who are not accredited investors (with some meaningful exclusions from these calculations, including certain recipients of employee equity grants). The JOBS Act also expanded the maximum size of Regulation A offerings (i.e., Reg A+) and created a new exemption from registration for “crowdfunding” by private U.S. companies. Collectively, these developments have significantly expanded access to capital, particularly for early stage private companies, through means not requiring a formal IPO registration process.

The impact of the JOBS Act extends beyond exempt offerings. Moving along the company lifecycle, the JOBS Act also created an “IPO on-ramp” that affords several accommodations for emerging growth companies, or “EGCs” (generally defined as companies with total annual gross revenues of less than $1.07 billion—increased from $1 billion in April 2017, and subject to further adjustment for inflation every five years), in the process of going public. These include accommodations for reduced financial statement, MD&A, and executive compensation disclosure.

More recently, in 2020, the SEC adopted a host of rule amendments designed “to harmonize, simplify, and improve the multilayer and overly complex exempt offering framework.” Those amendments acknowledged that “[f]or many small and medium-sized business[es], our exempt offering framework is the only viable channel for raising capital.” To that end, these amendments increased the offering limits for Regulation A+, Regulation Crowdfunding, and Rule 504 offerings. They also modified the definition of “accredited investor” to expand those eligible for inclusion in this investor status and established a new framework to make it easier for companies to make integration determinations when conducting private offerings in parallel or close in time.

Notwithstanding the evolution of the exemption framework, challenges remain, and the debate continues as to whether additional modifications are necessary to further enhance the current exemption framework. Some contend that navigating the myriad of available exemptions with differing requirements remains unduly challenging. Others have focused more on the funding sources available to entrepreneurs to take advantage of the existing exemption frameworks. For example, when considering trends in capital raising and access to capital, disparity between rural and urban locales is just one topic under discussion. Changes among state regulations of securities are also relevant considerations to this ecosystem and any future adjustments thereto at the federal level. Relatedly, as retail investors come ever into the fore of investing and the types of offered securities become more complex, some have expressed concern about the need for additional protections for these investors, including whether further modifications to the accredited investor definition, or other or different regulatory requirements, are merited.

Much has been done over the years to protect Main Street investors, and enforcement actions and commentary from the SEC have kept them a priority. Nevertheless, there are indeed risks, including those arising from “bad actors,” illustrating the need for continued enforcement in the private offering contexts, which includes its own challenges. In that same vein, the role of gatekeepers remains of critical importance and significant policy interest at the SEC and more broadly in Washington. Recent enforcement actions underscore this point.

Looking forward, these and other questions in the ever-changing environment for private companies will contribute to the evolving discussion around the federal regulation of securities and the future of the SEC and the exempt offering framework. Continued input from all stakeholders will be critically important to supporting the evolution of the exempt offering framework while preserving the core principles upon which it is grounded.

This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members, or watch the related video.

This article is excerpted from Say the Right Thing: How to Talk About Identity, Diversity, and Justice (Atria Books), released on February 7, 2023. Kenji Yoshino and David Glasgow co-founded NYU School of Law’s Meltzer Center for Diversity, Inclusion, and Belonging, and have years of experience working with attorneys and other business and cultural leaders on these topics. Their book offers seven research-backed chapters about how to tackle tough topics with neighbors, friends, family members, co-workers, and anyone else you care about. Say the Right Thing will help readers have better conversations that lead to deeper understanding and a fairer society. Learn more about Say the Right Thing.

The children’s book The Magical Yet addresses a child who can’t get the hang of riding a bike and gives up trying. In the book’s illustrations, the child walks along a bike path sulking until she happens upon a glowing pink orb in the bushes known as The Magical Yet. With the Yet’s help, the child learns to persist whenever she makes a mistake, whether it involves playing a musical instrument, learning a language, or riding a skateboard. “No matter how big (or old) you may get,” the book observes, “you’ll never outgrow—you’ll never forget—you can always believe in the magic of Yet.”

The Magical Yet tracks psychologist Carol Dweck’s celebrated argument that people should move from a “fixed mindset” to a “growth mindset.” Individuals with a fixed mindset believe their basic qualities—their intelligence, personality, talents, and moral character—are basically unchangeable. If they’re not good at something, they probably never will be and should give up trying. Individuals with a growth mindset, in contrast, believe they can cultivate their qualities through effort. Across a variety of fields, from relationships to sports to business leadership, Dweck shows that a growth mindset leads to greater success. It prevents people from treating every setback as a verdict on their innate competence and moral worth.

This simple and crucial concept has taken over institutions from corporations to preschools, helping people recover from mistakes and improve their skills. Yet as our NYU colleague and social psychologist Dolly Chugh points out, the concept is glaringly absent from discussions of identity. She explains that people get mired in a fixed mindset on identity issues because the costs of making a mistake seem catastrophic. If you make a mistake when learning a musical instrument, you probably won’t be traumatized. Yet if you make a mistake on an identity issue, you haven’t just made an error—you’ve become a racist, a sexist, or a homophobe. Something you did comes to describe who you are. The perceived threat is so huge it’s no wonder you’re panicked. But that terror means you won’t even try to learn. Imagine if we began a class by saying: “Our one requirement for the semester is that you not make any mistakes.”

As Chugh argues, you won’t make progress until you let go of the fixed-mindset outlook that you’re either a good or bad person and embrace the growth-mindset idea that you’re a “good-ish” person. If you insist you’re a good person, you’re likely to react with overwhelming discomfort when you make a mistake that would reveal your imperfections. If, by contrast, you acknowledge you’re a “good-ish” person who falters like everybody else, you’re less likely to see mistakes as judgments of your character. You can then respond by treating mistakes as opportunities to learn.

Social science research backs up the idea that a fixed mindset derails identity conversations. In a series of experiments, Dweck and her colleagues found that participants with the fixed-mindset view that prejudice was unchangeable were less interested in having cross-racial interactions or learning about bias than people who believed prejudice could change through effort. In one experiment, white participants were put in a room and told they were about to speak with either a Black or white partner. When they expected a Black partner, those with a fixed mindset tended to place their seats farther away from the other person and expressed a desire for shorter interactions than those with a growth mindset. In another experiment, white participants with a fixed mindset made less eye contact, smiled less, and had a faster heart rate in cross-racial interactions. These findings held true even when controlling for the participants’ racial attitudes.

A fixed mindset might also trip you up in a sneakier way. In a separate study, Dweck and her colleague gave college students who did poorly on a test the opportunity to look at the completed tests of other students. Students with a fixed mindset tended to look at the tests of students who performed worse than they did. They didn’t think they could do better, so they settled for easing their discomfort. Students with a growth mindset tended to look at the tests of students who performed better than they did. Because they knew they could improve, they eagerly explored how to do so. A telltale sign of a fixed mindset in identity conversations is the urge to compare yourself to people more biased or gaffe-prone than you. In a growth mindset, you compare yourself to people who display the most inclusive behavior, not the least. Next time you’re at a family dinner and you mess up, watch out for those downward comparisons: “At least I’m not as bad as Aunt Edith!” Try to inspire yourself with role models instead: “What would Aunt Nell say to make this right?”

When you slip into a fixed mindset, we recommend two techniques. The first is to summon The Magical Yet from the bushes and add the word “yet” to the end of negative self-talk. It’s not: “I’m not good at talking about race.” It’s: “I’m not good at talking about race yet.” Educators use this technique a lot. Kenji’s children are not allowed to utter the words “I’m not good at math” at school. Their teachers insist they say: “I’m not good at math yet.”

The second technique is to do a self-comparison. Instead of “My younger colleagues find it so much easier to talk about mental health than I do,” you might say, “I find it easier to talk about mental health than I did a year ago.” We realize this recommendation sits in tension with our other recommendation to engage in upward comparisons to others. But here—and in general—our strategies aren’t mutually exclusive. Take whichever one works for you. If you find it inspiring to compare yourself to role models, do so. If you find it stressful or demoralizing, make self-comparisons instead. Regardless of the technique, the goal is to catch yourself when you’re feeling fatalistic and substitute thinking that’s both more honest and more compassionate.

When she visited our center, civil rights lawyer Chai Feldblum discussed her own struggles with this mindset shift. Feldblum is an iconic figure in American law and a principal author of the Americans with Disabilities Act. Despite her credentials, she told us during an event how she used to dread making mistakes in identity conversations. Whenever she made an error in the past, she said, “all I would do is berate myself.” Yet over a period of years, she learned to focus on growing from the mistake instead of letting it define her.

Feldblum asked us to imagine saying something inadvertently hurtful to a person with a disability. “If you’re not in the disability culture,” she said, “I assure you, you may not know that something you said just did not feel good to that person.” She then shared her recommended form of self-talk in response to that mistake: “Wow, I guess I just wasn’t ever taught that or thought about that.” This shift—from “I’m a terrible human being” to “I just wasn’t ever taught that”—offers you the gift of redemption. Just as importantly, as Feldblum noted, it grants you the opportunity to behave differently next time. If you didn’t learn it before, you can learn it now.

Today’s complex litigation landscape increasingly engages multijurisdictional and cross-border issues that in-house and external counsel need to consider early on to best contain and manage company risk. Defendants are wise to identify the differences in the applicable legal regimes of the various at-issue jurisdictions, with an eye to document and data preservation and collection, limitation periods, assumption of jurisdiction, certification criteria, requirements to prove liability, damages caps, and the recognition and enforcement of foreign orders.

Issues giving rise to class action and mass tort litigation, in particular, require early intervention and coordination among the client, company counsel, and external counsel in affected jurisdictions. Client and counsel must manage the intersection of internal investigations, regulatory compliance and response, legal liability, and public relations. Cases with cross-border components add a dimension of jurisdictional complexity to these already high-stakes cases.

The Parallel Proceeding’s Impact on Managing Complex Litigation

American companies with operations or customers in Canada are likely to see Canadian copycat or parallel actions to complaints filed in the United States. In U.S. and Canadian parallel proceedings, defendants are faced with a number of tactical decisions on each side of the border that may affect the counterpart proceeding.

For example, in Canadian class actions, precertification decisions include whether to attorn to the jurisdiction and/or whether to challenge the court’s adoption of jurisdiction over the defendant or subject matter of the dispute, whether (or when) to file a pleading prior to the motion for certification, and whether to include an evidentiary record in defense of certification. Regardless of whether the matter is a class action, mass tort, or other complex case, litigants should consider the impact of differing discovery regimes on the life cycle and timing of the case, as U.S. courts typically provide litigants with broader discovery rights than most Canadian jurisdictions. And when considering settlement, litigants should also maintain a coordinated focus to ensure that a settlement reached in one jurisdiction will be recognized and enforced in another, so as not to undermine the certainty of decision-making.

While the parallel proceeding is simply one dimension of a multidimensional problem, questions impacting the proceeding need to be considered and acted upon in their appropriate context. For example, at all stages of the proceeding, defendants need to make themselves aware of—and cautiously tread—regulatory minefields that may exist in the counterpart jurisdiction that will get tripped by a position taken in the main case.

Asking the Right Jurisdictional Questions

The jurisdictional questions that Canadian class action defendants need to ask include:

• Should I attorn to the jurisdiction?
• If there are extra-provincial class members, does the court have jurisdiction over them?
• If the claim involves absent out-of-country claimants, does the court have jurisdiction over out-of-country foreign claimants?^[1]

While counsel will be guided by the scope of the claim, these questions generally need to be asked in secondary market securities claims involving purchasers of securities on U.S. or foreign exchanges, competition (or antitrust) claims on behalf of indirect purchasers of goods and services, and product liability claims.

In the United States, national class actions tend to be in federal court pursuant to statute, so there is somewhat less concern about jurisdiction, though choice-of-law issues on pendent state law claims remain.

Considering the Interplay Between Preliminary Motions (and Class Action Certification) in Competing Jurisdictions

While a motion to dismiss is often the first motion to be heard in a U.S. class action, in Canada, unless the defendant brings an early jurisdiction motion, the first motion to be heard is typically the certification motion. Unlike motions to dismiss, contested certification motions usually involve evidentiary records.

In some class actions in Canada, defendants may choose whether to file a response pleading in advance of the motion for certification. This decision, like any made in a parallel or multijurisdictional proceeding, will bear on the overlapping cases proceeding in other jurisdictions. Filing a response pleading provides an early opportunity for the defendant to deny allegations and advance a narrative, but it will also precipitate discovery obligations, which could lead to evidence being filed in court on the motion for certification and made publicly available for use in another jurisdiction. Similarly, a decision to lead evidence in response to the motion for certification may (a) make the evidence publicly available to be put to use in another jurisdiction and (b) provide one set of class counsel an early opportunity to cross-examine the defendant.

As a result of amendments to class action legislation in Ontario in October 2020, which more closely aligned certification criteria with Federal Rule 23, some discernible shifts have begun to take shape in class counsel’s approach to certain types of cases. For example, defendants are seeing plaintiffs turn to jurisdictions other than Ontario—deemed more “plaintiff friendly” for a variety of reasons—to file cases. Another discernible shift is that product liability cases are being filed as mass tort cases rather than as class actions.

The End Game

For parallel actions that proceed beyond preliminary motions and certification, defendants need to develop a coordinated settlement or trial strategy that considers each jurisdiction’s laws governing recognition and enforcement. Bearing in mind that it is unlikely that competing jurisdictions will maintain the same pace of litigation, there are steps that defendants can take on either side of the border to reduce the likelihood of having to defend against already-settled claims with respect to certain class members, and increase the likelihood that a settlement achieved in one jurisdiction will be recognized and enforced in the other.

Claims with multijurisdictional and cross-border components require defendants to implement a forward-thinking and highly coordinated approach early in the case. Not only do they require the expertise of local counsel in multiple jurisdictions, they demand communication and coordination among all counsel—and a well-informed, in-house quarterback.

This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.

1. McCarthy Tetrault LLP, Defending Class Actions in Canada: A Guide for Defendants 203 (LexisNexis 5th ed. 2020). ↑

The Netflix series Madoff: The Monster of Wall Street is a compelling and largely accurate portrayal of Bernie Madoff’s Ponzi scheme. Unlike some other depictions of the fraud, it discusses how Madoff created the image of a statesman for himself to distract regulators. Unfortunately, it glosses over some things and is incorrect about some other parts of the story.

To its credit, the series does not focus exclusively on how Madoff enticed investors and institutions to entrust their money with him. It discusses his role in fulfilling his market-making responsibilities during the 1987 stock market crash. The series explains that when other market makers were not answering their phones, Madoff continued to buy stock at a loss. That earned him credibility on Wall Street and in Washington. Episode 1 (38:43).

Unfortunately, the series does not explain how Madoff’s legitimate broker-dealer and his advice to the Securities and Exchange Commission (SEC or Commission) helped the Commission meet a major challenge to modernize stock trading. The series makes a passing reference to Madoff’s role in helping computerize the over-the-counter market for stocks. Madoff’s firm helped drive the illiquid and opaque “pink sheet” market to become the liquid and transparent Nasdaq Stock Market. Episode 1 (25:18). But Madoff played a much bigger role in reshaping the structure of American securities markets.

In 1975, Congress enacted legislation granting the SEC new authority to facilitate the establishment of a national market system for securities.^[1] Among the legislation’s goals was to link securities markets to foster efficiency, enhance competition, and contribute to best execution of customer orders.^[2] Congress left the details up to the SEC. This mandate was fraught with political and technical challenges. Of course, Madoff furthered his own economic interests with the advice he gave to the SEC. Nonetheless, he provided meaningful input to help the agency achieve its goals.^[3]

There are some other elements in the series with which I disagree. I discuss those below:

1. Madoff was not running a purported hedge fund.

Speakers in the series frequently refer to Madoff as a hedge fund. To the best of my knowledge, it was not a hedge fund.^[4] Here’s why:

A hedge fund is a pooled investment vehicle, similar to a mutual fund. If you invest in a hedge fund, you own shares in the fund, not in the portfolio companies that the fund owns. In Episode 2 (46:48) an investor wants to see trading records to prove that he has shares in the stocks that Madoff said he was buying. If Madoff had been running a legitimate hedge fund, the investors would not have had an account with individual positions.

Furthermore, Depository Trust Company (DTC) (discussed below) does not hold positions for individual customers. A broker-dealer that is a participant in DTC will hold all of its positions together. The broker-dealer will have records showing how many shares each customer owns. For example, if XYZ broker-dealer holds 10,000 shares of ABC stock, DTC’s records will show only the 10,000 shares. XYZ broker-dealer’s records will show that Customer 1 owns 5,000 shares, Customer 2 owns 3,000 shares, and Customer 3 owns 2,000 shares. The episode implies that an investor would have been able to see his own positions at DTC. DTC records only would show an aggregate position.

Madoff was running a Ponzi scheme purporting to be an unregistered investment adviser. The irony is that had Madoff been running a real hedge fund, he would not have had to register with the SEC as an investment adviser under the Investment Advisers Act of 1940 (the Advisers Act).

At that time, the Advisers Act had a de minimis exemption from registration. It provided an exemption for “any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under [the Investment Company Act of 1940]….” A money manager’s client is the fund, not the investors in the fund. If a money manager only managed a single fund, it would have qualified for the de minimis exemption. Legitimate hedge fund managers relied on this exemption and did not have to register with the SEC.^[5]

The SEC tried to circumvent the de minimis exemption by adopting a rule requiring the adviser to count the investors in the fund as clients, rather than the fund itself. That change would have required most hedge fund managers to register with the SEC. In Goldstein v. SEC, the Court of Appeals for the District of Columbia Circuit said that the SEC rule was “arbitrary” and vacated it. 451 F.3d 873 (2006).

Congress addressed this issue when it enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.^[6] Section 403 of Dodd-Frank amended Section 203(b) of the Investment Advisers Act to require managers of hedge funds to register with the SEC as investment advisers.^[7]

Some of the investors in Madoff’s fraud probably were hedge funds—pooled investment vehicles.^[8] The fact that funds invested in Madoff did not make Madoff a hedge fund. More importantly, even if Madoff did not have to register as an investment adviser, it would not have shielded him from civil and criminal fraud charges.

2. DTC is not a regulator.

At the end of Episode 2 (46:05), Erin Arvedland refers to the Depository Trust Company as a “regulator.” It is not. It is a clearing agency registered under Section 17A of the Securities Exchange Act of 1934 (the Exchange Act).^[9] A clearing agency is a self-regulatory organization (SRO), meaning that it has some quasi-governmental authority.^[10] SROs are not government agencies and are not full-fledged regulators.

Unlike other SROs, the Exchange Act does not require a clearing agency to enforce its participants’ compliance with the Exchange Act. As a condition of registration as a clearing agency, Section 17A(b)(3)(A) of the Exchange Act requires a clearing agency “to enforce … compliance by its participants with the rules of the clearing agency….” By comparison, a registered securities association, such as FINRA, must have the capacity to enforce compliance by its members and persons associated with its members, with the provisions of this title, the rules and regulations thereunder, the rules of the Municipal Securities Rulemaking Board, and the rules of the association.^[11] “With the provisions of this title” means that a registered securities association must enforce the Exchange Act with respect to its members. That language is conspicuous by its absence in the clearing agency provision. Accordingly, a clearing agency, such as DTC, is not a regulator and its self-regulatory authorities are less extensive than other types of SROs.

Further as noted above, DTC keeps records of its participants’ positions, not the individual positions of the participant’s customers. The SEC’s Office of Investigations Report (“OIR”) on Madoff explains that Madoff’s total positions at DTC were substantially less than the amount that a single customer thought it had. The OIR notes:

We reviewed a January 2005 statement for one Madoff feeder fund account, which alone indicated that it held approximately $2.5 billion of S&P 100 equities as of January 31, 2005. On the contrary, on January 31, 2005, DTC records show that Madoff held less than $18 million worth of S&P 100 equities in his DTC account.^[12]

3. Congress did not cut the SEC’s budget.

Diana B. Henriques says in Episode 3 (19:43) that the SEC budgets had been “cut and cut again.” At the same time, the episode shows a clip of Ronald Reagan saying that “government is the problem.” There also are voiceovers of scenes from the aftermath of 9/11, stating that the SEC was not a priority. I do not agree with this portrayal of events.

The record as to when Madoff began his fraud is not clear, but it stretched for decades. The court records and press accounts are either vague or cite inconsistencies as to when Madoff or others said they began the Ponzi scheme.^[13] The SEC’s Office of Investigations Report noted that investors first complained to the SEC about Avellino & Bienes, a feeder fund, in June 1992.^[14] The SEC received complaints about Madoff during multiple chairmanships across several presidencies.^[15] President Reagan’s last day in office was January 20, 1989. Following the tradition of former presidents, he largely stayed out the political fray and retired to his California ranch.^[16] After a battle with dementia, President Reagan died on June 5, 2004. Showing a film clip of President Reagan sheds no light on the SEC’s failure to investigate Madoff. In my view, the film clip simply invokes a stereotype to inflame the audience.

President Reagan appointed John Shad, a former investment banker, as SEC chairman.^[17] Chairman Shad famously said that he was going to “come down on insider trading with hobnail boots.”^[18] During his tenure, the SEC brought landmark insider trading cases against Dennis Levine and Ivan Boesky.^[19]

The Reagan Administration did not cut the SEC’s budget. According to the New York Times, during Shad’s tenure, by 1986 “the [SEC’s] budget ha[d] grown a modest 35%.”^[20] An increase is not a cut.

Initially, Shad did not favor increasing the SEC’s budget significantly, a position consistent with the Reagan Administration’s views. After the Levine and Boesky cases, Shad said he would seek a major increase in SEC funding from Congress.^[21] Republican members of the Committee on Energy & Commerce of the U.S. House of Representatives supported an increase. The SEC’s 1988 Budget Request urged Congress to increase the SEC’s budget by 27% over the 1987 appropriation. The request sought additional increases for two subsequent years.^[22]

Congress increased the SEC’s budget every year between FY 1983 and 2021, with the exception of three years when the budget was essentially flat. In FY 2002, i.e., after the 9/11 terrorist attack damaged the SEC’s New York Regional Office, Congress added $20.7 million for disaster recovery. For the FYs 1983 to 1994, the median increase in funding was 12.9%, and the average increase was 10.78%. For the FYs 1995 to 2021, the median increase in Budget Authority was 6.09%, and the median increase in Actual Obligations was 7.34%.^[23]

There is no question that after 9/11, the country focused new attention on terrorism and devoted substantial resources to that effort. But there is no evidence to show that Congress cut the SEC’s budget to help pay for those antiterrorism efforts.

I also disagree with Henriques’s statement “that the laws that they [presumably the SEC] could rely on to pursue investigations had been tightened.” Episode 3 (20:03). I do not know which laws she has in mind.

President Reagan did sign into law two tough insider trading bills:

• Insider Trading Sanctions Act of 1984 (P. L. 98-376, Aug. 10, 1984)—among other things, the legislation authorized the SEC to seek a civil penalty against insider traders for as much as three times the profit gained or loss avoided; and
• Insider Trading and Securities Fraud Enforcement Act of 1988 (P.L. 100-704, Nov. 19, 1988)^[24]—among other things, the legislation:
  • allowed the SEC to impose a similar penalty against a person who controlled the insider trader;
  • authorized the SEC to award bounties to informants; and
  • required broker-dealers and investment advisers to have policies and procedures reasonably designed to prevent insider trading.

There is plenty of blame to go around for the SEC’s failure to uncover Madoff sooner. Did Congress give the SEC all the money that it wanted? Of course not. Congress almost never gives any agency the full amount of funding that it seeks. The SEC has to compete for resources with all other agencies. Nonetheless, Congress materially increased the SEC’s funding regardless of which party controlled the White House or Congress.

4. SEC staff do not wear metal badges.

I have never seen an SEC staffer with a metal badge. Episode 3 (43:15). They had laminated identification cards that many wore with chains around their necks. In my day, SEC lawyers kept their IDs handy in their purses or wallets, but avoided wearing them on chains.

*****

Bernie Madoff’s crimes were hideous. He caused suffering to many people around the world. This series is a useful reminder of Madoff’s horrific acts; there is no need to bend the truth for dramatic effect.

© 2023 Stuart J. Kaswell, Esq., who has granted permission to the ABA to publish this article in accordance with the ABA’s Single Title Publication Agreement, which is incorporated by reference.

1. The Securities Acts Amendments of 1975 (1975 Acts Amendments), among other things, amended the Securities Exchange Act of 1934 by adding Section 11A(a)(2), Pub. L. 94-29, 89 Stat. 112 (June 4, 1975). ↑

2. Id. at Section 11A(a)(1)(D). ↑

3. Kaswell, Stuart J. The Bernie Madoff I Knew: How He Gained the Confidence of Regulators and Legislators, Business Law Today, American Bar Association, June 30, 2021. (Explains how Madoff cultivated regulators with respect to the National Market System.) ↑

4. It is wrong to say that a crooked scheme is a hedge fund, even if it claims to be one. It’s fraud. Calling a crooked scheme a hedge fund is like saying that a person who practices medicine without a medical license is engaging in medical malpractice. That person simply is committing a crime. ↑

5. For the reasons noted above, I do not agree with SEC Inspector General H. David Kotz’s description of the registration requirements for hedge fund managers at the time of the Madoff fraud. Episode 3 (16:14).

   The series portrays Kotz sitting adjacent to an SEC logo, which might lead some viewers to assume that he was a member of the SEC staff at the time that that the producers filmed that segment. Kotz resigned his position as inspector general at the end of January 2012. SEC Inspector General David H. Kotz to leave Commission, SEC Press Release 2012-9. ↑

6. P.L. No. 111-203, July 21, 2010. ↑

7. Section 203 of the Investment Advisers Act of 1940 currently provides (deletions; additions):

   (a) Necessity of registration

   Except as provided in subsection (b) and section 203A of this title, it shall be unlawful for any investment adviser, unless registered under this section, to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.

   (b) Investment advisers who need not be registered

   The provisions of subsection (a) shall not apply to-

   (1) any investment adviser, other than an investment adviser who acts as an investment adviser to any private fund, all of whose clients are residents of the State within which such investment adviser maintains his or its principal office and place of business, and who does not furnish advice or issue analyses or reports with respect to securities listed or admitted to unlisted trading privileges on any national securities exchange;

   (2) [no change]

   (3) which read as follows: “any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under subchapter I of this chapter, or a company which has elected to be a business development company pursuant to section 80a–53 of this title and has not withdrawn its election. For purposes of determining the number of clients of an investment adviser under this paragraph, no shareholder, partner, or beneficial owner of a business development company, as defined in this subchapter, shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner, or beneficial owner;”.

   (3) any investment adviser that is a foreign private adviser;

   ↑

8. At one point, Diana B. Henriques quotes Madoff, who says, “I’m not running a hedge fund. I do trades for hedge funds, as I have explained over and over.” Episode 3 (42:28). If the quote is accurate, it may be one of the few times Madoff was truthful when describing his business. ↑

9. The 1975 Acts Amendments also added Section 17A of the Exchange Act. ↑

10. Section 3(a)(26) of the Exchange Act defines a “self-regulatory organization” as, among other things, “any national securities exchange, registered securities association, or registered clearing agency….” ↑

11. Section 15A(b)(2) of the Exchange Act [emphasis added]. ↑

12. “Investigation of Failure of the SEC to Uncover Bernard Madoff’s Ponzi Scheme,” Public Version, Office of Investigations, U.S Securities and Exchange Commission., August 31, 2009, Report No. OIG-509, at 20. ↑

13. Court records and press accounts note that it is unclear when Madoff began the fraud. The OIR does not specify a time and only indicates when the SEC received complaints, as discussed below.

    The Department of Justice alleged that it began “at least as early as the 1980s.” Transcript of Guilty Plea, U.S. v. Bernard L. Madoff, 09 CR 213(DC), S.D.N.Y March 12, 2009, at 32. The government alleged that “at the end [of the scheme], Madoff told his clients that he was holding nearly $65 billion in securities on behalf of those clients. In fact, he had only a small fraction of that amount.” Id. at 33-34.

    According to a CNBC report:

    It isn’t clear exactly when Madoff started crossing the ethical line, particularly because honesty was not his currency. He pegged the start of his scheme to 1987, but he later claimed that it was 1992. Madoff’s account manager, Frank DiPascali Jr., who began working for him in 1975, testified that the illegalities had been going on “as long as I remember.”

    Bernie Madoff, mastermind of largest Ponzi scheme in history, dies at 82, CNBC, April 14, 2021. ↑

14. OIR, at 42 et seq. ↑

15. The following chart indicates when investors or others complained to the SEC and identifies the president and SEC chair at that time.

    Complaints to the SEC	President	SEC Chairman
    June 1992	George H.W. Bush	Richard C. Breeden
    May 2000	William J. Clinton	Arthur Levitt
    March 2001	George W. Bush	Laura Unger (Acting)
    May 2003	George W. Bush	William H. Donaldson
    April 2004	George W. Bush	William H. Donaldson
    October 2005	George W. Bush	William H. Donaldson
    December 2008	George W. Bush	Christopher Cox

    Sources: OIR Report at 20-22; SEC Summary. ↑

16. President Reagan’s gave a farewell address to the nation on January 11, 1989, nine days before the end of his term. The last sentence of his remarks state “and so goodbye, God bless you, and God bless the United States of America”. Saying “goodbye” was unusual and a clear signal that Reagan was finished with public life. President Reagan’s last public speech was on February 3, 1994, on the occasion of his eighty-third birthday. On November 5, 1994, President Reagan released a handwritten letter announcing his Alzheimer’s diagnosis. ↑

17. SEC website. ↑

18. Sloane, John S. R. Shad Dies at 71, S.E.C. Chairman in the 80s, New York Times, July 9, 1994. ↑

19. Id. The SEC noted:

    On November 14, 1986, the Commission instituted the largest insider trading case in its history against arbitrageur Ivan F. Boesky. The Commission alleged that Boesky caused certain affiliated entities to trade in securities while in possession of material nonpublic information concerning tender offers, mergers, and other extraordinary corporate transactions. Boesky was alleged to have obtained this information from investment banker Dennis B. Levine, who previously had been enjoined in a Commission action brought in May 1986.

    U.S. Securities and Exchange Commission, Annual Report, 53d, 1987, at 10 (citations omitted). ↑

20. Sterngold, Shad Seeks SEC Expansion, New York Times, Dec. 6, 1986. John Shad stepped down as chairman on June 18, 1987. SEC Historical Summary of Chairmen and Commissioners (“SEC Summary”). ↑

21. Id., stating:

    John S. R. Shad, the chairman of the Securities and Exchange Commission, said here today that he would be seeking a “substantial increase” in the commission’s budget and staff for the coming fiscal year, the first such major expansion in five years.

    Mr. Shad refused to detail how much funding he was seeking for the year that begins next Oct. 1, but he said that most of the growth would be in the agency’s enforcement division.

    The comments were made to Wall Street executives assembled for the annual convention here of the Securities Industry Association. ↑

22. The SEC’s authorization request was:

    Fiscal Year	SEC Authorization Request
    1988	$153.9 million
    1989	$169.0 million
    1990	$181.1 million

    The request included a proposed 30% increase in budget for enforcement operations. Statement of John Shad, Chairman of the Securities and Exchange Commission, Before the Senate Subcommittee on Securities, Concerning the Commission’s Authorization Request for Fiscal Years 1988-1990, May 13, 1987, at 3. It is important to note that the authorization request is just the first step in a long appropriations process. ↑

23. According to the SEC:

    SEC Total Funding Level

    Line	Fiscal Year	Money $(000)	% Change
    1	1983	$ 88,690
    2	1984	$ 94,000	5.99%
    3	1985	$ 106,382	13.17%
    4	1986	$ 106,323	-0.06%
    5	1987	$ 114,500	7.69%
    6	1988	$ 135,221	18.10%
    7	1989	$ 142,640	5.49%
    8	1990	$ 166,633	16.82%
    9	1991	$ 189,083	13.47%
    10	1992	$ 225,792	19.41%
    11	1993	$ 253,325	12.19%
    12	1994	$ 269,150	6.25%
    Median			12.19%
    Average			10.78%

     

    Sources:
    Lines 1-7	SEC Annual Report 1989, Table 25, Page 162
    Lines 8-12	SEC Annual Report 1995, Table 25, Page 157

    *****

    SEC Budget FY 1995 – 2021 ($ in 000s)
    Fiscal Year	Budget Authority	% Change	Actual Obligations	% Change
    1995	$ 300,437		$ 284,755
    1996	$ 300,921	0.16%	$ 296,533	4.14%
    1997	$ 311,100	3.38%	$ 308,591	4.07%
    1998	$ 315,000	1.25%	$ 311,143	0.83%
    1999	$ 341,574	8.44%	$ 338,887	8.92%
    2000	$ 377,000	10.37%	$ 369,825	9.13%
    2001	$ 422,800	12.15%	$ 412,618	11.57%
    2002	$ 513,989A	21.57%	$ 487,345	18.11%
    2003	$ 716,350	39.37%	$ 619,321	27.08%
    2004	$ 811,500	13.28%	$ 755,012	21.91%
    2005B	$ 913,000	12.51%	$ 887,227	17.51%
    2006	$ 888,117	-2.73%	$ 877,278	-1.12%
    2007	$ 881,560	-0.74%	$ 875,456	-0.21%
    2008	$ 906,000	2.77%	$ 905,313	3.41%
    2009C	$ 953,000	5.19%	$ 960,189	6.06%
    2010	$ 1,111,000	16.58%	$ 1,101,547	14.72%
    2011	$ 1,185,000	6.66%	$ 1,212,859	10.11%
    2012	$ 1,321,000	11.48%	$ 1,289,675	6.33%
    2013D	$ 1,321,000	0.00%	$ 1,276,158	-1.05%
    2014	$ 1,350,000	2.20%	$ 1,415,814	10.94%
    2015	$ 1,500,000	11.11%	$ 1,550,548	9.52%
    2016	$ 1,605,000	7.00%	$ 1,681,882	8.47%
    2017	$ 1,605,000	0.00%	$ 1,651,317	-1.82%
    2018	$ 1,652,000	2.93%	$ 1,687,390	2.18%
    2019	$ 1,674,902	1.39%	$ 1,695,905	0.50%
    2020	$ 1,825,525	8.99%	$ 1,826,552	7.70%
    2021	$ 1,926,162	5.51%	$ 1,954,006	6.98%
    Median		6.09%		7.34%
    Average		7.72%		7.92%

    [SEC] Notes:

    Budget Authority figures above do not include carryover or recoveries

    A. Includes $20,705 for Disaster Recovery, $24,820 carryover for Pay Parity, $30,900 for 2nd Supplemental, & $336 rescission.

    B. Enacted at $913,000, but SEC was required to leave $25,000 unobligated to apply towards FY 2006.

    C. FY09 authority includes $10,000 Supplemental and does NOT include $17,000 reprogramming.

    D. FY13 authority does not include $66,050 sequestration reduction.

    Author’s Note: Information from the SEC appears in columns with a white background. I have calculated the year-to year percentage changes, median change, and average change using Excel. I highlighted those columns in grey. I did not combine these charts because the first set of data did not contrast Budget Authority with Actual Obligations and only identified the figures as “Money.” ↑

24. Kaswell, An Insider’s View of the Insider Trading and Securities Law Enforcement Act of 1988, Securities Law, Administration, Litigation, and Enforcement, Section of Business Law, American Bar Association, Vol. III (1991) at 252. ↑

Investors and stakeholders increasingly understand that long-term success is directly affected by how a company and its Board of Directors (the “Board”) manage environmental, social, and governance (“ESG”) factors. Best practices require that a Board establish and implement a framework for managing ESG concerns to avoid potential issues that may negatively impact the company or its stakeholders. For example, the failure of a Board to adequately address an ESG issue may result in poor market performance, a decline in company share price, and regulatory or legal action. A Board needs to ensure that its company stays up-to-date on mandatory ESG-related disclosure requirements. Regulatory authorities such as the U.S. Securities and Exchange Commission, European Commission, and Canadian Securities Administrators, including the Ontario Securities Commission, are frequently publishing updates and notices of changes to the disclosure regime.^[1] When tackling ESG concerns such as climate change impacts and Board diversity, how can a corporate director avoid facing peril?

ESG Risk Oversight

This article will outline the director’s obligations concerning ESG oversight and provide a framework that Boards can utilize to identify and evaluate ESG risks.

ESG Risk Management Framework

To effectively address ESG, a Board must have mechanisms in place to ensure that it understands how ESG issues may impact the company. This does not mean that directors and Boards must be involved in day-to-day risk management, but rather that directors must fulfill their role in risk oversight. Proper risk oversight of a company requires directors to be accustomed to the company’s ESG risk management policies and procedures. If directors do not disclose material ESG risk and maintain proper oversight, they may face discontent among shareholders, potential litigation, damage to their reputation, or regulatory investigation.

In developing ESG risk management policies and procedures, the company and the Board should establish an appropriate governance structure and allocate the roles and responsibilities of directors and different Board committees. The designation of specific roles ensures that each party knows who is responsible for certain tasks. To determine if ESG risk oversight should be allocated to the full Board or a committee, the Board should consider the nature of the ESG issues, the level of expertise required, the time commitments to achieve meaningful oversight, and the mandates of existing Board committees, if any.

A robust ESG risk management framework within a company is integral to the overall culture and success of business operations. ESG procedures and policies will look different for each company depending on its industry and the type of business, but generally, an ESG risk management system should:

1. identify material ESG risks promptly;
2. implement appropriate ESG risk management strategies that align with the company’s business strategies and ESG risk profile;
3. integrate ESG risk and risk management into corporate strategy and business decision-making; and
4. properly document and communicate necessary information on ESG risks to applicable parties such as employees, shareholders, and senior executives.

To properly manage ESG risk, the risk must first be identified; to identify risks, companies must develop reporting procedures to gather high-quality ESG data. To maintain consistency among different data sets, companies should aim to have a standard process and create central repositories or reference sets for recording ESG data. Ideally, having automatic processes to record data as opposed to manually adding data would minimize errors in data sets.

Given the wide-ranging nature of ESG, a Board should focus on risks and opportunities that are material to its business. Companies may consult an established ESG framework to ensure that all ESG risks are identified or consider whether their stakeholders have a preference for a specific disclosure regime. A Board should also know what is expected of the company in terms of ESG disclosure based on the standards specific to its industry.

Once ESG risks are identified and risk management strategies are implemented, these should be integrated into the company’s corporate strategy and business decision-making. The ESG risks should be assessed and evaluated by the proper parties to determine which actions would best address or mitigate potential issues. Boards should look to establish ESG metrics and targets to track progress and measure and improve their companies’ ESG performance. When establishing ESG metrics, Boards should not only leverage metrics established by various governmental bodies and industry associations but also establish ESG metrics that are specific to the operations of the business and the industry in which it operates.

Once the ESG policies and procedures, including setting ESG metrics and targets, are established and implemented, directors should then ensure that they are functioning in the way the Board and executives intended. To be effective, employees of the company must not only be aware of the ESG policies and procedures, but they must also follow the framework to properly recognize and appropriately escalate ESG risks. The Board must be aware of and align the company’s ESG risk profile and the principal ESG risks on an ongoing basis. To achieve this, the Board should continuously engage in discussions with management regarding potential ESG risks. The Board should also consider incentivizing senior management to meet the company’s ESG targets through ESG metrics in their executive compensation plans. ESG policies should also include procedures designed to ensure that any information required to be disclosed by the company, whether in its annual filings or other reports, is communicated to senior management as appropriate to allow timely decisions regarding disclosure. For public companies, certain ESG disclosure obligations may be dictated by regulatory authorities that have established mandatory ESG reporting requirements. In addition, stakeholders of the company, such as shareholders or lenders, may require the company to provide non-regulatory reports on ESG matters. The Board must be aware of what is required to be disclosed in each instance and whether an ESG concern meets the materiality threshold that means it must be disclosed. Determining materiality in ESG can be complex; public companies can engage third parties to assist with materiality assessments to assist in determining whether a matter should be included in an ESG disclosure the company may make.

ESG Expertise of Board Members

According to PwC’s 2021 Annual Corporate Director Survey, when directors and executives were both asked how well their Board understood ESG matters, 80% of directors felt that their Board understood ESG matters very or somewhat well.^[2] In contrast, when executives were asked the same question, only 47% of executives felt that their Board had a good handle on ESG matters. A Board and the company’s directors should perform ongoing evaluations of whether its members possess the requisite expertise to understand and advise the company on ESG issues. This includes understanding best practices and nuances specific to their market and assessing performance standards when comparing their company to similar companies in the same industry. Therefore, determining the expertise of each board member with respect to ESG matters is essential when assigning roles and assessing ESG risk. As ESG is continuously evolving, directors should consider ongoing training to ensure they have the knowledge to address complex issues relating to ESG.

Conclusion

As a best practice, directors should ensure that the company has an ESG risk management policy that is aligned with the company’s values and is observed by all of its employees and suppliers. Once ESG risks are identified and communicated, directors must then evaluate the ESG risk and implement an appropriate strategy to address the risk. The chosen strategy should then be monitored, reviewed, and appropriately then documented and communicated.

1. Ontario Securities Commission (OSC), CSA Staff Notice 51-364 – Continuous Disclosure Review Program Activities for the fiscal years ended March 31, 2022 and March 31, 2021, November 3, 2022; OSC, Canadian securities regulators consider impact of international developments on proposed climate-related disclosure rule, October 12, 2022. ↑

2. PwC, Board effectiveness: A survey of the C-suite, November 2021. ↑