Constructive receipt is a fundamental tax concept that can have a broad and frightening impact. According to the IRS, you have income for tax purposes when you have an unqualified, vested right to receive it. Asking for payment later does not change that. Childs v. Comm’r, 103 T.C. 634, 654 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996). The idea is to prevent taxpayers from deliberately manipulating their income. The classic example is a bonus check available in December that an employee asks to be withheld until January 1. Normal cash accounting suggests that the bonus is not income until paid; however, the employer tried to pay the bonus in December and made the check available, making it income in December even though it is not collected until January.
Cash v. Accrual Accounting
Constructive receipt is an issue only for cash method taxpayers like individuals. Constructive receipt is built into the accrual method (used by most large corporations), under which you have income when all events occur that fix your right, if the amount can be determined with reasonable accuracy. Treas. Reg. §§ 1.446-1(c)(1)(ii), 1.451-1(a). Thus, you book income in accrual accounting when you send out an invoice, not when you collect it. Rev. Rul. 84-31, 1984-1 C.B. 127. For cash method taxpayers, however, the IRS worries about “pay me later” shenanigans. The tax regulations provide that a taxpayer has constructive receipt when income is credited to the taxpayer’s account, set apart, or otherwise made available to be drawn upon. See Treas. Reg. § 1.451-2.
Effect of Restrictions
On the other hand, there is no constructive receipt if your control is subject to substantial limitations or restrictions. There is considerable debate over what substantial limitations or restrictions prevent constructive receipt. For example, what if an employer cuts a check on December 31 but tells its employee to either drive 60 miles to pick it up or wait for its arrival in the mail? The employer may book this as a December payment (and issue a Form W-2 or 1099 that way), but the employee may have a legitimate position that it is not income until received. Such mismatches occur frequently, and there is little to suggest that there is manipulation going on.
Legal Rights
Whether they know it or not, lawyers deal with constructive receipt issues frequently. Suppose a client agrees orally to settle a case in December, but specifies that the settlement be paid in January. When is the amount taxable? In January. The mere fact that the client could have agreed to take the settlement in Year 1 does not mean the client has constructive receipt.
The client holds legal rights and is free to condition his or her agreement (and the execution of a settlement agreement) on the payment in Year 2. The key is what the settlement provided before it was signed. If you sign the settlement agreement and condition the settlement on payment next year, there is no constructive receipt. On the other hand, if you sign first and then ask for a delayed payment, you have constructive receipt. In much the same way, you are free to sell your house and to insist on receiving installment payments, even though the buyer is willing to pay cash. However, if your purchase agreement specifies you are to receive cash, then it is too late to change the deal and say you want payments over time. The legal rights in the documents are important.
Lawyer Trust Accounts
If a case settles and funds are paid to the plaintiff’s lawyer trust account, it usually is too late to structure the plaintiff’s payments. Even though the plaintiff may not have actually received the money, the lawyer has. For tax purposes, a lawyer is the agent of his or her client, so there is constructive (if not actual) receipt.
Consider the impact of disputes between lawyer and client. Suppose that Larry Lawyer and Claudia Client have a contingent-fee agreement calling for Larry to represent Claudia in a contract dispute. If Larry succeeds and collects, the fee agreement provides that Claudia receives two-thirds, and Larry retains one-third as his fee. Before effecting the one-third/two-thirds split, however, costs are to be deducted from the gross recovery.
Suppose that Larry and Claudia succeed in recovering $1 million in September of 2016. Before receiving that money, however, Larry and Claudia become embroiled in a dispute over the costs ($50,000) and the appropriate fee. Larry and Claudia agree that $25,000 in costs should first be deducted, but Claudia claims that the other $25,000 in costs is unreasonable and should be borne solely by Larry. Furthermore, Claudia asserts that a one-third fee is unreasonable, and that the most she is willing to pay is 20 percent. Larry and Claudia try to resolve their differences but cannot do so by the end of 2016. In January 2017, the $1 million remains in Larry’s law firm trust account. What income must Larry and Claudia report in 2016?
Undisputed Amounts
Arguably, there is a great deal that is not disputed. Larry and Claudia have agreed that $25,000 in costs can be recouped and that Larry is entitled to at least a 20-percent fee, although it is not yet clear if that 20-percent fee should be computed on $950,000 or on $975,000. Nevertheless, Larry is entitled to at least $25,000 in costs and to at least a $190,000 fee, for a total income of $215,000. Although it is not yet clear how much Claudia will net from the case, the minimum she will get is specified in the provisions in the fee agreement. Thus, taking the $50,000 as costs, Claudia should receive two-thirds of $950,000, or $633,270. Even under Larry’s reading of the fee agreement, this is the amount to which Claudia is entitled, although she might receive more if her arguments prevail.
How much should Larry and Claudia report as income? You might think that you do not have enough information to make that decision, and you would probably be right. After all, you do not really know whether Larry and Claudia have agreed that partial distributions can be made, or if they are taking the position that they will not agree to anything unless the entire matter is resolved. However, that does not appear to be so. Indeed, the positions of the parties seem clear that each is already entitled to some money. That gives rise to income, regardless of whether they actually receive the cash. If they have a legal right to the money and could withdraw it, then that is constructive receipt, if not actual receipt.
Any talk of withdrawal should invite discussion of restrictions and partial agreements. For example, what if you add to the fact pattern that, although these are the negotiating positions of Larry and Claudia, neither of them will agree to any distributions, treating the entire amount as disputed. Does that mean neither has any income in 2016? Does it matter what documents are prepared? The answer to the latter question is surely “yes.” Good documentation always goes a long way to helping to achieve tax goals.
For example, an escrow agreement acknowledging that all of the money is in dispute and prohibiting any withdrawal until the parties agree might contraindicate income. A document each party signs agreeing that they disagree and that no party can withdraw any amount until they both agree in writing should be pretty convincing. Even so, I am not sure it is dispositive to the IRS. It may be hard to argue with the fact that the parties’ positions speak for themselves, and that some portions of the funds are undisputed. Besides, there is a strong sentiment that a lawyer is merely the client’s agent. Presumptively, settlement monies in the hands of the lawyer are already received by the client for tax purposes.
Consider the defendant in this example. The defendant paid the $1 million in 2016. Depending on the nature of the payment, it seems reasonable to assume that the defendant will deduct it in 2016. It will likely issue one or more IRS Forms 1099, too, probably to both Larry and Claudia in the full amount of $1 million each. How will Larry and Claudia treat those Forms 1099? There may be a variety of possibilities. Assuming both Larry and Claudia argue the entire amount is in dispute, one approach is to footnote Form 1040, line 21 (the “other income” line), showing the $1 million payment. Then, they might subtract the $1 million payment as disputed and in escrow and therefore not income, netting zero on line 21. There is probably no perfect way to do this.
Escrows and Qualified Settlement Funds
Apart from mere escrows, qualified settlement funds (sometimes called QSFs or a 468B trusts) are also increasingly common. A QSF typically is established by a court order and remains subject to the court’s continuing jurisdiction. Treas. Reg. § 1.468B-1(c)(1). If the fund is a QSF, the defendant would be entitled to its tax deduction, yet neither Larry nor Claudia would be taxed on the fund’s earnings. The fund itself would be taxed, but only on the earnings on the $1 million, not the $1 million itself.
In our example, there is no court supervision, so it seems unlikely that the escrow could be a QSF. If the fund is merely an escrow, either Larry or Claudia should be taxed on the earnings in the fund, but not on the principal until the dispute is resolved and the disputed amount is distributed. Unlike a QSF, escrow accounts typically are not separately taxable, so one of the parties must be taxed on the earnings. See Treas. Reg. §§ 1.468B-6, 1.468B-7.
Normally, the escrow’s earnings would be taxable to the beneficial owner of the funds held in escrow. Rev. Rul. 77-85, 1977-1 C.B. 12 (IRB 1977), modified on other grounds, IRS Announcement 77-102 (1977). Either Larry or Claudia (or both) could be viewed as beneficial owners. Therefore, an agreement specifying who will be taxed on the disputed funds while held in escrow would be wise.
Structured Settlements and Structured Legal Fees
Some clients prefer structured settlements that pay them (through the use of annuities) over time rather than in a lump sum. In a similar way, contingent-fee lawyers who expect to receive a contingent fee are allowed to “structure” their fees over time, but if they receive the funds in their trust account, it is too late to structure. In fact, it is too late to structure fees if the settlement agreement is signed and the fees are payable. A lawyer who wants to structure legal fees must put the documents in place before the settlement agreement is signed. Just as in the case of the plaintiff, legal rights are at stake. In general, a contingent-fee lawyer is entitled to condition his or her agreement on a payment over time.
In reality, of course, it is the client of the plaintiff’s lawyer that has the legal rights and is signing the settlement agreement. That is why a lawyer who wants to structure fees must build that concept into the settlement agreement. Like structured settlements for plaintiffs, legal fee structures usually are not installment payments by the defendant. Rather, the settlement agreement will specify the stream of payments and call for the contingent fee to be paid to a third party that makes those arrangements. As you might expect, it is important for each element of the legal fee structure to be done carefully to avoid the lawyer being taxed before he or she receives installments, but the entire concept of structured legal fees must be mindful of the constructive receipt doctrine.
Understandably, cash method taxpayers do not want to be taxed on monies before they actually receive them; however, the constructive receipt doctrine can upset this expectation. Constructive receipt often can be avoided through careful planning and proper documentation.
More About Qualified Settlement Funds
The rules pertaining to constructive receipt seem to be thrown out the window when using this important and innovative settlement device. A QSF typically is set up as a case is resolved. The IRS provides that a fund is a “qualified settlement fund” if it satisfies each of the following:
It is established pursuant to an order of, or is approved by, specified governmental entities (including courts) and is subject to the continuing jurisdiction of that entity;
It is established to resolve or satisfy one or more claims that have resulted or may result from an event that has occurred and that has given rise to at least one claim asserting certain liabilities; and
The fund, account, or trust must be a trust under applicable state law, or its assets must otherwise be segregated from other assets of the transferor. Treas. Reg. § 1.468B-1(c).
Section 468B trusts allow defendants to pay money into the trust and be entirely released from liability in a case, yet the plaintiffs and their counsel do not have income until the money comes out. The 468B trust is a kind of holding pattern where no one is (yet) taxed on the principal or corpus of the trust. Even so, the defendant can deduct the payment for tax purposes. Any interest earned on the monies in the QSF is taxed to the trust itself. There are many nuances to observe about the use of QSFs.
However, QSFs can be a kind of safety valve from the constructive receipt doctrine. In appropriate cases, QSFs can provide lawyers and clients with additional time to sort out who is entitled to what, to resolve liens, and to arrange for structured settlements and structured legal fees. A QSF allows plaintiffs and their lawyers to resolve such issues after the defendant(s) have paid the settlement or judgment but before the plaintiffs and their lawyers have receipt.
Conclusion
Constructive receipt is a fundamental, yet widely confused, tax doctrine. It applies when you have an unrestricted right to income but you do not accept it. Consequently, lawyers and their clients may encounter constructive receipt concerns if they sign legal releases or are otherwise entitled to payments that they then try to delay. Be careful. A good rule of thumb is not to sign a settlement agreement unless: (1) you are clear on what the timing of the payments will be; and (2) this timing is acceptable to you. Once you (or your client) signs and is entitled to payment, it may be too late to change it. In some litigation, one way to build in payment flexibility can be by using a QSF that holds the funds. A QSF can be especially appropriate in complex cases with multiple parties involving disputes over payment amounts and timing. However you address these issues, no one wants to be taxed on money they have not even received!
On December 6, 2016, the Supreme Court issued its decision in Salman v. United States, clarifying the personal benefit standard of insider trading under the federal securities laws. In resolving what it called a “narrow” issue, the court reaffirmed the long-standing “guiding principle” ofDirks v. SECthat disclosing nonpublic material information to a “trading relative or friend,” even without any showing of pecuniary or tangible gain to the tipper, can give rise to criminal insider trading liability. In such situations, the court concluded, giving is as good as receiving, “the commonsense point . . . made in Dirks.” That is, the “tip and trade resemble trading by the insider followed by a gift of the profits to the recipient.” Salmanthus underscores that market participants should continue to exercise vigilance when disseminating or receiving any material nonpublic information.
The court’s decision resolves a brewing dispute among the lower courts concerning the scope of tipper-tippee liability in insider trading cases. In particular, the Supreme Court took up Salmanto decide whether a tipper had received a personal benefit for purposes of insider trading liability when he or she makes a gift of material nonpublic information to a relative who thereafter trades on that information. The Supreme Court answered in the affirmative, overturning some lower courts, including the Second Circuit, which had previously held that a tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for the tip.
The disagreement among federal courts over the definition of personal benefit, which has caused uncertainty among regulated professionals and their business networks and social contacts, stems from the Supreme Court’s last ruling on this issue, made more than three decades ago in 1983. In Dirks v. SEC, the Court explained that an unlawful personal benefit could be either a benefit that was effectively a cash equivalent, such as “pecuniary gain or a reputational benefit that will translate into future earnings” or, alternatively, “mak[ing] a gift of confidential information to a trading relative or friend.”
In 2014, the Second Circuit in UnitedStatesv. Newman held that a corporate insider who made a gift of confidential information could not be held criminally liable unless the insider also received a personal benefit that “represent[ed] at least a potential gain of a pecuniary or similarly valuable nature.” In the 2015 United States v.Salmandecision, however, the Ninth Circuit rejected the Second Circuit’s limited reading ofDirksand affirmed an insider trading conviction on the basis of an insider who had simply “ma[de] a gift of confidential information to a trading relative or friend.” In its December 16 decision, The Supreme Court affirmed the Ninth Circuit’s decision and thereby overruled the Second Circuit’s more limited reading of insider trading liability.
The Salman Decision
Salman centered on the relationship, and exchange of insider information, between two brothers, one of whom worked at a large investment bank. For more than two years, Maher Kara, who was the banker and the defendant’s brother-in-law, “regularly disclosed” to his brother, Michael Kara, information about upcoming mergers and acquisitions of and by the bank’s clients. Michael traded on that information and also passed it along to Bassam Salman, the defendant. Salman in turn gave the information to another relative, Karim Bayyouk. Salman and Bayyouk, the downstream tippees, then traded on the information and netted over $1.5 million in profits.
The Ninth Circuit found that Maher had disclosed the confidential information knowing that Michael intended to trade on it. According to the Ninth Circuit, the government had met its burden underDirksbecause Maher had testified that, by providing Michael with inside information, Maher intended to benefit his brother and to fulfill whatever needs he had. On one occasion, for example, after Michael requested a favor because he “owe[d] somebody” but turned down Maher’s offer of money, “Maher gave him a tip about an upcoming acquisition instead.” To the Ninth Circuit, this was “precisely the ‘gift of confidential information to a trading relative’ that Dirksenvisioned.”
The Supreme Court agreed, concluding that, under the long–standing rule set forth in Dirks, an insider effectively receives a concrete personal benefit where the disclosure of confidential information is made to a “trading relative or friend.” The court explained that when a tipper gives inside information to a trading relative or friend “the tipper benefits personally because giving a gift of trading information is the same thing as trading by the tipper followed by a gift of the proceeds.” In Salman, the corporate insider, Maher, “would have breached his duty had he personally traded on the information . . . himself [and] then given the proceeds as a gift to his brother.” By disclosing the information to his brother and allowing him to trade on it, “Maher effectively achieved the same result.” The court also overturned Newman to the extent it “held the tipper must receive something of a ‘pecuniary or similarly valuable nature’ in exchange for a gift to family or friends.”
Notably, however, the court’s Salmannarrow ruling is limited to tips made to friends and family. It leaves open the possibility that tips made to acquaintances may be subject to a different standard and may, for example, still require the exchange of something “pecuniary or similarly valuable” to result in insider trading liability. And it leaves undisturbed the requirement that the government show that a trading defendant knew that a corporate insider received a personal benefit in exchange for the tip.
Implications
Salman makes clear that the Court’s decades–old Dirks decision set forth the correct standard for the definition of personal benefit. Under the right circumstances, as exemplified by Salman, the government may prosecute tippers and tippees where the insider conferred gifts or profits to a relative or friend. Thus, in Salman’s wake, government regulators will likely pursue insider trading cases with increased vigor. Absent a need to show that a corporate tipper disclosed confidential information for a tangible benefit or pecuniary gain, the government will likely launch more investigations and litigate more cases involving exchanges with only social or reputational benefits to the tipper. In particular, arrangements in Salman’s mold, where a corporate insider disseminates confidential information to a family member in order to obtain private advantage, may attract increased scrutiny from the government. All told, Salman may make it easier for the government to go after downstream tippees, including those who are multiple levels removed from the corporate insider, as long as they possess knowledge of the initial exchange that was made for direct or indirect personal benefit.
After Salman, corporate professionals are advised to trade with at least the same diligence and care as they have always undertaken. Legal and compliance departments are encouraged to continue monitoring trading activity and encouraging an open dialogue with employees regarding the dissemination and receipt of material nonpublic information. That said, the personal benefit test is a legal issue that need not influence trading decisions. Regulators will likely assess whether there was a personal benefit only after the government has issued a subpoena or otherwise initiated an investigation. But in the meantime, government enforcement activities carry the risk of reputational harm to the business, distraction from core business concerns, and added legal fees and expenses.
Model Business Corporation Act (2016 Revision) Launches
Model Business Corporation Act (2016 Revision): Official Text with Official Comment & Statutory Cross-References was published in December by the Business Law Section’s Corporate Laws Committee. The book is available to order at the Section member price of $329.95 here.
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Sixty-six years ago the Corporate Laws Committee (the “Committee”) of the American Bar Association’s Business Law Section published the Model Business Corporation Act (the “Act” or the “Model Act”). Now substantially adopted by a majority of the states, the Act has strongly influenced the law governing U.S. corporations and is an important and often cited reference for courts, lawyers and scholars. Just as corporate law has evolved over time, so has the Act. The Committee approved a substantial revision of the Act in 1969, less than 20 years after its initial publication, and just 15 years later, in 1984, the Committee adopted what was then called the Revised Model Business Corporation Act, a top to bottom revision of the original Act.
Through periodic amendments, the Act has continued to evolve in significant ways since 1984, as further described below. Until recently, however, the Committee had not undertaken another comprehensive revision of the Act that would facilitate adoption by state legislatures by capturing all of the changes to the Act since 1984. Nor had there been any systematic attempt to revise the Act to eliminate inconsistent terminology and adjust provisions that had become outdated over the more than three decades since the 1984 Revision.
As a result, beginning in 2010, the Committee undertook a thorough review and revision of the Act and its Official Comment. This effort has resulted in the recent publication of the Model Business Corporation Act (2016 Revision) (the “2016 Revision”).
The 2016 Revision, which is based on the 1984 version of the Model Act, incorporates all of the changes to the Act since 1984, provides consistency among provisions, and includes a streamlining and updating of the Official Comment. It also is designed to accommodate the Uniform Law Commission’s Uniform Business Organizations Code for those states that choose to follow a “hub and spoke” business entity statutory approach, as well as serving as a model for those states that wish to continue with a standalone corporation statute.
Most of the substantive changes included in the 2016 Revision have been previously adopted through the regular process for amending the Model Act, in which the Committee publishes for comment a notice of proposed amendments in The Business Lawyer and adopts the amendments after review of any comments received. A June 2016 Exposure Draft of the proposed 2016 Revision was posted on the Committee’s website along with an invitation for comment, particularly regarding matters that were not previously published for comment and adopted as amendments to the Act. After consideration of the comments received, the Committee approved the 2016 Revision at its meeting in September 2016 and published the 2016 Revision in December 2016.
Model Act Innovations
The Model Act, over the years, has made a number of important innovations to corporate statutory law. The following are a few of those made in prior years:
* streamlining the capital provisions by eliminating the concepts of par value, stated capital and treasury shares, permitting the consideration for shares to consist of any tangible or intangible benefit to the corporation, and eliminating the distinction among classes of shares and between classes and series;
* modernizing statutory financial provisions by establishing clearer tests for determining the legality of all types of distributions to shareholders;
* separating director standards of conduct from standards of liability and providing standards of conduct for officers;
* authorizing a provision in the articles of incorporation exculpating directors from liability for monetary damages to the corporation and its shareholders;
* creating a new approach with greater certainty for dealing with director’s conflicting interest transactions;
* adding a safe harbor for dealing with director and officer business opportunities;* requiring universal demand for bringing shareholder derivative actions and establishing certain independent determinations as a basis for dismissal of a derivative action;* permitting adoption of a bylaw for majority vote for the election of directors;* requiring shareholder approval for issuance of shares, other than for cash, that will result in an increase of more than 20 percent of the voting power of the outstanding shares;* authorizing statutory share exchanges, permitting mergers and share exchanges between a corporation and a non-corporate entity, and adopting uniform voting rules for all fundamental changes, including rules regarding separate group voting;
* clarifying when shareholder approval is required for disposition of significant corporate assets by establishing a test of whether the disposition will leave the corporation without a significant continuing business activity and providing as a safe harbor retention of 25% of total assets and 25 percent of income or revenue from continuing operations;
* introducing the concept of domestication to change the state of incorporation and conversion to change the form of entity;
* modernizing the appraisal remedy for dissenting shareholders, including by reintroducing the “market out” provision for non-interested transactions; and
* adding flexibility for non-public corporations, including by authorizing shareholders to establish their own governance rules in unanimous shareholder agreements.
Highlights of Recent Changes
Revisions to the Statutory Provisions. The following are examples of some of the more significant changes in the 2016 Revision since the Act’s prior publication in 2010:
1. Changes Related to the Uniform Business Organizations Code
Many of the amendments reflected in the 2016 Revision stem from the 2011 adoption of Article 1 of the Uniform Business Organizations Code (“UBOC”) by the Uniform Law Commission (“ULC”). That uniform legislation contemplates what is commonly described as a “hub and spoke” form of business entity legislation in which a “hub” contains provisions generally applicable to all forms of business entities and a “spoke” contains the substantive provisions for each form of entity. The Committee is now preparing a “spoke” version of the Act governing business corporations for use by jurisdictions that adopt the UBOC. That version will be drawn from the standalone 2016 Revision, which has been framed so as to make it compatible with the terminology and concepts used in the UBOC.
This adaptation of the 2016 Revision to the “hub and spoke” form of entity legislation accounts for many of the changes in the chapters on domestication and conversion, mergers and share exchanges, and foreign corporations, as well as corresponding changes in pertinent definitions. In particular, the provisions on domestication and conversion have been thoroughly revised, with the separate subchapters in the prior version of the Act for nonprofit conversion, foreign nonprofit domestication and conversion, and entity conversion now combined into the general conversion provisions. For foreign corporations, the most notable change is the elimination of the concept of qualification to do business, and the substitution of foreign corporation registration as a prerequisite to doing business within the state.
2. New Statutory Provisions
The 2016 Revision includes a number of amendments to the Act since its prior publication in 2010 which reflect recent corporate law developments. They include the following:
* new provisions permitting the ratification of defective corporate actions, including actions in connection with the issuance of shares;
* amendments that permit corporations to include in their articles of incorporation a provision that limits or eliminates a director’s or an officer’s duty to present a business opportunity to the corporation;
* addition of a provision permitting the articles of incorporation or the bylaws to specify the forum or forums for litigation of internal corporate claims;
* amendments clarifying the scope and operation of qualifications for nomination and election as directors;
* amendments that eliminate the requirement that a director or officer seeking
advancement of expenses provide a written affirmation that he or she has met the applicable standards for indemnification under the Act or, in the case of a director, that the proceeding involves conduct for which liability has been eliminated under the articles of incorporation;
* amendments permitting the merger of corporations without a shareholder vote
following a tender offer if certain conditions are met; and
* amendments that address the obligations of corporations to make financial statements available to shareholders, the maintenance of corporate records, and the inspection rights of shareholders and directors of corporations.
3. Procedures for Approving Fundamental Changes
The Act has long prescribed similar procedural steps for approval of mergers, share exchanges, amendments of the articles of incorporation, disposition of assets not in the ordinary course of business, dissolution, domestication and conversion. Despite this substantive similarity, the statutory language of the Act varied depending on the form of the transaction. The 2016 Revision amends the fundamental change provisions so that there is uniform language for the procedural steps for approval of these matters.
4. Distributions in Liquidation
The Act did not clearly articulate the treatment of distributions to shareholders made in the course of liquidation after dissolution of the corporation. Accordingly, the 2016 Revision reflects several changes that clarify the establishment of a record date for determining shareholders entitled to receive a distribution in liquidation after dissolution.
5. Corporation Voting its Own Shares
The Act historically has disenfranchised shares held by majority-owned subsidiaries (direct and indirect) of the corporation. The 2016 Revision more clearly prescribes disenfranchisement for shares in which the corporation has the economic interest, including shares owned by or belonging to the corporation indirectly through entities (corporate or non-corporate) that are controlled by the corporation.
6. Director Duties and Eliminating the Term “Public Corporation”
As a result of amendments adopted in 2005, the Act prescribed “oversight duties” for directors of “public corporations.” The Committee concluded that such a sharp demarcation of duties between directors of “public corporations” and other corporations has become increasingly artificial, especially in view of recent federal legislation permitting a greater number of shareholders before a corporation must become an SEC registrant and the evolution of trading of shares of such non-SEC registrants in alternative, secondary securities markets. Accordingly, the 2016 Revision deletes from the Act the specification of particular oversight duties for directors of “public corporations” and places discussion of those duties in the Official Comment as an elaboration on the more general articulation in the Act of the managerial and oversight responsibility of boards of directors. The 2016 Revision also deletes the definition of “public corporation.”
Consistent with the deletion of the definition of “public corporation,” a shareholders’ agreement no longer automatically ceases to be effective when the corporation becomes a “public corporation.” Nonetheless, the Act’s requirement of unanimous shareholder approval will likely make such shareholders’ agreements unavailable to public corporations as a practical matter, and in any event such agreements can still be drafted to effect automatic termination upon occurrence of a specific event such as an initial public offering. Similarly, the Act no longer limits use of a bylaw requiring a majority vote for election of directors to public companies.
7. Effective Date
The Committee found that the Act’s provisions defining when filings and transactions become effective were not internally consistent. The 2016 Revision makes those provisions more uniform and adopts a definition of “effective date” for filed documents that applies throughout the Act. That definition provides definitive rules for when a filing with the secretary of state becomes effective and has been revised to improve its clarity.
Changes Not Intended to Have Substantive Effect. Many of the changes in the statutory provisions of the Act included in the 2016 Revision are stylistic; others are intended to promote internal consistency with the Act’s provisions. The Committee does not intend for any of these changes to have substantive effect, through negative implication or otherwise. For example, the Committee added a provision that a shareholder does not have a vested property right resulting from any provision in the bylaws. This addition aligns with the provision that disavows the vested rights concept in relation to the articles of incorporation. There should be no implication from adoption of that amendment that the vested rights concept had any force in relation to bylaws that were in place before the amendment.
Revisions to the Official Comment. The Committee extensively revised the Official Comment to the Act so that the commentary functions solely as a guide to interpretation of the statutory provisions. Thus, the 2016 Revision:
* eliminates language in the Official Comment that merely restates operative
statutory language;
* eliminates comparisons with prior versions of the Act or with state corporation statutes; and
* eliminates discussion of case law and law review articles.
Conclusion
The Committee hopes that the 2016 Revision of the Act will encourage state legislatures—in states that have already adopted much or all of the Act and in other states as well—to consider adopting the 2016 Revision in full and thereby bring their corporate statutes into line with the most recent developments in corporate law. The 2016 Revision, as a comprehensive and updated Act, affords states the opportunity to modernize their corporation statutes, and in so doing, to enhance the business climate and revenue generating opportunities in their state. In addition, the greater the uniformity among states, the more likely a useful body of law can develop that will increase the certainty and efficiency of corporate actions and corporate transactions.
The Committee stands ready to assist states in this effort and to work with members of the Business Law Section and other groups to help make this happen. The Committee therefore welcomes inquiries about how the newly revised Act might be tailored for adoption in a particular jurisdiction.
New Publication: Model Asset Purchase Agreement for Bankruptcy Sales
Using the Negotiated Acquisitions Committee’s 2001 Model Asset Purchase Agreement as a guide, the Business Bankruptcy Committee created a Model Asset Purchase Agreement for bankruptcy sales. Bankruptcy sales differ in many respects from a non-bankruptcy sale. This publication highlights the differences, includes commentary as a teaching mechanism, and provides ancillary documents and appendices.
This new publication is not a stand-alone asset purchase agreement. Instead, it highlights how certain terms and provisions may vary between a bankruptcy and a non-bankruptcy sale and, in some circumstances, provides commentary and case law to explain the reasoning underlying those variations. This publication about bankruptcy asset purchase agreements (and sales generally) does not include provisions that do not vary between a sale that would be consummated in bankruptcy and one that would be consummated outside of bankruptcy. For example, a definition for “Assets” is not included in this publication as it is generally identical in a bankruptcy and non-bankruptcy asset purchase agreement.
In addition, sample provisions and language not typically in non-bankruptcy asset purchase agreement are included—provisions concerning bid procedures, credit bidding rights, and executory contracts, for example. This publication should be used in conjunction with another asset purchase agreement and, in particular, the Negotiated Acquisitions Committee’s 2001 Model Asset Purchase Agreement. Such an approach will provide you with a comprehensive and flexible agreement for bankruptcy sales as well as a deep understanding of the purposes underlying each provision.
Section members can order the book at the price of $199.95 here.
Payments made under supply-of-goods contracts, or contracts for the sale of goods, are often the subject of bankruptcy avoidance actions. Sections 546(e) and (g) of the Bankruptcy Code (11 U.S.C. § 546(e) and (g)) prohibit the avoidance and recovery of preferential and constructively fraudulent transfers made in connection with forward contracts and swap agreements. Specifically, section 546(e) protects settlement payments made to a forward contract merchant in connection with a forward contract, whereas section 546(g) protects transfers made to a swap participant in connection with a swap agreement.
At first blush, sections 546(e) and (g) seemingly apply exclusively to forward contracts and swap agreements relating to financial markets. Indeed, in amending several of the safe-harbor provisions in 1982, Congress explained that, “the amendments are intended to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries.” H.R. Rep. No. 97-420, at 1 (1982), reprinted in 1982 U.S.C.C.A.N. 583, 583. Yet, despite Congress’s intentions, the terms “forward contract,” “forward contract merchant,” “settlement payment,” and “swap agreement” are so broadly defined that they arguably encompass transfers made in connection with ordinary supply-of-goods contracts. This article explores the Bankruptcy Code’s safe harbors and the ambiguities that can arise when dealing with such contracts.
Section 546(e) and Forward Contracts
Except for actual fraudulent transfers, section 546(e) prevents a bankruptcy trustee from avoiding and recovering: (1) a transfer that is a settlement payment made by or to (or for the benefit of) a forward contract merchant; or (2) a transfer made by or to (or for the benefit of) a forward contract merchant in connection with a forward contract that is made before the commencement of the case. Thus, to establish a section 546(e) defense, a defendant must show that: (1) the underlying agreement between the parties is a forward contract; (2) one of the parties to the agreement is a forward contract merchant; and (3) the transfers at issue constitute settlement payments.
Establishing the Existence of a Forward Contract
A party must first establish the existence of a forward contract to invoke section 546(e). The Bankruptcy Code defines a “forward contract,” in relevant part, as a contract for the sale of a commodity that is presently or in the future becomes the subject of dealing in the forward contract trade with a maturity date more than two days after the date into which the contract is entered. In defining “forward contract,” Congress stated that the “primary purpose of a forward contract is to hedge against possible fluctuations in the price of a commodity. This purpose is financial and risk-shifting in nature, as opposed to the primary purpose of an ordinary commodity contract, which is to arrange for the purchase and sale of the commodity.” H.R. Rep. No. 101-484, at 4 (1990), reprinted in 1990 U.S.C.C.A.N. 223, 226. Although legislative history relating to forward contracts indicates otherwise, the Bankruptcy Code’s definition arguably is broad enough to encompass ordinary supply-of-goods contracts so long as the contract: (1) is for the purchase, sale, or transfer of a commodity or any similar good that is presently or in the future becomes the subject of dealing in the forward contract trade; and (2) has a maturity date more than two days after the date into which the contract is entered.
The broad scope of the term “forward contract” can be limited only by its elements. As for the first element, the Bankruptcy Code specifically defines a “commodity” as wheat, cotton, rice, corn, oats, barley, rye, flaxseed, grain sorghums, mill feeds, butter, eggs, Solanum tuberosum (Irish potatoes), wool, wool tops, fats, oils (including lard, tallow, cottonseed oil, peanut oil, soybean oil, and all other fats and oils), cottonseed meal, cottonseed, peanuts, soybeans, soybean meal, livestock, livestock products, frozen concentrated orange juice, and all other goods and articles in which contracts for future delivery are presently or in the future dealt in. Given this broad, and circular, definition of “commodity,” nearly any and all goods and articles will fall within its scope.
However, the term “commodity” must be “the subject of dealing in the forward contract trade” to fall within the scope of a forward contract. The Bankruptcy Code does not define the term “forward contract trade.” In the context of an ordinary supply-of-goods contract, a litigator could introduce expert testimony to establish that such a contract does not involve a commodity involved in the forward contract trade. Still, the litigator likely will face an uphill battle, as numerous goods and articles are the subject of dealing in the forward contract trade.
As for the second element of a forward contract, the Bankruptcy Code does not define the term “maturity date.” Courts have reached differing conclusions on the term’s meaning. For instance, some courts have held that the maturity date is the date of delivery, while others have held that it is “the future date at which the commodity must be bought or sold.” McKittrick v. Gavilon, LLC (In re Cascade Grain Prods., LLC), 465 B.R. 570, 575 (Bankr. D. Or. 2011).
This lack of consensus is ripe for a savvy litigator to explore. For example, a typical supply-of-goods relationship involves a purchase order for certain goods, delivery of the goods, and payment in full 30 days after delivery. It is unclear at what point the maturity date occurs in such a relationship, if one occurs at all. A litigator could argue that the contract fully matures when the purchase order is issued, when the goods are delivered, or when payment is received. A litigator could even argue that the contract lacks a maturity date, as once the purchase order is issued and accepted, the parties’ obligations have matured. Finally, a litigator could introduce expert testimony to limit the scope of the term “maturity date” to its traditional meaning in the financial markets.
The Forward Contract Merchant Requirement
Having established the existence of a forward contract, one of the parties to the contract must be a forward contract merchant to invoke section 546(e). The Bankruptcy Code defines in section 101(26) a “forward contract merchant” in relevant part as “an entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity or any similar good . . . which is presently or in the future becomes the subject of dealing in the forward contract trade.” Courts and commentators alike have interpreted this definition broadly and narrowly. For instance, Collier on Bankruptcy ¶ 556.03[2] (Alan N. Resnick & Henry J. Sommer eds., 16th ed.) provides that “[t]he language ‘in whole or in part’ in th[e] definition substantially broadens its coverage to include any person that enters into forward contracts as or with merchants in a commodity business context.” At least one bankruptcy court has followed Collier’s broad definition, which arguably would apply to supply-of-goods contracts.
Other courts, however, have followed a narrower definition espoused by Judge Dennis M. Lynn in Mirant Americas Energy Marketing, L.P. v. Kern Oil & Refining Co. (In re Mirant Corp.), 310 B.R. 548 (Bankr. N.D. Tex. 2004). In that case, Judge Lynn focused on the undefined terms “business” and “merchant” within the term “forward contract merchant” and found that the definition is limited in scope. Specifically, Judge Lynn defined “merchant” as “one that is not acting as either an end-user or a producer. Rather, a merchant is one that buys, sells, or trades in a market.” Judge Lynn further defined “business” as “something one engages in to generate a profit.”Accordingly, the court defined a forward contract merchant to be “a person that, in order to profit, engages in the forward contract trade as a merchant or with merchants,” with “merchant” meaning an individual or entity that is not acting as either an end-user or a producer.This construction gives effect to all parts of the definition because “[w]ithout references to ‘business’ and ‘merchant,’ the definition of ‘forward contract merchant’ could as easily have been ‘a person that enters into forward contracts.’”Most courts have adopted this interpretation over Collier’s construction.
Judge Lynn’s interpretation, if followed, might preclude the application of section 546(e) to an ordinary supply-of-goods contract. In such a context, a buyer simply purchases goods from a supplier. The buyer is an end-user and the supplier is a producer. To fall within the definition’s scope, a merchant would have to buy, sell, or trade the underlying contract in a financial market. This interpretation is not only logical, but also gives effect to Congress’s overall intentions in enacting section 546(e).
Transfers as Settlement Payments
Once the existence of a forward contract and forward contract merchant are established, a defendant must finally show that the transfers at issue constitute settlement payments. The Bankruptcy Code at section 101(51A) defines a “settlement payment” as, “for purposes of the forward contract provisions of this title, a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade.” Although tautological, courts have held that a commodity settlement payment must, at a minimum, be some kind of payment on a commodity forward contract.Therefore, any payment on account of a forward contract likely falls within the definition, making this element easily met.
As the foregoing discussion demonstrates, the requirements to enter the safe harbor are seemingly straightforward, but the definitional issues may make section 546(e) much broader than Congress intended.
Section 546(g) and Swap Agreements
If unable to meet any of the elements contained in section 546(e), a party may seek protection under section 546(g). Except for actual fraudulent transfers, section 546(g) prohibits a bankruptcy trustee from avoiding a transfer made by or to (or for the benefit of) a swap participant or financial participant, under or in connection with any swap agreement that is made before the commencement of the case. To establish a section 546(g) defense, a defendant must show that: (1) the parties entered into a “swap agreement”; (2) one of the parties to the swap agreement is a “swap participant” or “financial participant”; and (3) the transfer was made “under or in connection with” the swap agreement. The second and third elements rarely are litigated because the essential element is whether a swap agreement exists. If a swap agreement exists, section 546(g) undoubtedly will be satisfied because the transfer sought to be avoided will be in connection with a swap agreement to a “swap participant,” which is defined as an entity that, at any time before the filing of the petition, has an outstanding swap agreement with the debtor.
Establishing the Existence of a Swap Agreement
The Bankruptcy Code defines a “swap agreement” broadly as, in relevant part, a commodity index or a commodity swap, option, future, or forward agreement.Although the Bankruptcy Code defines a “forward contract,” it does not define a “commodity forward agreement.” The leading and only authoritative case on the term “commodity forward agreement” is the Fourth Circuit’s decision in Hutson v. E.I. du Pont de Nemours & Co. (In re National Gas Distributors, LLC), 556 F.3d 247, 259–60 (4th Cir. 2009). In that case, the Fourth Circuit held that a commodity forward agreement exists when the following are present: (1) the subject of the agreement must be a commodity; (2) the agreement must require a payment for the commodity at a price fixed at the time of contracting for delivery more than two days after the date into which the contract is entered; (3) the quantity and time elements of the agreement must be fixed at the time of contracting; and (4) the agreement must have a relationship with the financial markets (although it need not be traded on an exchange or be assignable).
Subject to the previous discussion regarding section 546(e), the first three elements for a swap agreement likely will be met in the context of an ordinary supply-of-goods contract. Yet, the contract must also have a relationship with the financial markets. Whether this is the case depends on the terms of the contract. For instance, a purchase order for oil could have a relationship to the financial markets if the price of the oil depends on the overall market price for oil. On the other hand, a purchase order for corn at a fixed price likely lacks a relationship with the financial markets. Again, a litigator could use expert testimony to determine whether the agreement has such a relationship.
To be fair, Hutson’s interpretation of “commodity forward agreement” is problematic because it nullifies the forward contract merchant requirement that exists in section 546(e). In other words, a contract that does not meet the definition of “forward contract” for purposes of section 546(e) may meet the requirements of a forward agreement for purposes of section 546(g). In reaching its decision, the court in Hutson determined that the term “agreement” is broader than the term “contract”: “As Black’s states, the term ‘agreement,’ although frequently used as synonymous with the word ‘contract,’ is really an expression of greater breadth of meaning and less technicality. Every contract is an agreement; but not every agreement is a contract.”Using Hutson’s definition, any party to a commodity forward agreement can invoke the safe-harbor protections, even if neither party is a forward contract merchant.
Whether this was Congress’s intention is unclear. On the one hand, Congress seemingly intended a broad definition by stating that “[t]he use of the term ‘forward’ in the definition of ‘swap agreement’ is not intended to refer only to transactions that fall within the definition of ‘forward contract.’ Instead, a ‘forward’ transaction could be a ‘swap agreement’ even if not a ‘forward contract.’” H.R. Rep. No. 109-31, at 122 (2005), reprinted in 2005 U.S.C.C.A.N. 88, 184. On the other hand, Congress also stated that “[t]he definition of ‘swap agreement’ . . . should not be interpreted to permit parties to document non-swaps as swap transactions. Traditional commercial arrangements, such as supply agreements . . . cannot be treated as ‘swaps’ under . . . the Bankruptcy Code because the parties purport to document or label the transactions as ‘swap agreements.’”
As of now, the Hutson elements, if followed, would protect any commodity forward agreement that has a relationship with the financial markets, even if neither party is a forward contract merchant. Similar to section 546(e), the definitional issues of section 546(g) may render section 546(g) broad enough to encompass supply-of-goods contracts.
Conclusion
Congress’s adoption of sections 546(e) and 546(g) has created unintended results. Although clearly seeking to protect transfers made in connection with forward contracts and swap agreements relating to financial markets, Congress may have inadvertently protected transfers made in connection with ordinary supply-of-goods contracts. If the legislative history surrounding the safe-harbor provisions accurately reflects Congress’s intentions, the provisions should be amended to expressly exclude supply-of-goods contracts. As it currently stands, litigators that prosecute or defend bankruptcy avoidance actions should familiarize themselves with the safe-harbor provisions because their ambiguities may present unanticipated curveballs in what normally are considered straightforward avoidance actions.
Do you have a financial interest in or signature authority over a foreign nest egg that is worth over $10,000 on any day of the year? Then you cannot afford to hide your head in the sand and ignore the annual Report of Foreign Bank and Financial Accounts (FBAR) filing and recordkeeping requirements. In addition to negligence or fraud penalties, steep civil and/or criminal penalties may apply if you fail to file the FBAR. What can happen, you ask? Consider the creator of Beanie Babies, H. Ty Warner, as an example. In 2008, he paid $53.6 million (i.e., 50 percent of the maximum balance of his foreign account), one of the largest FBAR penalties the United States has collected to date. United States v. Warner, 792 F.3d 847 (2015). Enough to make anyone’s feathers ruffle!
The United States requires its citizens, residents, and domestic entities to file FBARs because foreign financial institutions (unlike domestic ones) are not under U.S. jurisdiction and, therefore, are not subject to U.S. reporting obligations and to the power of the U.S. district courts to enforce the Internal Revenue Service’s (IRS) summons authority. The United States has several foreign asset filing requirements (see Chart 1). However, the FBAR is unique in that, unlike the IRS forms and schedules depicted in Chart 1, the FBAR is not a tax return protected under the taxpayer confidentiality rule, found in IRC (Internal Revenue Code) section 6103. Rather, it is a required yearly report, regardless of whether income is earned. It assists the United States with ferreting out secret foreign accounts used to fund international terrorist activities, launder money, hide income, and other illegal acts. Accordingly, it is freely shared among a network of law enforcement agencies.
Additionally, the FBAR, or the Financial Crimes Enforcement Network (FinCEN) Form 114 (formerly TD F 90-22.1), is not filed with the IRS but electronically through the FinCEN BSA E-filing system (no paper filing as of July 2013). Beginning in 2017, the FBAR due date will be moved from June 30 to April 15, and a maximum six-month extension to October 15 will be allowed (as a result of the enactment of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015). Thus, this new due date will coincide with that of tax return filings.
Since the Bank Secrecy Act’s (BSA) enactment, the FBAR has been around for over forty-five years, and is codified in Title 31 of the U.S. Code. Then why all the recent attention? Because the United States has stepped up FBAR enforcement efforts.
During the late 1990s, there were few FBAR indictments. In response to the tragic events of September 11, 2001, however, the United States made several efforts to improve the tracking of foreign funds. In April 2003, through a Memorandum of Agreement, FinCEN delegated full civil investigatory and enforcement authority to the IRS, giving the IRS power to assess and collect penalties, investigate civil violations, employ the summons power, issue administrative rulings, and take any reasonably necessary enforcement actions. The advent of the American Jobs Creation Act of 2004 (Jobs Act) created more stringent civil penalties for noncompliance. In 2008, the Department of Justice launched a crackdown into secret overseas assets, starting with Swiss Bank UBS, one of Europe’s largest financial institutions. In February 2009, UBS entered into a deferred prosecution agreement, agreeing to pay a settlement of $780 million to the United States as well as to identify over 4,000 U.S. taxpayers with hidden Swiss accounts. Finally, in March 2010 came a momentous change in the detection of offshore tax evasion: Congress passed the Foreign Account Tax Compliance Act (FATCA). FATCA enhanced the enforcement of the FBAR through mandatory disclosures by both foreign financial institutions (FFIs) and U.S. taxpayers. As IRS Commissioner John Koskinen commented in a March 15, 2016 IRS News Release, “Taxpayers here and abroad need to take their offshore tax and filing obligations seriously.”
This article focuses on the elements triggering a mandatory FBAR filing (with a skeletal flowchart) and concludes with a short overview of the possible outcomes for noncompliance.
Do You Need to File an FBAR?
To make the determination whether you are obligated to file an FBAR, ask yourself the four questions presented in Flowchart 1. Certain IRS forms and schedules also direct you to a possible FBAR filing requirement, if you check the box “Yes” as to having a financial interest or signature authority over a foreign financial account (see Item 5 of Chart 1).
Question 1: Is the Filer a U.S. Person?
Under the BSA, U.S. persons include: (1) U.S. citizens; (2) U.S. residents; and (3) entities formed within the United States. For FBAR purposes, the United States includes the 50 states, the District of Columbia, the territories and insular U.S. possessions (i.e., American Samoa, the Commonwealth of the Northern Mariana Islands, the Commonwealth of Puerto Rico, Guam, and the U.S. Virgin Islands), and the Indian lands as defined in the Indian Gaming Regulatory Act. Children are also included in the definition of U.S. persons, although their parents or guardians may file on their behalf. Let us look at these terms in more detail:
(1) Citizens. U.S. citizens are those with a U.S. birth certificate or naturalization papers.
(2) Residents. Residents are individuals who meet one of the following tests: (1) the green card test (i.e., a green-card holder who has entered the United States); (2) the substantial presence test (i.e., physically present in the United States for at least 183 days out of the current year, or at least 31 days during the current year and the sum of the number of days as calculated in IRC section 7701(b)(3) ); and (3) the resident alien election (i.e., filing a first-year election to be treated as a U.S. resident alien under IRC section 7701(b)(4)).
(3) Entities. Domestic entities may be corporations, partnerships, LLCs, estates, or trusts. The key to determining whether an entity is required to file an FBAR is the law under which it was created (e.g., state certificate of incorporation). A foreign entity that has elected to be treated as a U.S. entity for U.S. tax purposes and a foreign subsidiary do not need to file an FBAR. However, a domestic parent (or U.S. individual) may be obligated to file an FBAR if it has a financial interest in a foreign subsidiary that owns an offshore account.
The entity’s tax exemption and disregarded federal tax status are irrelevant for FBAR reporting purposes. For example, a domestic charitable organization, IRC under section 501(c)(3) and a single-member LLC may be obligated to file an FBAR (in conjunction with his or her owner), despite their tax situation.
Domestic subsidiaries may be exempt from filing an FBAR, however, if their parent entities name them in a consolidated FBAR. A parent may file a consolidated FBAR on behalf of itself and its subsidiary if it is formed under U.S. law, owns a greater than 50-percent interest in its subsidiary, and files an FBAR (which includes its financial and other information as well as its subsidiary’s). Thus, Subsidiaries O2, a California corporation, and O3, a Nevada corporation, do not need to file an FBAR when Parent O1, a Delaware corporation, files a consolidated FBAR (identifying all reportable accounts, itself, and its subsidiaries; see Part V of FinCEN Form 114).
Question 2: Does the Filer Have a Financial Interest in a Foreign Financial Account?
This question involves three special terms, namely, “foreign,” “financial account,” and “financial interest.” First, what does “foreign” mean, for FBAR purposes? It does not refer to the financial institution’s nationality, but to its geographical location outside the United States, District of Columbia, the Indian lands, and the territories and insular possessions of the United States. So, an account in a branch of a French bank that is located in New York is not a reportable account. By contrast, an account in a branch of a U.S. bank that is located in France is a reportable account.
What about “financial account”? This includes but is not limited to the following:
bank account, or an account maintained with a person engaged in the business of banking, such as a checking account;
securities account, or an account with a person engaged in the business of buying, selling, holding, or trading stock or other securities, for example a brokerage account;
commodity futures or options account;
insurance or annuity policy with a cash value, such as a whole life policy;
mutual fund or similar pooled fund, meaning a fund that issues shares to the general public that have a regular net asset value determination and regular redemption (foreign hedge funds and private equity funds are excluded); and
any account with a person that is in the business of accepting deposits as a financial agency. See 31 C.F.R. (Code of Federal Regulations)
§1010.350.
Let us examine a couple of financial account examples. In a 2016 case, the district court ruled that a U.K. poker fund, used for the exclusive purpose of facilitating poker playing, was not a financial account. Similarly, a credit card is generally not an account. However, the IRS posited, in I.R.S.Legal Memorandum 2006-03-026 (Jan. 20, 2006), that a credit card may constitute an account if the cardholder was making advance payments and using the card like a debit card or checking account. Likewise, a safe deposit box is customarily not an account; however, if it is used in ways similar to an account, such as holding and issuing cash to the owner and facilitating the transmission of funds or extension of credit, then the IRS may argue that it is an account (IRS’s expressed position at the June 12, 2009 ABA Section of International Law’s Committee on International Taxation).
Finally, what does “financial interest” mean? The regulations define it as a U.S. person being the foreign account’s owner of record or having ownership or control over the owner of record, which rises to a level of having a financial interest. Generally, it can be any one of these possibilities: (1) an owner of record; (2) an agent; or (3) a U.S. person with greater than a 50-percent interest in an entity (either directly or indirectly) that owns a foreign account. Let us examine each of these situations in more detail:
Owner of record (or legal-title holder). A U.S. person has a financial interest if he or she is the legal owner or titleholder of a foreign account, regardless of whether he or she benefits from the account. This is true even if the account is used for the benefit of a non-U.S. person. If there are multiple U.S. persons who share ownership or title to the account, then each of them has a financial interest and a separate FBAR obligation (e.g., each U.S. co-trustee of a trust with an offshore account).
An exception exists for a married couple that jointly owns a foreign account(s). In that case, the couple may file a joint FBAR as well as complete and sign FinCEN 114a, Record of Authorization to Electronically File FBARs. Nevertheless, to prevent the risk of joint FBAR liability due to a noncompliant spouse, each spouse may file his or her own separate FBAR. If one spouse has signature authority and/or separately owns other offshore account(s), then each spouse should separately report his or her FBAR, including those jointly held account(s).
Agent, nominee, attorney, or a person acting on behalf of a U.S. account beneficiary. A U.S. person has a financial interest in an account if he or she uses an agent (or other person acting on his or her behalf) to acquire account benefits. For example, if U.S. citizen Oscar opens a foreign account in the name of his brother Ollie, who maintains it for Oscar’s benefit, such as in paying Oscar’s bills, then Oscar has a financial interest. If Ollie is a U.S. citizen or resident, then Ollie also has an FBAR reporting requirement.
Note: Financial interest encompasses those U.S. persons who may desire to avoid an FBAR obligation with a non-U.S. agent or nominee who obtains account benefits on their behalf (i.e., FBAR responsibilities follow economic reality). Thus, if a U.S. individual structures a foreign entity (e.g., trust or corporation) to own his or her overseas accounts, that individual still has a financial interest in the offshore accounts. The regulations’ anti-avoidance provision captures situations in which U.S. individuals create entities for the purpose of evading their FBAR obligations.
Person with a direct or indirect interest (e.g., voting power or equity interest) that is greater than 50 percent in an entity (e.g., corporation or trust) that is the record owner or titleholder of a foreign account. This situation may take on various scenarios, but we will focus on corporations and partnerships. If a domestic or foreign corporation directly or indirectly owns an overseas account, then a U.S. person who owns more than half of thetotal value of the corporate shares of stock or voting power of all shares of stock has an FBAR reporting obligation. Similarly, if a domestic or foreign partnership owns an offshore account, then a U.S. person who directly or indirectly owns more than half the partnership’s profits or capital has an FBAR reporting requirement.
To illustrate, U.S. resident Odell owns 75 percent of a California parent corporation that, in turn, owns 100 percent of a foreign subsidiary that has a foreign account. Both Odell and the California parent must file an FBAR because they are both U.S. persons with a majority financial interest in the total value of shares of the foreign subsidiary’s stock (even though Odell’s interest is indirect).
In contrast, if Odell owns only 40 percent of the California parent corporation while each of his children own 20 percent, none of the family members have an FBAR financial interest (unless, as described above, the anti-avoidance rule applies). Nevertheless, they may still have an FBAR reporting requirement if they have signatory authority over the offshore account.
Question 3: Does the Filer Have Signature or Other Authority Over the Foreign Account?
Signature or other authority is defined as an individual (either alone or in conjunction with another) who can control the disposition of account assets (e.g., withdrawing funds) by directly communicating (e.g., in writing or by oral mandate) with the person in charge of maintaining the account. 31 C.F.R. § 1010.350(f)(1). In other words, “signature or other authority” means that a financial institution will act upon a person’s direction (although more than one individual’s communication is required), regardless of whether the power is exercised.
Generally, a person who can control the deposits and withdrawal of bank funds has signature or other authority. The mere ability to control the investment of funds does not constitute such authority. Likewise, there is no such authority when an individual is an intermediary in the chain of command regarding the disbursement of account property. However, if the intermediary were introduced for the purpose of evading FBAR reporting, then the IRS can impose a higher FBAR penalty for a willful violation.
Let us look at an example: Omar opened an Australian account and hired an Australian attorney for the purpose of serving as the power of attorney over the account. Omar gave his partner the authority to make the account’s investment decisions and to instruct the attorney, but not the bank. Here, Omar has a financial interest because he is the owner of the account.Additionally, his attorney has signature authority allowing him to control the disposition of account funds by directly communicating with the bank representative who maintains the account. However, Omar’s partner has no such authority because he can control only the investment of account funds and is unable to control any transmission of these funds.
FBAR reporting exceptions apply to the following officers and employees who have signature or other authority but no financial interest: (1) certain financial institutions; (2) certain authorized service providers; or (3) certain entities whose security is listed on any national security exchange or registered under section 12(g) of the Security Exchange Act. See 31 C.F.R. § 1010.350(f)(2).
For all other officers and employees who have signature or other authority but no financial interest, the regulations impose a duty to file an FBAR. However, the IRS has granted several extensions (from May 31, 2011 to December 8, 2015) and a new filing due date of April 15, 2017. See FinCEN Notice 2015-1. On March 1, 2016, FinCEN proposed to modify the regulations by exempting certain officers, employees, and agents of domestic entities with signature or other authority but no financial interest, provided that the FBAR is otherwise reported by the entities and that the entities maintain records regarding these individuals for at least five years.
Question 4: Is the Aggregate Value of All the Foreign Financial Account(s) Greater Than $10,000 at Any Time during the Calendar Year?
Now it is time to dust off your calculators! Aggregate value refers to the highest total amount of all those offshore accounts (in which you have either a financial interest or signature or other authority) at any time from January 1 to December 31.
You may rely on periodic quarterly or more frequently issued statements so long as they reasonably reflect the maximum account balance during the year. So, if you make several-thousand-dollar deposits in one month and withdraw all those monies before the end of the monthly statement, then your statement will not fairly reflect the largest account balance.
To determine your maximum account balance, you must value each account’s largest amount separately. Based on the Treasury Reporting Rates of Exchange’s (https://www.fiscal.treasury.gov/) end-of-year conversion rates, each account’s local currency value is transformed into U.S. dollars. You then add the maximum values of all your foreign accounts to see if you exceed the threshold of $10,000. Make sure that you do not double count the same monies transferred from one account to another.
For example, Oliver opened three Swiss bank accounts: A ($3,000 balance), B ($3,000 balance), and C ($2,000 balance). Presently, Oliver need not file an FBAR because the total account value of his overseas accounts is below $10,000. Suppose, however, that he closes bank account C and transfers the entire amount to account D. Suppose further that the value of each of his accounts increased by $1,000 during the following year. In that case, although none of the accounts (A, B, or D) individually exceed the threshold amount, their aggregate value does, so Oliver has an FBAR obligation. Note also that the transferred monies from account C to account D are counted only once.
What Are the Rules for U.S. Persons With a Financial Interest in or Signature or Other Authority for 25+ Foreign Financial Accounts?
Currently, the regulations provide that, if a U.S. person has a financial interest in 25 or more accounts, then that person may provide certain basic information regarding these accounts. A similar rule applies to those with signature or other authority over 25 or more accounts. See 31 C.F.R. § 1010.350(g). However, detailed information should be available upon the request of either the IRS or FinCEN (i.e., recordkeeping is still mandatory). On March 1, 2016, FinCEN proposed to make detailed information about all such offshore accounts mandatory, despite their numerousness.
Conclusion
In summary, the FBAR is a yearly, mandatory report on offshore accounts that helps the government to combat tax evasion, money laundering, and other illegal activity. As can be seen from the above FBAR requirements, there can be multiple filers for one account, such as joint owners and account co-signers. Accordingly, each filer may be subject to a penalty for noncompliance.
Civil penalties range from $10,000 for a non-willful violation (i.e., good-faith inadvertence, mistake, or negligence) to the greater of $100,000 or 50 percent of the amount of the transaction or account balance at the time of the willful violation (e.g., an intentional violation or a conscious effort to avoid learning about the FBAR reporting and recordkeeping requirements). Both criminal and civil penalties may be imposed simultaneously, as well as non-FBAR penalties (e.g., an accuracy-related penalty). However, the IRS may apply mitigation measures, provided that certain conditions are met. In addition, there is penalty relief if the violation was: (1) due to reasonable cause (i.e., a violation despite an exercise of ordinary business care and prudence); and (2) the amount of the transaction or the balance of the account at the time of the transaction was properly reported.
If you believe you have an FBAR filing requirement (or may be a delinquent FBAR filer), you should consult with your tax professional. Quietly disclosing your late FBAR may open you to risks (e.g., filing an amended return and past-due FBAR without reasonable cause and enrollment in an FBAR amnesty program). There are different options for delinquent FBAR filers; for example, the streamlined program for a non-willful violation and the offshore volunteer disclosure program (OVDP) for a willful violation, which may be better than paying the full penalty. Of course, it is best to avoid all penalties by timely filing; therefore, remember that, when it comes to the FBAR, do not be an ostrich!
Raising seed capital is not easy. Most entrepreneurs raise capital by using up savings, soliciting donations or small loans from friends and family, or convincing a local bank to provide a loan, which usually requires personal collateral and years of cash-flow projections, which are fairly arbitrary for a business that has not even started yet.
Many entrepreneurs seek out angel investors or, at later stages, consider going public, but even for more mature start-ups, going public is not always feasible. There are substantial legal and accounting costs associated with taking a company public, not to mention the complexity of facilitating and keeping up with ongoing reporting and disclosure requirements.
The goal of this article is to give small businesses some creative and viable financing ideas that do not require expensive legal filings, complicated securities regulations, or even angel investors.
Subscriptions and Preselling Products
So far, preselling a product generally is not considered selling a security in most states; therefore, regulators have not interfered with these rewards-based funding ideas. United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 852 (1975) (the Supreme Court reasoned, “What distinguishes a security transaction […] is an investment where one parts with his money in the hope of receiving profits from the efforts of others, and not where he purchases a commodity for personal consumption […].”). See generally 15 U.S.C. § 77b(a)(1). The key to ensuring that preselling does not attract the attention of securities regulators seems to be making sure that customers who purchase the product do not receive any extra financial return in exchange for their payment (in addition to the product itself, that is). Buyers can receive their purchased products weeks or months after paying for their order. Put another way, funds can be raised from the public, in advance, without restrictions on the amount of money raised or the number of customers, and without subjecting the business to securities registration, reporting requirements, and the associated fees.
KICKSTARTER, for example, lets you set up a company project and accept money from any person in exchange for products, services, or other copies of the work produced. Indiegogo offers donors VIP perks in exchange for their donations. Awaken Café in Oakland California raised money to open a new store by preselling its coffee. Michael H. Shuman, 24 Top Tools for Local Investing (Oct. 11, 2013), available at http://michaelhshuman.com/wp-content/uploads/2013/12/Top-Tools-2.0.pdf. Some co-ops, like Weaver Street Market, a natural foods grocery store in North Carolina, offer their members a t-shirt, bag, and coupons to buy the market’s food products in exchange for their membership fee.
Allowing investors to prepurchase goods and services is a good way to attract more investors and, more importantly, customers all in one go; whereas, simple requests for donations are a one-way street—donors receive nothing in return for their contribution, and they may or may not decide to become a customer.
As mentioned previously, another benefit of this financing option is that federal securities laws generally do not apply to this kind of transaction because products, rather than securities, are sold. Forman, 421 U.S. at 852 (1975). State securities regulators, however, may have a different point of view. For example, in 1959 a country club in California presold club memberships and used the membership funds to start the business. Under federal securities laws, these memberships likely would not be considered securities, but a California court found that there was a significant risk that the business might fail before members got a chance to use their membership benefits. Because of the risk of loss involved, the memberships were deemed securities, and the club was found to be in violation of state securities laws for not registering the membership sales with California’s state securities regulator. Silver Hills Country Club v. Sobieski, 55 Cal. 2d 811, 814–16 (1961). But see Moreland v. Dep’t of Corp., 194 Cal. App. 3d 506, 522 (1987).
Roughly 17 states, including California, use the risk-capital test to determine whether a presold good might be considered a security (Alaska, Arkansas (1987), California, Georgia, Guam (Appellate Division, 1981), Hawaii (1971), Illinois, Michigan, New Mexico, North Carolina, North Dakota, Ohio (10th District, 1975), Oklahoma, Oregon (1976), Washington, Wisconsin, and Wyoming). Cutting Edge Capital, What is a security, and why does it matter? (last visited Dec. 2016). The risk-capital test focuses on whether there is a possibility that an investor will lose value (i.e., money) rather than whether the investor might make a profit from the investment, and has three elements: “(1) an investment, (2) in the risk capital of an enterprise, and (3) the expectation of a benefit.” Joseph C. Long, 12 Blue Sky Law § 2:80 (2014). For example, an investor in a risk-capital state might prepurchase 100 widgets. If the investor never receives the 100 widgets, then the investor has lost money, which potentially would make the transaction a security in a risk-capital state. In states that do not follow the risk-capital model, however, the investor never expected to receive a profit when paying for the widgets; consequently, the transaction likely will not be classified as a security. Therefore, it is important to understand how your state defines a security.
In addition to understanding securities regulations, budgeting and planning will be a critical part of preselling your product. Costs like taxes on the income and the shipping, packaging, and manufacturing expenses should be kept in mind when the orders start rolling in.
Further examples of this financing model in action include Credibles, an online food voucher company that lets anyone prepay a local restaurant for food that they will eat in the future. When the customer makes payments, they receive credits to use at their favorite restaurant. The restaurant owners receive those payments in advance and use the funds to grow their businesses.This strategy is not news to local farmers, who commonly have customers pay in advance for a year’s worth of produce, giving the farmer enough money to cover planting costs.
Gift Cards and Coupons
As far as securities laws go, selling regular gift cards is very similar to preselling products. In fact, one start-up called Stockpile actually allows customers to buy stock and place it on a gift card to give to someone else. Discounted gift cards, however, may be cause for concern from a regulator’s perspective. For example, if you sell a gift card with a purchasing value of $20 for only $15, then the gift card owner technically has the expectation of receiving $5 worth of extra value for his or her money. Unfortunately, this looks to regulators fairly similar to hedging futures on Wall Street.
As a general rule of thumb, securities regulators usually look to the substance and characteristics of a transaction, rather than the label you use for it. Sec. & Exch. Comm’n v. Howey Co., 328 U.S. 293, 298 (1946). See also Tcherepnin v. Knight, 389 U.S. 332, 339 (1967). Anything that creates an expectation of an increased value or profit, over and above what was given in exchange for it, can be characterized as a security. For instance, if you issue coupons that can be used later to buy a product, the market value of the product that will be purchased might increase in value between the time for which the coupon is paid and the time the product is actually purchased. Getting a deal like this arguably encourages people to buy coupons to get extra value (i.e., as does any other investment).
When it comes to selling gift cards and coupons, some ideas for avoiding regulator attention might include limiting gift card maximum values, having a fixed value, and having very clear disclaimers to purchasers that the gift card is not a security. In addition, there are other legal considerations. These include federal limits on card fees that may be charged to customers, if and when the card should expire, and what should be included in any required disclosures. See Kaufman v. Am. Express Travel Related Serv. Inc., 283 F.R.D. 404 (N.D. Ill. 2012) (wherein American Express failed to notify purchasers of the full terms and conditions applicable to its gift cards). For example, money on a gift card cannot expire in less than five years after purchase under the Credit Card Accountability Responsibility and Disclosure Act of 2009 (commonly referred to as the CARD Act), 12 C.F.R. § 1005.20(e)(2), and card service fees generally cannot be charged under 12 C.F.R. § 1005.20(c)(3) and (d) unless there is no activity on the card for at least one year and prior disclosure of the fee is made. In addition, gift cards that are issued in amounts greater than $2,000 may be subject to certain additional recordkeeping and reporting requirements under the Bank Secrecy Act (otherwise known as the Currency and Foreign Transactions Reporting Act of 1970, 31 C.F.R. § 1010.100(ff)(4)(iii)(A) (2011)).
Each state also has its own separate restrictions and requirements as well, which preexempt the CARD Act rules described above (e.g., expiration is not permitted at all in about half of all U.S. states). Emily Atkin, 3 Tips to Keep Gift Cards from Bestowing Legal Trouble, Law360 (Sept. 24, 2013); National Conference of State Legislatures, Gift Cards and Gift Certificates Statutes and Legislation (last updated Apr. 22, 2016). Some states prohibit imposing fees on gift cards. Also keep in mind that, if the gift card is purchased in one state and used in another, there may be two different sets of gift card laws with which to comply.
Keeping within a few guidelines, gift cards are a good way to avoid costly regulatory fees and, according to some marketing research, tend to make customers who shop with gift cards less sensitive to price and spend more money, not to mention the potential for referral business. A gift card vendor can offer information about what type of gift card might be most suitable.
Cooperatives
A cooperative is a group of members that pool their capital to make a common purchase, such as a piece of real estate. All members usually are co-owners of the collective purchase and are entitled to take advantage of any services provided by the cooperative and to use the purchased item, which an individual might not be able to afford alone.
Cooperatives do not just work in real estate. Equal Exchange is an example of a successful produce cooperative that has over 100 owner employees. Though Equal Exchange also raises money through selling securities and using an exemption from securities laws, a primary source of funding comes from employee contributions that do not require going through securities regulators. Daniel Fireside, How Equal Exchange Aligns Our Capital with Our Mission (May 29, 2015). Similar to many other types of businesses, each owner periodically gets a share of profits and losses, one equal vote in making decisions for the business, and an opportunity to serve on the managing board. Employees each put half of their annual profit earnings into a joint account used to reinvest in the co-op. Other cooperatives, like Coop Power, a consumer-owned energy cooperative in Massachusetts, pool funds from customers (who contribute and become members) and use the pool of capital to run their businesses, which involves investing in other sustainable energy businesses and developing job training programs.
The SEC has given certain cooperatives an exemption from registration requirements under federal securities laws. 17 C.F.R. § 240.15a-2. See Forman, 421 U.S. at 858. For example, collectively buying an apartment building through a licensed real estate agent generally is not subject to securities laws, even if each investor’s ownership interest takes the form of a share of stock, so long as the primary purpose of the purchase was not to make a profit from increases in the property value. Forman, 421 U.S. at 851. See also Grenader v. Spitz, 537 F.2d 612 (2d Cir. 1976), cert. denied, 429 U.S. 1009 (1976). Typically, the primary purpose of such a purchase is to have a place to live.
Based on court rulings thus far, a cooperative is more likely to qualify for an exemption if:
members are prohibited from selling or transferring their membership interest to others;
voting rights are equal, rather than directly proportional to the amount contributed;
membership interests do not appreciate in value over time;
the primary purpose or motive of the contribution is not financial gain (Forman, 421 U.S. at 851–54); and
all members are actively involved in management of the cooperative (Howey, 328 U.S. at 301).
State securities laws vary. Some states have an exemption from securities laws for all cooperatives, some do not have an exemption, some have a limited exemption if certain conditions are met (e.g., a maximum contribution amount is imposed), and others only have exemptions for certain kinds of cooperatives (e.g., farmer’s cooperatives). See Ariz. Rev. Stat. Ann. § 10-2080 (2015); Ariz. Rev. Stat. Ann. § 10-2146 (2015); Cal. Corp. Code § 25100(m) (West Supp. 1983); Ark. Stat. Ann. § 67-1248(a)(12) (1980). Also see Colo. Code Regs. 11-51-307(1)(j) (2015); Mass. Ann. Laws ch. 110A, § 402(a)(12) (Michie/Law. Co-op. Supp. 1983); Tex. Rev. Civ. Stat. Ann. art. 581-5(N) (Vernon Supp. 1982–83). Therefore, it cannot be stressed enough how important it is to be familiar with your state’s point of view.
Revolving Loan Funds
Another way to attract investors is to offer loans that pay a reasonable interest rate. In addition to borrowing funds from the community and/or members, some organizations take loans from investors and then use those funds to make microloans to other businesses and earn interest. For example, the La Montanita Grocery Co-op in New Mexico uses its members’ capital to financially support local farmers and food processors. Mountain Bizworks, a small business lending company headquartered in North Carolina, borrows money from investors, lets the investors choose their own loan terms, and loans the pooled funds to other small businesses.
Generally, a loan is represented by a promissory note. The definition of a security under the Securities Act at 15 U.S.C. § 77b(a)(1) includes any “note.” However, the law is not black and white about whether a promissory note is a security; the question is whether the note resembles a security close enough. For example, some ways to differentiate a loan from a security include:
providing some collateral for the loan (offering collateral also attracts more lenders);
disclosing to all lenders: (1) that the loans are not intended to be securities or registered pursuant to securities laws; (2) what laws would apply to protect the lender in the event of default (e.g., FDIC laws); and (3) the specific purpose of the loan;
advertising primarily through private networks, rather than to the general public;
keeping the number of lenders to a minimum;
using the funds for specific business purposes, rather than general business use;
offering investors that contribute to your loan fund services perks or products instead of interest in return (which is evidence that the lenders’ main interest is to make the business grow, not to earn a profit on an investment);
offering a very low interest rate (i.e., well below the prime market rate) if you do decide to pay interest;
borrowing from a bank or credit union rather than individuals (when possible); and
setting the loan term for less than nine months. 15 U.S.C. §§ 77c(a)(3), 78c(a)(10); See also Exch. Nat’l Bank of Chicago v. Touche Ross & Co., 544 F.2d 1126, 1137–38 (2d Cir. 1976) (created a rebuttable presumption that a note with a maturity greater than nine months is a security unless it bears a strong family resemblance to an item on the judicially crafted list of exceptions); Reves v. Ernst & Young, 494 U.S. 56, 64–65 (1990); Lee Lashway, Promissory Notes as “Securities”—A Trap for the Unwary? (July 16, 2013); HG.org, When Is a Promissory Note a Security?(last visited Dec. 2016).
As with all other types of fundraising, keep in mind that both federal and state laws should be followed. Lending laws in both the lender’s state and borrower’s state may apply.
Certificates of Deposit
Regular bank CDs generally are considered bank deposits rather than securities, which keeps CD issuers relatively safe from securities registration and reporting. Marine Bank v. Weaver, 455 U.S. 551, 555–61 (1982); 15 U.S.C. § 78a(10); 12 U.S.C. § 1813(l). SeeLloyd S. Harmetz, Frequently Asked Questions About Structured Certificates of Deposit, Morrison & Foerster LLP, (2015), at 4. As many small business owners already know, local banks and credit unions are not eager to make business loans without full collateral. That is not only because conservatism often makes good business sense, but also because, by law, banks are required to be conservative with their assets.
Some local businesses have created a financing model that involves a three-way partnership with banks and investors essentially to get fully collateralized loans from banks using CDs. For example, Equal Exchange created its own private CD. Equal Exchange advertises its CD publicly, and anyone who wants to invest in its purpose simply buys the CD from Eastern Bank. In exchange, like a normal CD, investors get the future return of their principle plus reasonable interest. Eastern Bank then loans the funds back to Equal Exchange to help finance its business. Essentially, investors who buy the CDs are agreeing to allow the CD funds to be used as cash collateral for the line of credit to Equal Exchange. In the event that Equal Exchange defaults on its loan to Eastern Bank, Eastern bank keeps the investor’s deposit. Daniel Fireside, How Equal Exchange Aligns Our Capital with Our Mission (May 29, 2015).
Similarly, Alternatives Credit Union in Ithaca has formed a partnership with several local, environmentally focused businesses. The Credit Union offers CDs to any investor interested in contributing to the betterment of the environment. The investor’s deposits are pooled and distributed as loans to various businesses that share this common purpose. Alternatives Credit Union not only facilitates the CD/loan set-up for small businesses, but also helps nonprofits by matching the nonprofit’s funds raised dollar-for-dollar and issuing microcredit loans with the combined amount. For example, if investors purchase a total of $5,000 in CDs, Alternatives loans out a total of $10,000 to the intended beneficiaries of that nonprofit.
A regular CD usually is FDIC-insured (or NCUA-insured in the case of credit unions), and the investor is entitled to a return of his or her deposit if the bank goes under. 12 U.S.C. § 1821(f)(1); Federal Deposit Insurance Corporation, A Guide to What Is and Is Not Protected by FDIC Insurance (last visited Dec. 2016); Federal Deposit Insurance Corporation, When a Bank Fails—Facts for Depositors, Creditors, and Borrowers (last visited Dec. 2016). This insurance protection may be what keeps securities regulators from seeing the need to get involved. Harmetz, Frequently Asked Questions About Structured Certificates of Deposit, Morrison & Foerster LLP (2015). However, the insurance recovery is only available in the event that the bank becomes insolvent. Default of the small business on its loan to the bank will not qualify for FDIC insurance coverage under 12 U.S.C. § 1821(b), (f)(1). Therefore, the investor’s funds are still wholly at risk if the business defaults, just as any other collateral would be.
This model requires that the investor be aware that he or she is putting up collateral on behalf of a small business owner who may not be able to do so. The risk for the investor is essentially the same in a CD-loan set-up as it would be if the investor had made a loan directly to the small business. The benefit of this set-up, however, is that the bank acts as a facilitator and administrator of the transaction, adding a sense of legitimacy and formality to the deal. In addition, banks and credit unions are experts at processing loan paperwork, handling cash, and providing regular reporting statements to both the investor and the small business borrower.
Conclusion
In short, there are many creative funding structures, including the few discussed above, that can allow small businesses to access a wider number of contributors without spending large amounts of money on legal and accounting fees and without becoming overburdened with extensive reporting and disclosure requirements.
Trevor Norwitz delivered the following remarks at the 2016 Delaware Business Law Forum, held in Wilmington, Delaware, during the week between Halloween and Election Day.
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Is the Delaware appraisal rights remedy in need of repair? You may as well ask: is the American electoral system in need of repair?
In both cases the flaws are manifest and the scary results apparent. The difference is that the Delaware legislature can easily fix the General Corporation Law to eliminate the artificial and socially destructive phenomenon of appraisal arbitrage. This, of course, is the investing strategy in which an arbitrageur buys shares in a target company after the announcement of a deal specifically for the purpose of asserting appraisal rights. It is a recent development that has resulted directly from judicial interpretations of the outdated wording of section 262. Appraisal arbitrage leads to perverse incentives, unjust results, and a reduction in overall social benefit. Delaware lawmakers brought this Frankenstein creature into the world; they can and should take it out. (I hope you will forgive my gruesome metaphors and horror-flick references, but it is Halloween week, and we are still living through “The Nightmare on Pennsylvania Avenue.”)
Note that the question is not, “Is Section 262 good enough?” “Good enough” is not good enough for the State of Delaware. Delaware is the greatest jurisdiction for corporate law in the world—its sensible statutes; highly responsive legislators; sophisticated, fair-minded, and efficient judges; superb bar; and unparalleled deal- and case-flow all combine to make it the jurisdiction of choice for states in which to incorporate, conduct M&A deals, and litigate. That is good for Delaware. It is also good for business and for America. Delaware’s excellence in corporate law is part of America’s “secret sauce.”
In embracing appraisal arbitrage, however, Delaware distinguishes itself negatively, adding complexity and inequity to deal-making and threatening stockholder value in a wide range of transactions.
I am not arguing today for a total revamp of the appraisal rights remedy, such as the inclusion of a market out (which many other states recognize). I am not even arguing that the appropriate time for appraisal to attach should be the stockholder vote rather than the closing, or that stockholders should have to vote against a deal in order to assert appraisal rights. There are good arguments that can be made for those positions, and I believe those are conversations worth having over time. Today I am merely urging that the legislature should pluck the low-hanging fruit with alacrity. A modest amendment can eliminate the looming dark cloud of appraisal arbitrage. The need is clear and the fix is easy: dissenters’ rights should be for dissenters, not for speculators.
My learned opponent likely will say that this is all overblown, that Delaware’s judges are perfectly capable of making sense of the statute as it is and of dispensing justice to the parties before them, that the law was recently amended and should be given time to work before making more changes, and that appraisal arbitrage is actually beneficial.
These are inapt arguments. Of course Delaware’s judges are capable of dispensing justice, but they should not have to twist themselves into pretzels to deal with a poorly worded, outdated statute, creating artificial and perverse incentives in the process.
The fact that the statute was recently amended—seemingly as a compromise between the interests of the appraisal arbitrage community on the one hand, and those of Delaware corporations and their stakeholders on the other hand—is no reason not to fix the law. The interests of appraisal arbitrageurs should have no more weight in determining the appropriate legislative outcome to this question than the interests insider traders should have in determining what our insider trading laws should be.
I would like to be clear that I am not suggesting that appraisal arbitrageurs are evildoers who must be stopped. Well, they must be stopped, but that is because what they are doing is bad for Delaware corporations and stockholders and, ultimately, bad for Delaware and for America, not because they are bad people. They are merely doing what opportunistic investors are supposed to do, namely, find market inefficiencies, or gaps and loopholes in the law, and take advantage of them to divert wealth to themselves. I should not even call it an abuse. They are really just doing their civic duty by pointing out that our laws are broken and, as currently written, allow them to profit at everyone else’s expense. If they point this out to us and we do not fix it, then that is not their fault. Shame on us.
Why do I say that appraisal arbitrage leads to perverse incentives, unjust results, and a reduction in overall social benefit? Because it does. Let us go back to basics.
When you are buying a business, the most fundamental things you must know are what you are going to get and what you are going to pay for it. That is the essence of the deal—the quid and the quo. Buyers know they have to take some risks on the “get” side and go to great lengths and cost to minimize them, but at least they have some certainty as to what they will pay for the company they are buying, right? Unfortunately, in Delaware today that is not right.
Today, if you are buying a Delaware corporation, you can participate in an auction admirably conducted by independent directors unquestionably satisfying their fiduciary duties, engage in tough negotiations with those independent directors, compete with other bidders, potentiallty get held up by activist “bumpitrageurs” and be forced to raise your price to get their support, then have the stockholders of the target company approve the transaction based on full and fair disclosure—by a majority of the minority if you are a controlling stockholder—and still run a significant risk of having to write a large check years later because an “expert” testifies based on a subjective discounted cash flow (DCF) analysis, or a petitioner points to your success in running the business since you bought it, that the price you paid did not reflect fair value for the company.
You paid a market-clearing price in a fair and open process, yet you face a claim that the price was not fair; the fair price—which no one offered to pay—was really 30, 40, or even 50 percent higher.
This is not just a theoretical risk. These are basically the core facts of the Dell appraisal decision handed down a few months ago, which I will talk a bit more about (and in which, in the interests of full disclosure, my firm represented Michael Dell). This risk is one that troubles buyers of Delaware companies (especially private equity firms), preventing them from paying the highest prices they can pay or causing them to structure deals in ways that are not optimal just to avoid the appraisal risk. This means that it is also a worry for Delaware companies looking to sell because they know that buyers cannot pay top dollar due to the asymmetrical appraisal risk: the buyer takes all the downside risk, but arbs get an option on the upside.
Buyers must take all known risks into account, and they know what likely lies ahead: aggressive activist investors who get multiple bites at the proverbial apple. After negotiating the deal with independent directors, the buyer is not only at risk of the “headless highwayman” who jumps out from behind the bushes and tries to force a price bump before the stockholder vote (remember, it is Halloween week), but now must also worry about being chased for years after the deal closes by “zombie stockholders” who were never real investors in the company in the first place. These arb-zombies invested in a litigation play, not in the company.
Buyers must protect themselves, and they will. Sometimes they can structure a deal specifically to avoid appraisal rights, even if it is not the most economically desirable or efficient manner in which it could be done. In one large, pending merger in which my firm is involved, the deal was originally going to include some cash consideration for stockholders who wanted cash, but that changed. I am not going to go beyond the public disclosure, but it is a matter of public record that originally this was proposed as a stock-and-cash deal with appraisal rights. There was discussion over an appraisal condition, and by the time the deal was announced, it was an all-stock deal with no appraisal rights. Companies should not have to factor in appraisal risk when determining the optimal deal structure. If buyers cannot avoid the risk structurally, they must deal with it some other way, typically by holding back some of the price they would have been willing to pay to all stockholders so that they can pay off the “highwaymen” and the “zombies.” Of course they are never going to admit to holding back, but as someone who sits in these meetings and strategizes with the decision-makers, I can assure you that what they are calling the “Dell-risk” is not lost on anyone. A sizable appraisal award could make the difference between a successful transaction and an unsuccessful one. In a leveraged deal, where the risks to the buyer are significant and the margin for miscalculation is razor thin, it can mean the difference between viability and insolvency.
The only argument anyone has offered to suggest that there is any social value to appraisal arbitrage at all is that it performs a “policing” or “monitoring” function in that it discourages abuse by controlling stockholders. That claim applies only to conflict transactions, or squeeze-outs. It has absolutely no force to the vast majority of arm’s-length deals, and even in conflict deals, that was never the purpose of appraisal. Delaware already has a mechanism for discouraging abuse by controlling stockholders called fiduciary duty litigation, and Delaware lawyers and judges are the olympians of that particular blood sport. If there is a view that the Delaware courts are incapable of enforcing fiduciary duties of controllers and directors, someone should try to make that case, and anyway the remedy would be to improve that mechanism if it is flawed. Allowing statutory appraisal rights to be abused as a back-door method of policing fiduciary duties not only leads to injustice, but also creates perverse incentives throughout the system.
Here’s why: the great advantage of appraisal suits from the claimants’ point of view is that they do not have to prove or even allege any wrong-doing by the board, controlling stockholder, or anyone else; they must only convince a judge (years after the deal) that the fair value of the shares at closing was greater than the deal price. What this means is that, if the board or controller can be shown to have acted improperly (i.e., to have breached their fiduciary duties), then all stockholders share in any recovery. If the board and controllers cannot be said to have done anything wrong—as was the case in Dell—only the opportunistic “hold-outs” benefit from any award. That is not right. If stockholders were, in fact, harmed by a bad process, and that can be shown, they should all be made whole. In addition, it creates perverse incentives, not only on the part of the arbitrageurs (who know that buyers will hold back value from stockholders at large to satisfy their more aggressive claims), but also on the part of buyers themselves (who, frankly, know that there are far fewer holdouts seeking appraisal than there are stockholders).
So how did we get into this scary movie? (I am not sure whether you would call it “American Werewolf in Wilmington” or “Rocky Horror Appraisal Show.”) Not surprisingly, through a series of unrelated, mostly well-intentioned acts that had unintended consequences.
Appraisal rights themselves are not the problem. They have been part of Delaware law longer than any of us have been alive. Delaware companies never had to worry about them too much. They were not pursued very often and only resulted in large awards in egregious circumstances where there was real abuse of an insider position (e.g., Emerging Communications).
Section 262, added to the General Corporation Law in 1967, provides that a stockholder of a corporation engaging in certain fundamental transactions may, so long as their shares are not voted in favor of the transaction and certain other formalities are followed, ask the Court of Chancery to appraise the fair value of their shares. The legislative history of this provision is clear that this was intended to compensate minority stockholders who dissented from a fundamental transaction like a merger for the loss of their right to veto it. That appraisal rights were intended as a remedy for dissenting stockholders has been explicitly recognized by Delaware courts for decades (see, e.g., Weinberger, Technicolor and Transkaryotic).
Over the years, the appraisal remedy evolved: Weinberger opened up the range of permissible valuation techniques, whereas a series of later cases (see, e.g., MG Bancorp and Cox Radio) established DCF as the strongly favored valuation technique for establishing going-concern value. Golden Telecom posited that the Court of Chancery may not simply defer to the merger price full stop, but had to undertake an independent appraisal.
A key development was the dematerialization of shares. Unlike in 1967 when section 262 was enacted, we live in a world where almost all public company shares are held through depositaries in undifferentiated fungible bulk, as Chancellor Chandler so poetically put it. The question arose as to what should happen when a stockholder who bought shares in the market was not able to establish the statutory precondition to asserting appraisal rights, that the shares were not voted in favor of the transaction—that they were really dissenting shares. Almost 10 years ago, in Transkaryotic, the Court of Chancery held, regrettably, that the literal language of section 262 did not require that appraisal seekers must actually demonstrate that their shares were not voted in favor of the transaction. It is sufficient that enough shares were not voted in favor by the depositary for it to be mathematically possible. At the end of his decision, Chancellor Chandler noted the concern that his decision would “pervert the goals of the appraisal statute by allowing it to be used as an investment tool for arbitrageurs as opposed to a statutory safety net for objecting stockholders.” However, relief, he wrote, “more properly lies with the legislature.”
In effect this was a double invitation: to the arbitrageurs to “pervert the goals of the appraisal statute by allowing it to be used as an investment tool” and to the legislature to stop them. Sadly, only one of those invitations has thus far been taken up.
Even though Transkaryotic noted, like many cases before it, that appraisal rights were created as a remedy for “dissenting stockholders,” the interpretation it adopted allowed one to seek appraisal of shares one owns or later buys without being a dissenting stockholder as to those shares.
Transkaryotic laid the groundwork for a new industry—appraisal arbitrage—which was pioneered in part by members of the Delaware plaintiff’s bar who saw the lucrative potential in this legislative misalignment. Funds were raised specifically for the purpose of targeting this strategy, and a few years ago the all-out assault was launched, with a host of appraisal claims brought by speculators who were not real stockholders of the target companies. Among the first deals targeted were the buyouts of Ancestry.com, Ramtron, and BMC software. (In the interests of full disclosure, my firm represented Ancestry.com.)
Vice Chancellor Glasscock, in his first decision in Ancestry (that case has become known as Ancestry I), followed Transkaryotic and allowed the arbitrageurs to pursue their claims. He repeated Chancellor Chandler’s admonition that, if the legislative intent behind appraisal rights was not met by the words of the statute, then it was for the legislature, not the judiciary, to fix. Unfortunately, that has still not happened, and that is why we are having this debate.
After Ancestry I, a great hue and cry was heard across corporate America. Many people in business, legal practice, and academia (myself included) wrote to warn of the danger of appraisal arbitrage and implore the Delaware legislature to fix the statute. The problems were well-documented, including subversion of the legislative purpose, the uncertainty and deal risk created by buyers’ not knowing what they will have to pay, and the risk that they would hold back consideration to pay off arbitrageurs or seek to insert appraisal conditions in deals, which create dangerous uncertainty for both sides, but especially for sellers.
These problem were then exacerbated by the very high statutory interest rate that, in this current low-interest-rate environment, created an irresistible “heads I win; tails I win a bit less” dynamic. When the current statutory interest rate was adopted about 10 years ago, it was double the federal discount rate; now it is six times the federal discount rate.
Plaintiff’s lawyers were, to a large degree, driving the appraisal arbitrage gravy train, using slick marketing presentations to show hedge funds how to profit from appraisal arbitrage. Billions of dollars in hedge fund money were now targeting this unintended little aberration in the law.
The appraisal arbitrage claims kept coming—Dole, Petsmart, Safeway, Zale, and on and on. By one account, appraisal actions were filed in about a quarter of all Delaware transactions eligible for appraisal, making up a substantial part of the Delaware Court of Chancery docket. Add to the parade of horribles the wasting of judicial resources and the diversion of judicial brainpower to the intricacies and rabbit-holes of DCF analyses.
After all the fuss over Ancestry I, the Delaware Corporation Law Council proposed a partial measure to ameliorate the problem. I assume everyone here knows that this proposal was to exclude small, de minimis nuisance claims and to allow companies facing appraisal suits to make partial payments to the appraisal claimants, thereby cutting off the compounding above-market interest as to the amount paid. This proposal was criticized as inadequate by some (including yours truly), but it became embroiled with the fee-shifting tempest in a teapot, and the Delaware legislature did not take it up in 2015.
Then last year, we went into a period of a few months when the Court of Chancery was issuing its valuation determinations in a number of appraisal cases, and these decisions—Ancestry II, Autoinfo, Ramtron, and BMC II—suggested that, so long as a proper sale process was followed, the court would show a high degree of deference to the negotiated deal price. This “judicial solution” made people feel a lot better. The critics of the council’s proposal were mollified by the comforting notion that, even if the statute still facilitated appraisal arbitrage, the judges would step in to ensure that the rights were not abused. In that environment, the council repeated its anti-nuisance and partial-payment recommendations in 2016, and these changes were adopted by the legislature, taking effect this past August.
The recent revisions to section 262 are not very controversial as far as they go, but they do not go nearly far enough. This is because, at best, they may reduce but do not eliminate the artificial incentive to arbitrage appraisal rights. They may actually encourage appraisal arbitrage because they create a path for up-front funding for the litigation costs. Appraisal arbitrageurs will get most of their capital back, be able to pay their lawyers, and still be able to roll the dice for the upside. In Atlantic City they call this “playing with the House’s money.” It is early days, but so far in most cases, companies facing arbitrageur claims have chosen not to pre-fund their attackers, and the changes do not appear to have affected the tide of appraisal claims much.
At the time, however, with this legislative tweak and the Court of Chancery emphasizing the gravitational force of negotiated deal prices so long as a proper sale process was followed, a warm and fuzzy feeling set in among the M&A community. People stopped worrying and quit whining. (The noise level went from Texas Chainsaw Massacre to Silence of the Lambs.) It felt safe to go back into the water. Then came Dell. That decision made a lot of us feel like those holidaymakers on the beach at Amity Island.
Let us briefly recall the salient facts in Dell, as recounted in the court’s opinion. Dell Inc. was in deep trouble, facing declining prospects and a “changing ecosystem.” One analyst cited by the court called the company a “sinking ship.” Its stock was plummeting, its market share was declining, and its projections kept dropping lower and lower. Blue-chip private equity parties were dropping out of the process like Republican presidential candidates. KKR said it could not get its arms around the risk to the PC business; TPG said the cash flows were too uncertain and unpredictable to establish a business case.
The independent special committee of the Dell board ran an exemplary sales process. They negotiated hard and they achieved the best price that was available in the market. After the deal’s announcement, they engaged a second bank to run a full-go shop, which reached out to 60 new parties. Blackstone took a whiff and passed; there was only one guy who actually made a proposal: Carl Icahn. Talk about the mouse going to the cat for love. Icahn did not want to buy Dell, of course, but rather was merely playing his favorite game of “bumpitrage” and succeeded in extracting a price bump as tribute for his support of the deal.
The entire process followed in this case was pristine. Vice Chancellor Laster so held, noting expressly that, “this court could not hold that the directors breached their fiduciary duties or that there could be any basis for liability.” Indeed, the Vice Chancellor praised the manner in which the members of the special committee, acting for the sellers, conducted themselves, as he did Michael Dell, the controlling stockholder who was the largest member of the buyout group. Nevertheless, he found that the fair value of Dell was almost one-third higher than that hotly negotiated, stockholder-approved price that had even won Arbzilla’s approval.
In his decision, the Vice Chancellor effectively acknowledged that the fair value he decided on was not attainable in the circumstances in which the Dell special committee found themselves. It was not available in the market. There were no strategic buyers (as the Dell board and its advisers had correctly determined). All of the private equity firms who bid based their offers, as private equity firms do, on what they could afford to pay to receive the rate of return they required to justify the investment and the risk of taking on huge debt. Nevertheless, he determined that the fair value for statutory appraisal purposes was 28 percent higher than the established fair market value.
Was a great injustice done in Dell? Of course not. Only a small percentage of the overall shares had perfected their appraisal rights. The arbitrageurs who held them were very happy. With the benefit of almost three years of hindsight, one could see that Michael Dell and his co-purchasers at Silver Lake were doing rather well on the acquisition. Their bet was working out. So this might appear to be one of those win-win/no-loser situations, right? Not right. The losers are the stockholders of Delaware corporations in future transactions because decisions like this create a disincentive for buyers to pay top dollar out of a rational fear that a court will later require them to pay some theoretical “fair value” that the market itself would not support.
The appraisal process has largely become a battle of DCF experts-for-hire offering “chasmically” diverging opinions on the same sets of facts. As Chancellor Bouchard recently wrote (quoting Justice Jacobs in part): “The advantage of an arm’s-length transaction price as a reliable indicator of fair value is that it is ‘forged in the crucible of objective market reality (as distinguished from the unavoidably subjective thought process of a valuation expert) . . . .’”
The Dell case was not a mere aberration. Shortly after Dell, there was another case concerning the appraisal of DFC Global in which the Chancery Court awarded the appraisal plaintiffs a fair-value award of 7.5 percent above the negotiated deal price, despite the fact that the deal was the product of a robust two-year, arms-length sale process.
These were two very different cases, and 7.5 percent is a lot less than 28 percent, but to some ears, DFC Global amplified the alarm bells that Dell had sounded, alerting purchasers that they still must contend with appraisal risk.
In DFC Global, the company’s board also faced extremely difficult circumstances. As the Chancellor noted, “at the time of its sale, DFC was navigating turbulent regulatory waters that imposed considerable uncertainty on the company’s future profitability, and even its viability . . . the potential outcome could have been dire, leaving DFC unable to operate its fundamental businesses. . . .” In these dire straits, the DFC Global board made the decision that it was best to sell the company and let the buyer bear those risks. So the board ran an exhaustive process to successfully secure for stockholders the best price the market would deliver. Nevertheless, the Chancellor agreed with the appraisal plaintiffs that the company was sold “at a discount to its fair value during a period of regulatory uncertainly that temporarily depressed the market value of the company” and awarded them a price increase (admittedly not as much as they had hoped).
The Chancellor expressed that “[t]he merger price in an arm’s-length transaction that was subjected to a robust market check is a strong indication of fair value in an appraisal proceeding as a general matter, but the market price is informative of fair value only when it is the product of not only a fair sale process, but also of a well-functioning market.” In that case, he found, “the transaction . . . was negotiated and consummated during a period of significant company turmoil and regulatory uncertainty, calling into question the reliability of the transaction price as well as management’s financial projections.” These are carefully calibrated words, but not every lawyer reads every word.
So long as appraisal arbitrage is allowed, appraisal claims likely will be brought in certain situations, for example where DCF models suggest theoretical valuations higher than the deal price, or when the deal is struck at a time of great uncertainty. This litigation will be much more extensive and serious than traditional appraisal litigation because it will not be brought by real dissenting stockholders who are unhappy with the price, but by professional opportunists who are well-funded and who have organized themselves specifically to game the system and take advantage of this legislative quirk.
These decisions not only have troubling policy implications, but they also raise doctrinal questions. The law defers to the decisions of loyal and well-informed directors. That is especially true under the new MFW “unified standard” where the combination of effective independent director negotiation and minority stockholder approval leads to business judgment review of board action. It is difficult to see these determinations—that the fair value of these companies was higher than the board achieved or could possibly have achieved in the circumstances—as anything other than second-guessing the decisions of the board in each case that it was the right time to sell the company. The Dell and DFC Global boards decided to accept a premium to the trading value—the best price they could get—and to allow someone else to take the risk (the risk of righting the “sinking ship” in Dell’s case, or of regulatory Armageddon in DFC Global’s case). Rather than deferring to their loyal and well-informed decisions, the court said they sold too cheap. There is an inconsistency there, and it is not eliminated by the fact that the immediate consequences of this judicial second-guessing are borne not by the directors themselves, but by the buyers because the buyers simply will pass those costs on.
Some of the problem is inherent in the appraisal rights concept itself and in the wording of the statute. The judge’s statutory obligation is to determine de novo the target company’s fair value as of the closing date, which might be many months after a sale process has established the company’s fair market value. A company’s fair value is not necessarily the same as its fair market value, especially if the two determinations are separated in time. The temporal aspect is baked into the appraisal statute, and with the appraisal arbitrageurs attacking deals that can make it very hard to sell companies in certain circumstances, such as during regulatory turmoil or if they have a significant FDA approval pending. The legislature might consider revising the statute to have the appraisal valuation speak as of the date the stockholders make their decision to sell, as some jurisdictions do, but I am not promoting that amendment today.
Most appraisal fights are not driven by the timing differential, but by the difference between fair value and fair market value. This means the litigation battleground centers on valuation metrics, the intricacies of DCF modeling, projections, discount rates, terminal multiples, and dueling valuation experts. It is the Wharton version of Alien vs. Predator, and it is up to the courts to decide how deeply they want to get dragged into that quicksand, or whether the “value that is forged in the crucible of objective market reality” is close enough in most cases.
The modest changes I am urging would not completely eliminate the risk of timing or valuation arbitrage, but it would greatly alleviate the magnitude of the problem by limiting appraisal rights to those whom the law is supposed to protect. What the legislature should do is amend section 262 of the Delaware General Corporation Law to specify that only shareholders on the record date who can demonstrate that their shares were not voted in favor of the transaction are eligible for appraisal.
If that simple change were made, the number of appraisal cases, the dollars involved, and the risks to corporations doing business in Delaware will go down dramatically, with no loss of protection for the dissenting stockholders the law was aimed to protect. In fact, any “policing” value added by the fact that appraisal claims are easier to win than fiduciary claims would still exist; it would simply benefit the people it was always supposed to benefit, namely, dissenting stockholders rather than enriching opportunistic, quick-buck artists.
The Delaware Supreme Court might get the opportunity to weigh in on these questions, in Dell or in other cases in the pipeline, but there is no reason to ask the Supreme Court to fix what the legislature could with the stroke of a pen. The Delaware legislature must be The Exorcist.
The Legal Opinions Committee of the ABA Business Law Section recently published a report on cross-border closing opinions (the ABA Report). The City of London Law Society (CLLS) and the Toronto Interfirm Opinion Group (TOROG) have also published reports providing guidance for English and Canadian lawyers on closing opinions. In addition, lawyers in the Netherlands, Germany, and other countries have significant experience reviewing, and responding to requests for, closing opinions from counsel to U.S., English, and Canadian parties to business transactions. Nevertheless, the absence of a shared conceptual framework among lawyers in different jurisdictions often gives rise to misunderstandings due to differences among legal systems and language barriers (even when documents are in English). A program presented at the Spring 2016 ABA Business Law Section meeting in Montréal brought together opinion practitioners from the United States, Canada, the Netherlands and England to discuss how to make cross-border opinion practice more efficient and less contentious.
The premise of the program was that lawyers and their clients would benefit from consensus on recurring issues in transactions where opinion givers and recipients are from different jurisdictions, given that it is unlikely that a body of “supra-national” cross-border customary opinion practice will develop any time soon. The topics included: Which specific opinions should not be requested or given? What assumptions, qualifications or exceptions are appropriate in the cross-border context? How do different national laws interact and impact opinion practice? How do we account for the peculiarities of international transactions? How do opinion givers deal with the risk that their opinion will be litigated in a foreign jurisdiction? Can there be agreement on standard limitations on the liability of the opinion giver?
Not so long ago the practice of giving closing opinions to nonclients (so-called third-party legal opinions) was restricted to the United States. For example, in England the lender typically would receive an opinion that a loan agreement was valid, binding, and enforceable from its own counsel, whereas in the United States, it would be the borrower’s counsel that gives that opinion to the lender. Over the past decade, the practice of giving third-party legal opinions in cross-border transactions has spread beyond the United States, raising the question: Would it be helpful to establish some degree of uniformity in the opinion practice? It is critical, however, to strike the right balance between uniformity and respect for national practice, especially as it becomes more common that the governing law in cross-border transactions is notU.S. or English law—jurisdictions where third-party opinions have been most common—but rather the law of another country.
The program panel agreed on a number of core principles:
although parties must look primarily to advice from their own counsel to help structure financial transactions, negotiate agreements, and deal with potential legal issues, there are situations where requesting third-party closing opinions to complement that advice makes sense;
weighing the benefits of third-party legal opinions against the cost is critical;
third-party closing opinions should be limited to specific legal issues that involve the exercise of professional judgment by the opinion giver;
opinions are expressions of professional judgment, not guarantees that a court will reach the same conclusions as the opinion giver;
the specifics of a transaction may require exceptions or make it impossible to give an opinion; in such cases, if the parties wish to consummate the transaction, they must do so by accepting the risk or restructuring the terms which cause the opinion problem, not by attempting to coerce an unwilling opinion giver;; and
the meaning of an opinion must be understood in light of the customary practice in the jurisdiction of the lawyer giving it, which also shapes the diligence required to issue the opinion.
This last point is particularly important because, in some jurisdictions, customary practice may be to squeeze everything believed relevant into the four corners of the opinion letter, whereas in other jurisdictions (such as the United States) opinions may take a more streamlined form based on an understanding among the parties that matters not expressed in the opinion letter nevertheless are to be read into it. Customary practice in the United States also relies on a “golden rule” that: (1) an opinion should not be requested by counsel for the recipient if such counsel would not give the opinion if it represented the opinion giver’s client; and (2) the recipient should not be denied an opinion that lawyers experienced in the matter would commonly give in comparable circumstances.
Although the United States approach to legal opinions has its limitations, there is ever growing agreement on what third-party legal opinions should cover and what assumptions, exceptions, and qualifications are appropriate; there is no such custom in most foreign jurisdictions.Given the lack of a customary practice in cross-border transactions, applying the golden rule is even more difficult because counsel to a recipient in one jurisdiction may request an opinion that is commonly given in that jurisdiction, but not in the jurisdiction of the opinion giver. In addition, the golden rule is based on the premise that the roles of counsel for the opinion giver and the recipient could be reversed in a subsequent transaction, but this role reversal may not be as realistic in the cross-border context as it is in the U.S. domestic context. Nevertheless, the panelists agreed on a core tenet that should always apply: a closing opinion should be neither a bargaining chip between the parties, nor a zero-sum game; instead, it should be an exercise in professionalism with a limited purpose.
In light of the foregoing, the panel considered whether it makes sense to form a small working group, drawn from the growing community of lawyers active in cross-border transactions who deal regularly with third-party closing opinions to: (1) identify key practices in the most recurring jurisdictions; (2) define some broad archetypes of closing opinions; (3) define the most common areas of friction; and (4) develop common guidance to make giving and receiving cross-border opinions more consistent and less costly. The panel also considered whether the “charter” of such a cross-border working group should extend to closing opinions that counsel gives to its own client in connection with specific transactions, which may be functionally equivalent in some jurisdictions to third-party legal opinions. Developing a common lexicon might be especially helpful to in-house counsel which may have less experience than outside counsel in the area of opinion practice and may have to ensure that client checklists are met in circumstances where such lists and the law of the opinion giver’s jurisdiction may be at odds.
The interaction among members of the panel clearly illustrated both commonalities and differences among jurisdictions. For example, Canadian practitioners have led the way in developing guidance for giving and receiving cross-border opinions because many transactions involving Canadian clients have links to London or the United States, resulting in a fairly robust cross-border opinion practice in Canada. TOROG, which has been widely followed, has been instrumental in creating standard practices among Canadian law firms. Consequently, model opinion language and customary practice for Canadian lawyers engaged in transnational transactions has developed over the last 15 years and evolved into a fairly well-established body of guidance, which generally is consistent with U.S. practice. There are, however, recurring points of friction, particularly with English recipients, such as opinions in the financing context on bank regulatory matters, tax opinions, and, to a lesser extent, insolvency and creditor priority opinions. A Canadian lawyer pointed out that there are occasional requests for what he called “broad-form enforceability opinions:” an opinion under Canadian law on the enforceability in Canada of a document governed by foreign law (e.g., a loan agreement governed by English law with Canadian borrowers). The ABA Report refers to this kind of opinion as an “as if” enforceability opinion and takes a firm stand against giving such an opinion in cross-border transactions. Although Canadian lawyers sometimes give “as if” opinions, often in combination with opinions covering local enforceability of security interests in collateral located in Canada, the consensus is that Canadian lawyers would not have difficulty accepting the guidance in the ABA Report.
It also became apparent during the panel discussion that Dutch lawyers habitually give opinions to recipients in other jurisdictions when their clients engage in cross-border transactions. In the context of financing transactions involving Dutch borrowers, Dutch firms often face the issue of who should give a closing opinion that the loan agreement is valid, binding, and enforceable– lender’s counsel, as is the practice in London, or borrower’s counsel, as is the practice in the United States. Dutch lawyers tend to adopt a practical approach: when the transaction involves a U.S. lender, Dutch counsel representing the borrower is prepared to give the enforceability opinion, but when the transaction involves a U.K. lender, London practice is followed. Using both practices, however, can create difficulties for Dutch lawyers who do not participate regularly in cross-border transactions. Apparently, Belgian and Luxemburg law firms adhere to the English practice of borrower’s counsel giving opinions only on matters such as their client’s corporate status, power, and authority, whereas lender’s counsel gives enforceability and choice-of-law opinions. There seems to be well-established market practices among BeNeLux firms on giving most of the opinions discussed in the ABA Report, although friction sometimes arises on who can rely on the opinion and on limitations on the liability of the opinion giver. With respect to “as if” enforceability opinions, an experienced Dutch practitioner remarked that for the last 15–20 years, Dutch firms have given them when pressed but with significant qualifications that end up eroding coverage to something like “we are not really saying that the foreign law agreement is enforceable in the Netherlands, rather that, if the lender goes to a Dutch court, some remedy will be available.” Again, in this context there was support for the ABA Report’s position against giving “as if” enforceability opinions in cross-border transactions because they are costly and rather meaningless. Apparently, while Dutch firms generally are willing to give tax opinions in financing transactions, they often refuse to give (without facing much resistance) no-conflict, no-violation-of-law and no-litigation opinions. Some Dutch firms give a no-violation opinion limited to violations that would cause the contract to be unenforceable.
A lawyer familiar with both English and U.S. opinion practice made the point that many of the opinions identified by the panel as contentious are routine in the United Kingdom, which can result in friction when English lawyers are faced with different practice for cross-border opinions. She remarked that European lawyers have developed ways to accommodate those requests over 20 years of transactions among parties who share the commonalities of the European Union; therefore English lawyers are sometimes surprised when they face resistance from U.S. or Canadian lawyers. The conversations that ensue can be difficult, but are necessary, as evidenced by United States customary practice on issues such as withholding-tax opinions and “as-if” enforceability opinions. She also pointed out that for transactions involving English lenders, it is the in-house lawyers’ responsibility to confirm that their “standard checklist” of required items is fully satisfied; therefore, when U.S. borrower’s counsel refuses to cover an item on the list, much time can be spent explaining to the lenders’ in-house counsel how else those matters can be addressed. Similar issues arise in other countries with respect to certifications, for example, when a notary must be involved in the closing and certain matters which U.S. counsel typically does not cover (such as factual matters) must be addressed to the notary’s satisfaction.
Based on the views expressed by both panelists and members of the audience who practice in different jurisdictions, there was a consensus that a working group of lawyers experienced in requesting and preparing closing opinions in cross-border transactions could productively undertake an effort to build a common lexicon to bridge conceptual divides on issues that often make the negotiation of opinions time-consuming and unnecessarily acrimonious, such as:
the differences in approach between common law and civil law practitioners;
the nature and function of “true” closing opinions versus reasoned legal opinions versus the lawyer’s responsibility for due diligence reports;
the rights of opinion recipients versus those of nonaddressees who are given access to or allowed limited reliance on the opinion versus those of future assignees who are permitted to rely on a previously given opinion; and
the role of factual assumptions versus reliance on certificates of clients or public officials versus knowledge-based factual confirmations.
The working group could also work toward developing common ground on foundational matters, such as:
whether uniform structures can be developed for third-party closing opinions in common types of transactions;
how far assumptions can be taken (“I have no reason to doubt X” versus “I wash my hands of X regardless of reasonableness.”);
whether assumptions relate to only facts or can extend to legal matters;
how assumptions, qualifications, and exceptions differ;
when is disclosure to the opinion recipient appropriate if the law is uncertain;
whether choice-of-law and forum-selection clauses should be included in opinions; and
what fair limitations could be placed on the liability of opinion givers.
It was agreed that the working group’s analysis would transcend the law of individual jurisdictions and focus on ways for lawyers across jurisdictions to better communicate about opinion issues and that, to discover common ground, it may help to take a step back and ask:What are we trying to accomplish by asking counsel to client A in jurisdiction X to provide a legal opinion at closing to client B in jurisdiction Y who is represented by its own counsel in the transaction (who may or may not be familiar with the law of jurisdiction X)? Sometimes practitioners fail to address this basic question; focusing on it could allow both counsel and their clients to determine whether it is worthwhile to spend client A’s money on specific opinions or on a third-party opinion generally. The answer may be “yes,” but there may also be more efficient ways to satisfy client B’s concerns. On the other hand, in cross-border transactions, client B may fear unexpected results under the law of jurisdiction X and may not have its own counsel in that jurisdiction; then a third-party opinion covering agreed-upon aspects of the transaction, framed by an understanding of the customary diligence expected of the opinion giver and balanced by reasonable assumptions, qualifications, and exceptions, could be the right answer. Nevertheless, cross-border opinions are often significantly more costly than similar domestic opinions, and should not go beyond what is justified by a rigorous cost-benefit analysis. Moreover, the opinion giver cannot be expected to assume risk when it is not possible to reach “opinion-level” legal certainty on a particular issue.
The difficulty of this last point is illustrated by one member of the panel having witnessed increasing requests, primarily from civil law jurisdictions, for so-called “certifications” by counsel for a U.S. party, possibly because in those jurisdictions a notary may be responsible for certifying both the facts underpinning the transaction and the law that makes the contract valid, binding, and enforceable. When a third-party opinion is seen as part of the record before the notary, the distinction between factual confirmations and legal conclusions can blur. Although the request for a certification may be understandable, it puts the U.S. opinion giver in a difficult position because as a matter of U.S. customary practice, it is standard for a U.S. lawyer is to rely on a secretary’s or officer’s certificate without taking responsibility for the facts. That practice may be seen as problematic, at least in the eye of the recipient, because it lacks a “professional imprimatur.”
It seems important for the working group to grapple with the extent to which different jurisdictions may allow third-party opinions to be based on “customary practice” being read into the opinion without having to spell out every detail within the four corners of the document. For example, the CLLS report reads that all matters upon which an opinion is based are to be set out within the text of the opinion letter.By contrast, U.S. practitioners generally have moved toward avoiding expressing in opinion letters those matters which are well understood as a matter of customary practice. English lawyers in the audience pointed out, however, that the CLLS report represents one version of London opinion practice and, although useful and helpful, is not as authoritative as some U.S. bar groups’ reports. A Canadian lawyer on the panel pointed out that Canadian practitioners do not tend to rely heavily on unstated assumptions and scope limitations. The working group could analyze whether the courts of different jurisdictions might be willing to consider customary practice as one of the sources of evidence for resolving disputes over third-party legal opinions. If judges recognize something as “customary practice” and are prepared to use it as a benchmark for interpreting an opinion, then expert testimony would become relevant. That could be helpful, but the agreement on use of customary practice must be such as to avoid the definition of “customary practice” degenerating into a battle of the experts, where judges are left to decide whether to prefer one interpretation over another or reject all of them and do their best based solely on the wording of the opinion.
Knowing how different jurisdictions deal with this important aspect of opinion practice would lay a foundation for further work on cross-border opinions. The U.S. practitioners on the panel pointed out that they spend significant time thinking about customary practice with beneficial effects. First, customary practice can be invoked when counsel is asked to do something out of the ordinary or to give an opinion covering novel or unsettled areas of the law. Secondly, it establishes the work opinion preparers must do to support particular opinions. Thirdly, it helps define which assumptions or limitations are commonly understood to apply, whether they are stated or not. The “duly authorized” opinion offers a good example: would Canadian or English lawyers feel a need to state what U.S. lawyers typically do not (“we are only covering the requirements of the corporation law of the jurisdiction in which the company is organized, and we are not covering regulatory or other requirements that the company might have to satisfy, even though they may be applicable and relevant, despite what the opinion recipient might think if he or she simply relied on the plain meaning of the words ‘duly authorized’ without more”) because unlike U.S. lawyers they do not rely on customary practice to determine how opinion recipients should understand the scope of the words “duly authorized” in a third-party legal opinion?
Although non-U.S. lawyers on the panel generally agreed that practitioners in their jurisdiction often do have an understanding of what is covered in a legal opinion and what opinion preparers are doing to support the statements made in an opinion, what makes non-U.S. lawyers uncomfortable about relying on a customary practice concept is the wide range of contexts in which opinions are given. For example, finance lawyers may share an understanding that opinions in lending transactions do not cover tax or bank regulatory issues unless they are covered expressly, but lawyers operating in other transactional settings may lack a common understanding of what is or is not covered. As a general matter, then, an opinion giver in Canada, for example, would not be comfortable saying that an express statement with respect to the matters not covered is needed “because in Canada there is no customary practice which implies a scope limitation,” but rather would decide whether to add one based on the circumstances. It is also the case that there is limited case law in Canada on opinions.The discussion ended with consensus that, even if one starts from the position that there is no reliable customary practice and things must be spelled out, the reality is that the terms lawyers use in closing opinions are laden with special legal meaning, and no matter how much one tries, it is not possible to spell everything out. Thus, this looks like a productive area of analysis for a cross-jurisdictional working group.
The final topic the panel discussed was whether part of the effort to find common ground should address uncertainty around litigation with respect to cross-border opinions. In the United States it has been well settled for many years that opinions are neither contracts nor guarantees, and liability is predicated on the doctrine of negligent misrepresentation without any limits on liability. English lawyers routinely limit their liability to the opinion recipient, specify the choice of English law to cover disputes regarding the opinion, and insist on jurisdiction in England. That is not the practice in the United States, although all three topics increasingly have been the subject of debate. In the Netherlands, choice of Dutch law and Dutch forum selection are seen as noncontroversial because there is a strong sentiment that, when a Dutch firm renders an opinion on Dutch law, the recipient should not have the right to sue that firm in an English or U.S. court if that is where the opinion recipient happens to be. The same seems to be true in Canada, at least according to the TOROG report. There may be a compelling counterpoint, however: when a firm from jurisdiction X gives an opinion to a party in jurisdiction Y, the recipient might not be sympathetic to the concept that litigation should always take place in jurisdiction X, at least when there are significant contacts between the transaction and jurisdiction Y.
Even more complicated are issues relating to limitations on the liability of opinion givers because there is such a difference in understanding among jurisdictions as to the standards of liability of lawyers in general and of opinion givers to nonclient recipients in particular. For example, Dutch law provides that one of the considerations in awarding damages in a tort claim is what kind of insurance is in place. Thus, for a Dutch lawyer to limit liability to insurance proceeds, particularly where Dutch professional rules speak to appropriate levels of insurance coverage for lawyers, is absolutely uncontroversial. In England, lawyers mostly give opinions to their own clients, so liability is governed by the terms of engagement but for third-party opinions, where there are no such terms, opinion givers worry about potentially uncapped liability, particularly when the opinion is addressed to a party in a foreign jurisdiction and that party may turn out to have larger or broader claims than the opinion giver’s own client would not have if it were receiving the opinion. For that reason, English lawyers spell out a number of restrictions on the rights of a nonclient recipient in their opinions. It appears that it is rare in Canada for the opinion to get into matters such as forum selection, limitation of liability, and limitations on reliance principally as a result of limited experience with lawsuits against opinion givers. Moreover, it is not clear that Canadian case law on the liability of lawyers would always be favorable for opinion givers, so leaving the issue vague may be an attractive option as compared to agreeing expressly to governing-law and forum-selection language in cross-border opinions, particularly because those clauses might permit opinion recipients to bring contract-based claims, which might be a worse result.
The panel only scratched the surface on a host of other meaningful issues for lawyers who request or give legal opinions in cross-border transactions. It is undeniable that there are many substantive and procedural differences in opinion practices in different countries. Although there is no “right way,” it was agreed that understanding the differences and, ideally, promoting some measure of convergence where consistent with the legal regime of the opinion giver would seem like a worthwhile exercise. The Legal Opinions Committee of the ABA Business Law Section has authorized its leadership to pursue formation of a cross-border working group as a useful first step toward reducing the difficulties encountered in rendering opinions in cross-border transactions. Although this may be a small first step in what will be, at best, a long journey, U.S. lawyers look back at the very first attempt in Silverado, California, to deal in U.S. domestic opinion practice with many of the issues (which over the years have been resolved) with which we now wrestle anew in cross-border transactions as evidence that the journey can be successful.
This new journey is well worth undertaking for the benefit of all lawyers involved in cross-border transactions, as well as their respective clients.The fact that lawyers from, for example, the U.S. and Germany who are active in transnational transactions operate without the benefit of a largely shared conceptual framework in the same way as lawyers from New York and California is important, but need not force us to throw up our hands. We must be attentive to the tension between different legal systems, how international financial markets operate, and the fact that language barriers in legal analysis are still present even when everybody communicates in English. Nevertheless, the possibilities are exciting.
It is now time for a large number of non-U.S. companies to prepare their annual reports on Form 20-F. For companies with a calendar year-end, the Form 20-Fs must be filed with the U.S. Securities and Exchange Commission (SEC) by May 2, 2017.
To facilitate the preparation of this year’s annual reports, 20-F filers should note the following recent developments, trends, and topics that may be important focus areas of the SEC in the 2017 review process.
Trends in SEC Comment Letters in 2016
During the 2016 review process of Form 20-Fs, the SEC focused on the following themes.
Non-GAAP and Non-IFRS Disclosures
Disclosures of non-GAAP and non-IFRS measures continue to be important areas of focus for the SEC, as indicated by its comments not only on Form 20-F filings, but also on other SEC filings, such as quarterly earnings releases furnished on Form 8-K. In May 2016, the SEC updated its Compliance and Disclosure Interpretations (C&DIs) regarding the use of non-GAAP and non-IFRS financial measures and highlighted the following topics covered in comment letters to various Form 20-F filers.
Equal or Greater Prominence. The SEC has requested, as required by Regulation G and Item 10 of Regulation S-K, that a presentation of the most directly comparable GAAP financial measure must be presented “with equal or greater prominence” whenever a non-GAAP measure is disclosed. Accordingly, headings, bullets, and tables must first present the GAAP and then the non-GAAP measures (in that order). In addition, derivative non-GAAP metrics such as “adjusted EBITDA as a percentage of sales” need both reconciliation and a presentation of the comparable GAAP measure in a location of equal or greater prominence; in this case, a presentation of net income as a percentage of sales. Such presentations, to the extent they appear elsewhere in the 20-F, must also follow the same chronological order as presented in the first instance.
Reasons for Inclusion of Non-GAAP/Non-IFRS Measures. It may not be sufficient to include boilerplate language that management believes the company’s non-GAAP or non-IFRS measures provide investors with helpful supplemental information. In several comment letters, the SEC has asked companies to elaborate on the usefulness of each non-GAAP or non-IFRS measure to the specific circumstances of the company, sometimes focusing on particular adjustments.
Accurate Labeling. Measures such as “EBITDA” or “Free Cash Flow” must be labeled as “adjusted” if they include adjustments beyond those customarily made for measures with those names. Similarly, “pro forma” could only be used where such financial measures have been prepared in accordance with the SEC’s rules for pro forma financial statements in Article 11 of Regulation S-X.
Proper Adjustments and Reconciliation. In its updated C&DIs, the SEC has identified several adjustments as problematic, taking the position that certain non-GAAP adjustments, while not expressly prohibited, are presumed to be misleading. Those adjustments include, among others: normal, recurring cash operating expenses; acquisition-related expenses; and purchase accounting adjustments. In upcoming 20-F filings, companies can still provide explanations as to why such adjustments are relevant but may now face an uphill battle in retaining such adjustments.
Dealings with Sanctioned Countries
As in past years, the Office of Global Security Risk of the SEC’s Division of Corporation Finance continues to review annual reports on Form 20-F for transactions in or with countries and entities subject to sanctions implemented by the Office of Foreign Assets Control of the U.S. Department of Justice. In its comment letters (sometimes even referencing 20-F filings as far back as 2011), the SEC has required 20-F filers to disclose any past, current, and anticipated contacts with sanctioned countries, such as direct or indirect agreements, commercial arrangements, or other contacts with the governments of those countries or any entities that might be controlled by those governments. Given this practice, 20-F filers may want to review their prior filings to prepare themselves for any inquiries in this area.
In particular, the comments have instructed 20-F filers to describe the materiality of their contacts with any sanctioned countries and explain whether those contacts constitute a material investment risk for security holders. The materiality assessment should be provided in both quantitative and qualitative terms. Quantitatively, estimates should be denominated in U.S. dollar amounts of the associated revenues, assets, and liabilities for a period spanning the last three fiscal years and any subsequent interim period. Qualitatively, the disclosure should provide any information that a reasonable investor would deem important in making an investment decision, including the potential impact of the transactions on the company’s reputation and share value.
Litigation Disclosure
The SEC has continued to request 20-F filers to disclose, whenever possible, their best estimates of the potential outcome of pending litigation, and to describe the effects the outcome would have on their financial condition. In particular, where there is at least a reasonable possibility that a loss may have been incurred (in excess of the amounts already recognized), the comment letters have requested further information on the nature of the loss contingency. Additionally, the SEC has requested disclosure on a) the amount or range of reasonably possible losses in excess of amounts accrued, b) whether reasonably possible losses cannot be estimated, or c) whether any reasonably possible losses are not material to the company’s financial statements.
Where a reasonable estimate cannot be made, the SEC has requested 20-F filers to explain a) the procedures the 20-F filer undertook to develop a range of reasonably possible losses for disclosure and b) for each material matter, what specific factors are causing the inability to estimate and when the company expects those factors to be alleviated. In light of these instructions, however, the SEC has recognized that uncertainties associated with loss contingencies exist. To address this potential area of concern for companies, the SEC has allowed 20-F filers to disclose pending matters on an aggregated basis.
Impairment Charges
Impairment calculations, including the methodology and assumptions, have continued to be an area of interest for the SEC. In certain instances, the comment letters noted inconsistencies in the impairment assessment between certain impairment calculations compared against other impairment calculations performed throughout the 20-F filing. In other cases, the SEC has requested clarification on why certain segments of the company’s business were not subject to impairment pursuant to IAS 36. Where an impairment assessment was made, the comment letters instructed companies to explain which factors (including external factors such as declines in commodity prices in 2015) led companies to recognize an impairment charge.
Disclosure of Government Payments by Resource Extraction Issuers
On June 27, 2016, the SEC adopted a final rule implementing Section 1504 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). Pursuant to Section 1504 of the Dodd-Frank Act (commonly known as “publish what you pay”), the SEC implemented rules requiring resource extraction issuers to disclose payments made to governments for the commercial development of oil, natural gas, or minerals.
The commercial development of oil, natural gas, or minerals is given broad scope to include stages from exploration to midstream activities, but does not extend to the final processing stages of refining and smelting. A wide range of payments, such as taxes, royalties, fees, bonuses, infrastructure payments, and community social responsibility payments, whether made in cash or in-kind, must be reported if paid to any level of government, including majority state-owned enterprises. Under the rule, payments must be disclosed by type and total amount at the project level.
The new rule will take effect for an issuer’s first fiscal year ending on or after September 30, 2018, and will require disclosure of government payment information annually in a specialized disclosure report on Form SD no later than 150 days after an issuer’s fiscal year-end. For companies with a calendar year-end, the first year of compliance will be the year ending December 31, 2018, and the filing deadline will be May 30, 2019. Reports filed in compliance with the substantially similar Canadian and European Union reporting regimes will be accepted by the SEC for purposes of compliance with the SEC rule.
Risk Factors Relating to “Brexit” and the U.S. Presidential Election
Several 20-F filers began including Brexit-related risk factors, and some (as a result of their filing date) have also disclosed potential risks relating to the results of the U.S. presidential election. Although SEC comment letters have not yet requested 20-F filers to assess any risks related to Brexit or the election, some comments directed at U.S. filers have requested consideration of those factors.
Brexit
A number of Brexit-related risk factors disclosed in 20-F filings have focused on the uncertainty surrounding the United Kingdom vis-à-vis its relation to the European financial and banking markets. Almost all risk factors explain that the withdrawal of the United Kingdom from the European Union will involve lengthy negotiations, and the uncertainty could increase volatility in the markets. Some risk factors also note that the Brexit vote is non-binding and that the United Kingdom has yet to invoke Article 50 of the Lisbon Treaty to trigger the withdrawal (which is currently expected to occur in late March of this year). Examples of Brexit risks identified by 20-F filers include: the fact that sales are denominated in British pounds the depreciation of which may impair purchasing power of European customers, potentially leading to cancellation of contracts or default on payments; restriction of imports and exports; reduction in movement of skilled professionals between the United Kingdom and the rest of the European Union; and increase in regulatory compliance costs.
U.S. Presidential Election
Results of the U.S. presidential election have led to identification of a few risk factors, namely potential changes to existing trade policies and agreements, proposed reforming of the U.S. Food and Drug Administration, potential repeal of the Patient Protection and Affordable Care Act (Obamacare) as well as perceived changes in U.S. social, political, regulatory, and economic conditions. As the SEC has continued to emphasize the need to tailor risk factors to the particular company’s circumstances, 20-F filers may need to carefully consider how potential changes in the U.S. social, political, regulatory, and economic landscape could impact the companies’ operations and financial conditions. While the result of the election may not be considered a risk itself, subsequent changes in legislation, trade policy, and economic conditions may be important considerations in drafting risk factors.
Iran Sanctions Update
On January 16, 2016, the Joint Comprehensive Plan of Action (JCPOA), which was signed among the Islamic Republic of Iran and the E3/EU+3 (China, France, Germany, the Russian Federation, the United Kingdom and the United States, with the High Representative of the European Union for Foreign Affairs and Security Policy), was implemented, lifting a number of “secondary” sanctions. However, the “primary” U.S. sanctions, which are directed primarily at U.S. persons, continue to apply, as well as certain sanctions outside the scope of the JCPOA, such as those relating to terrorism and human rights violations in Iran.
Furthermore, the results of the U.S. presidential election suggest that the lifting of “secondary” sanctions might be short-lived. The JCPOA contained a provision allowing any party to unilaterally “snap back” sanctions if it determines that Iran has violated the terms of the agreement. Although there is no public information indicating that to be the case, the JCPOA is only an executive agreement, and President-elect Trump has stated that one of his first tasks will be to withdraw from the JCPOA and reimpose the full panoply of sanctions on Iran. For European and other non-U.S. companies that have cautiously reopened commercial ties with Iran, the election considerably raises the risk that sanctions will be reimposed. Companies in the financial and oil and gas sectors face a choice of pursuing Iranian business and thereby taking the risk of facing secondary sanctions. The Office of Foreign Assets Control (OFAC), however, published Frequently Asked Questions guidance that should sanctions snap back, the U.S. government would provide a 180-day wind-down period for payments. For further details, please see our recent memo on this topic.
Even though the JCPOA has lifted certain sanctions, the current reporting company disclosure requirements under the Iran Threat Reduction and Syria Human Rights Act of 2012 (TRA) have not been eliminated. Under the TRA, any foreign private issuer that prepares annual reports on Form 20-F is required to disclose in its annual report certain of its (and its affiliates’) investments and transactions relating to the Iranian petroleum and petrochemical sectors and transactions involving the government of Iran. The company is required to disclose the nature and extent of the activity, the gross revenues and net profits attributable to the activity, and whether the activity will be continued. In addition, the TRA requires companies to continue to file separately with the SEC a notice that the disclosure of that activity has been included in the company’s annual report on Form 20-F.
SEC Updates
Updated Compliance and Disclosure Interpretations
The Division of Corporation Finance last updated its Compliance and Disclosure Interpretations in November 2016. The Compliance and Disclosure Interpretations are available here.
Updated Financial Reporting Manual
The Division of Corporation Finance last updated its Financial Reporting Manual in November 2016. The Financial Reporting Manual is available here.
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