Virtual patent marking (“VPM”) is a powerful tool with immense potential to enhance the value of patent portfolios covering products. General counsel and attorneys representing U.S. patent owners and licensees need to understand the compelling value of VPM to maximize economic and enforcement advantages and unlock monetization opportunities.
The U.S. introduced VPM in 2011, when it amended 35 U.S.C. §287. Prior to this change, “traditional marking” required listing every relevant patent on the associated article. The VPM statute enables patent owners to post a single list of numerous patents (“VPM list”) on the Internet, associating the patents with articles sold, offered for sale, or imported into the United States. Marking an Internet web address (“VPM-URL”) on patented articles allows the public to navigate to a VPM page hosting the VPM list. The VPM page gives the public legal “constructive notice” of the patents on the VPM list and easy access to understand which patents are associated with particular articles. Updating the VPM list is straightforward, eliminating numerous changes needed to molds, stamping tools, and product labels required with traditional marking. A VPM program streamlines the marking process while providing a convenient platform for patent information.
VPM programs mitigate the risks associated with false marking claims, when expired patents inadvertently linger on physical products. Revisions in 2011 to 35 U.S.C. §292 remove risk that was formerly associated with inadvertently leaving an expired patent on a product. The statute now requires that the alleged false marking was done with an “intent to deceive the public” and that a plaintiff suffer competitive injury as a result.
The VPM list should not have any barriers to access and should be kept up to date. The VPM-URL must be substantially on all associated products and continuously used to support constructive notice. Despite these requirements, the undeniable value and benefits of VPM programs make the effort worthwhile.
Typically, in a patent infringement case, a U.S. patent owner sends a letter to an accused infringer, providing “actual notice.” The date of sending this letter starts a period during which damages may be assessed after a determination of infringement. The U.S. patent owner is entitled to damages for the period from actual notice until infringement stops. Importantly, however, the period can be as little as a few days or months from the actual notice date.
In sharp contrast, using VPM, damages can be assessed for up to six years starting from the date when the VPM-URL appeared on the article and the patent and associated article first appear on the VPM list: the constructive notice date. With U.S. patent infringement damages awards approaching many tens of millions of dollars or more, the monetary value can be greatly influenced by the longest period established by the earliest constructive notice date.
Beyond U.S. litigation, in the context of business acquisitions or the acquisition of a VPM-listed patent portfolio, VPM can provide leverage for higher valuations based on earlier constructive notice dates. This is because, as discussed above, the date of constructive notice holds substantial weight in assessing the enforcement value of a U.S. patent. Thus, incorporating robust and auditable VPM programs into patent strategies presents a wide avenue to amplify value, expand monetization opportunities, and fortify IP assets.
Establishing a VPM program may seem daunting initially, but the benefits it offers through an early constructive notice date are vital to maximizing patent value. VPM management software platforms can be helpful in streamlining this process. General counsel and attorneys must grasp the multitude of benefits VPM offers and encourage adopting VPM as an integral part of ongoing patent strategies. By embracing VPM, U.S. patent owners can elevate the strength and value of their portfolios, safeguard their rights, and provide the maximum options to help navigate the complexities of the intellectual property landscape with confidence.
This article should not be construed as legal advice or legal opinion on any specific facts or circumstances. This article reflects only the personal views of the authors and not the views of the authors’ firms. Consult your patent professional regarding your specific questions.
Private equity funds (“PE funds”) have increasingly embraced carve-out transactions as a strategic maneuver to unleash untapped value within their portfolio companies and generate returns for shareholders. These transactions involve divesting non-core business units from larger enterprises, allowing PE funds to reshape and revitalize their portfolio companies with an eye towards a more profitable exit in the future. In today’s challenging economic climate, PE funds are compelled to evaluate their investments and focus on enhancing the fundamental operations of their portfolio companies.
This article explores the key features of carve-out transactions, highlights the challenges that selling PE funds must anticipate and navigate, and provides insights for improvement and accuracy.
Structuring
Structuring a carve-out transaction is complex, as it entails separating and disposing of a business integrated within the seller’s operations. Selling PE funds must carefully consider the impact of the sale on the retained business enterprise and plan accordingly. Carve-outs can involve the disposal of subsidiaries, business divisions, or specific assets of the portfolio company. In the public market, carve-outs can take the form of a spin-off transaction accomplished through a statutory plan of arrangement.
In addition to tax considerations, PE funds must analyze the operational complexities associated with disentangling shared business functions such as IT systems, supply chains, and human resources. Developing a comprehensive plan to address these challenges is crucial.
Separation of the Target Business
Carve-outs typically require corporate reorganization to separate the target business before completing the transaction. The selling PE fund collaborates with the buyer to identify which assets, liabilities, and contracts are part of the deal and which ones will remain with the retained business. This task becomes particularly complex when the divested business is intertwined with the operations of the corporate parent. PE funds must gain a thorough understanding of shared services, historical cost allocations, and the costs involved in replacing these services going forward. Despite the challenges posed by negotiating terms while the management team is in sell-side mode, effective coordination between the buyer and the management team during the due diligence process is vital. The purchase agreement should include a “sufficiency of assets” representation to ensure the buyer has recourse if they discover that they did not acquire all the necessary assets for the business. While transitional services agreements can temporarily bridge post-closing gaps, pre-closing preparations may be required to ensure that the divested business is ready to operate independently.
A common approach involves spinning off assets, liabilities, and contracts into a newly formed subsidiary, whose shares are subsequently sold to the buyer. Carve-out buyers often seek a thorough understanding of the separation process, contemplating whether the target business will operate as a standalone entity or integrate into the buyer’s group post-closing. The separation process presents structural complexities, including shared key assets or contracts that require transfer, assignment, replacement, or partial termination prior to or in connection with closing. Some contracts and certain types of assets may necessitate third-party consent for transfer or assignment, which can be time-consuming or result in stranded assets if consent is unattainable.
To ensure an orderly and efficient separation, the parties usually incorporate a reorganization step plan into the definitive transaction documentation, aligning all stakeholders on the process. Effective implementation of the reorganization plan is often a condition precedent to closing the carve-out transaction. The definitive agreement may also include “wrong pocket” provisions to ensure assets inadvertently transferred from either the target or retained business are returned to the appropriate entity after closing.
Financial Statements
Availability of financial statements for the target business is critical in pricing a carve-out transaction, just as in any M&A deal. Carve-out financial statements serve as a key aspect of due diligence for the buyer and are essential for the buyer’s capital-raising efforts. However, in some cases, there may be no financial reporting at the target business level, or the consolidated financial information provided by the seller may lack sufficient clarity, particularly where standalone audited or unaudited financial statements are required to secure debt financing. Consequently, preparing suitable financial statements for the target business becomes a significant undertaking for selling PE funds in any carve-out transaction.
Carve-out accounting—as well as determining assets, liabilities, revenues, costs, and expenses attributable to the target business—can be a complicated and time-consuming process, often impacting the transaction timeline.
Pricing the Target Business
Pricing the target in the carve-out transaction requires careful consideration to avoid potential “leakage” due to a number of factors, such as intercompany transfers. Various valuation methods such as discounted cash flow analysis, comparable company analysis, and precedent transactions analysis can be utilized. These methods help establish a fair and reasonable purchase price based on the financial performance, growth prospects, and market dynamics of the target business.
Buyers will look to conduct extensive due diligence to evaluate the financial information provided by the seller, understand intercompany arrangements, and assess the impact on the value of the target business. Negotiations revolve around leakages and potential adjustments to ensure a fair and equitable transaction. Sellers should be prepared for post-closing inquiries to verify compliance with the agreed-upon terms and conditions.
Addressing Employment Matters
Addressing which employees should be transferred to the target in carve-outs can be complex, especially when employees are entangled within the seller’s other business units. Determining which employees will transfer with the divested business, the process of transferring employees, and the treatment of compensation and benefits all require careful planning and analysis. Human resources matters become simpler when the divested business is already operating as a standalone entity with its own employees and subsidiary.
IP and IT Considerations
Carve-outs involving intellectual property (“IP”) assets present challenges in allocating and sharing those assets. Specificity in identifying IP assets and establishing favorable transition services and licensing arrangements can supplement the default allocation standard. Shared IP assets need to be addressed in deal documents, considering the need for one-way licenses or cross-licenses to ensure freedom to operate for both parties. Commercial arrangements for shared IP rights may also be necessary for ongoing dealings between the seller and the divested business.
Data transfer and protection are critical in carve-outs, with careful consideration given to the transfer and sharing of data post-closing. A significant portion of the value of the target business may be tied to data; therefore, the buyer will need to understand what data it requires and how it can ensure it will receive the data. This may include pricing information or customer records, which could include personal information. Compliance with data protection laws, contractual obligations, and cybersecurity concerns should be addressed. Thoroughly reviewing obligations regarding data confidentiality and restrictions on transferring or sharing data is vital. The transaction documents, particularly the transitional services agreement, should establish clear responsibilities for data compliance, remediation of breaches, and liability allocation.
Tax
Tax considerations play a significant role in multi-jurisdictional carve-outs, requiring close collaboration with tax advisors to ensure compliance with local tax obligations. Transfer taxes, value-added taxes, and indirect capital gains taxes should be assessed and addressed in the acquisition agreement, as liability for these taxes can vary.
Transitional Services
Upon completing a carve-out transaction, the unwinding of internal services such as legal, accounting, procurement, licensing, and human resources from the retained business requires careful planning and execution. The parties often negotiate a post-closing transition phase to facilitate this process. Offering transitional services from the outset can expand the pool of potential buyers and maximize the exit value for selling PE funds. However, providing transitional services may burden the management team of the retained business and require their careful attention.
Finding the right balance between providing transitional services and ensuring operational efficiency in the retained business is crucial. Clear delineation of responsibilities, establishing timelines, and effective communication between the parties are essential for a smooth transition and minimizing disruptions.
Conclusion
At a strategic level, PE funds often turn to carve-out transactions in an effort to focus on the portfolio company’s core assets, boost its value proposition for a subsequent exit, improve operational agility, or to simply raise cash in order to shore up the balance sheet. Historically, we have seen carve-out transactions account for a significant percentage of overall deal activity, and this trend is expected to continue in the face of recent supply chain disruptions and difficult economic conditions. While carve-outs often require careful due diligence, strategic planning, and effective execution, they present PE funds with a viable avenue for growth, value creation, and liquidity.
A much-publicized 2003 KPMG survey concluded that nearly 70 percent of mergers and acquisitions (“M&A”) (in various verticals) did not achieve the acquiring companies’ management goals.[1] The key to success in this regard is due diligence. Appropriately conducted due diligence serves a variety of functions, including (1) identifying issues that may reduce the price of the target company;[2] (2) identifying the value and sustainability of product technologies, their threats, and improvement opportunities;[3] (3) identifying possible opportunities for investment;[4] (4) validating existing contracts, approvals, registrations, etc.;[5] (5) identifying the appropriate warranties and indemnities,[6] and (6) assisting in developing the sale and purchase agreement.[7]
While due diligence can serve a variety of goals, the process will often need to be customized for the type of organization being acquired. Specifically, we will focus on the regulatory and compliance due diligence process in the context of companies regulated by the Food and Drug Administration (“FDA”).
Noncompliance Issues and Due Diligence
An acquiring company is expected by the Criminal Division of the Department of Justice (“DOJ”) to perform appropriate due diligence to uncover compliance issues prior to merging with or acquiring a target. A company’s failure to comply with requirements can result in financial penalties, legal actions, damaged reputation, and loss of profit—and it could even extend to criminal charges in severe cases.
If a transaction continues when noncompliance is discovered, the acquirer should consider appropriate self-disclosure to the DOJ and, if appropriate, other agencies such as the Office of Inspector General (“OIG”), Federal Trade Commission (“FTC”), Office for Civil Rights (“OCR”), and FDA in order to minimize or avoid civil and criminal liability, as well as address the complexity and potential financial/criminal fallout.
DOJ Guidance
The DOJ’s updated guidance from March 2023, Evaluation of Corporate Compliance Programs, clarifies its expectations involving “pre-M&A due diligence.” The DOJ believes that “[t]he extent to which a company subjects its acquisition targets to appropriate scrutiny is indicative of whether its corporate compliance program is . . . able to effectively enforce its internal controls and remediate misconduct at all levels of the organization.”[8] To that end, the DOJ expects the following:
An acquirer must complete pre-acquisition due diligence and look to identify misconduct or the risk of misconduct. The due diligence should be conducted by appropriately qualified, appropriately empowered individuals with experience working with FDA-regulated companies.
The compliance function is an integral part of the M&A process.
The target company is evaluated for misconduct and its policies and procedures scrutinized to avoid and address compliance issues.
Noncompliant Companies and Individuals
Noncompliance with Department of Health and Human Services (“HHS”), FDA, and/or other agency expectations may result in a variety of punitive measures, including fines, exclusion from federal health-care programs, and even criminal prosecution. Companies may be a party to various agreements with the government that require a demonstration of ongoing compliance.
Failure to comply with FDA requirements can result in warning letters, product seizures, injunctions, and civil or criminal penalties. For more severe or persistent violations, the FDA may also withdraw product approvals, effectively barring a product from the market. This can lead to substantial financial loss and damage to the company’s reputation.
Both individuals and companies may be temporarily or permanently excluded from participation in federal health-care programs, which can be the death knell for a business or a career killer for an individual.[9] Additionally, the FDA can sue the responsible corporate official for a first-time misdemeanor (and possible subsequent felony) under the Federal Food, Drug, and Cosmetic Act[10] without proof that the corporate official acted with intent or even negligence—and even if such corporate official did not have any actual knowledge of, or participation in, the specific offense.[11]
Reasons Due Diligence May Be Limited
Due diligence is a crucial step in informed decision-making; however, there may be various factors that limit the comprehensiveness of a due diligence review. This endangers the chances of successful outcomes in any business transaction or strategic decision.
Time Restrictions: Due diligence is a comprehensive but time-consuming process. However, business deals and strategic decisions often operate within strict time frames, and this pressure to meet deadlines can restrict the depth and breadth of the due diligence process. Rushed due diligence may result in overlooked details, incomplete analysis, and uninformed decision-making.
Cost Restrictions: Due diligence can also be a costly process that requires the use of external experts or consultants in areas like law, finance, environment, technology, and more. An investor with a limited budget can limit the investigation, causing corners to be cut. This can result in a failure to identify risks or opportunities.
Client Instructions: An attorney conducting due diligence can potentially be limited by the client’s specific instructions. The client may only want certain areas to be investigated or may not wish to dive too deeply into certain aspects of the organization for a variety of reasons, including already available information, perceived insignificance of certain aspects, or the desire to maintain good relations during a merger or acquisition process. Such instructions can limit the comprehensiveness of the due diligence process.
Specifics of the Operation in Question: The nature and specifics of the operation or deal in question can also limit due diligence. For instance, in some cases, the information might be highly sensitive or classified, making it difficult to access. In other cases, the operation might be in a niche or highly specialized field, where expertise is limited or the benchmarks for evaluation are not well-defined. In such cases, despite best efforts, the due diligence process may be inherently limited.
Phase I: Initial Investigation
During the initial request for documents, it is important to set the stage and develop an initial scope of review. In the context of life sciences due diligence scope development, you must consider outlining the metes and bounds of the scope. Working with an experienced FDA regulatory and/or compliance attorney can help you make sure that your scope is all-encompassing and that you have evaluated all possible areas of compliance.
A possible scope for a due diligence audit for a drug company (“Company”) being purchased by a private equity firm, particularly focusing on FDA and HHS compliance issues, may read as follows:
This due diligence process will provide an assessment snapshot of the potential regulatory risks, liabilities, and compliance gaps for the Company. This due diligence will
confirm the validity of the Company’s product approvals;
obtain and review the listing of the Company’s ongoing clinical trials;
briefly review the safety (including adverse event reports) and efficacy data of the Company’s products in question;
briefly review the Company’s quality-control processes, including in the context of its manufacturing practices, labeling, advertising practices, and health-care fraud and abuse issues; and
briefly evaluate the company’s adherence to the Health Insurance Portability and Accountability Act (“HIPAA”) and other HHS regulations related to patient privacy and data security.
Regulatory Strategy
Once a scope of review has been established, consider beginning by looking at the core regulatory strategy for the target company’s products. Review company registrations at both the federal level (including facility, product, and clinical trial registrations) and the state level. At the state level, make sure to examine manufacturer/distributor licenses, sales representative licenses, and more.
Internal Investigation
During your internal investigation, make sure to review the company’s organization chart along with names, titles, and job descriptions of individuals to gain a clear understanding of the company’s internal structure, its decision-making process, and the responsibilities of key personnel.
After this initial phase, request and review standard operating procedures (“SOPs”), work instructions, and records of training on procedures to gain critical insight into the company’s day-to-day operations, processes, and quality-control measures.
Audits and Inspections
Acquirers may find it useful to review the target’s internal and external audit/inspection records for the past two to five years. Records may include quality-control records and details on how adverse events are handled. External inspections, on the other hand, often involve FDA audits, which assess the operation’s adherence to regulatory standards. By reviewing these inspection records, you can identify potential areas of focus for further inquiry.
As requested by the DOJ, utilize an experienced professional to review the existing corporate compliance program,[12] and consider reviewing voluntary disclosures made by the company.[13] Particularly noteworthy is the review of employment agreements, which should ideally include clawback provisions in line with the March 2023 DOJ Criminal Division recommendations.[14]
Moreover, depending on the organization and the acquirer’s desire for audits, the review may extend to matters related to the Foreign Corrupt Practices Act (“FCPA”). This involves identifying areas of potential interest or concern, considering the company’s interactions with foreign officials, and assessing the risk of bribery or corruption.
Phase II: Response Evaluation
After gathering an initial list of inspection and audit findings related to regulation by entities such as the FDA, DOJ, and OCR, as well as state and local law authorities, the next step is to assess the actions taken by the company to address the adequacy of these findings. This involves reviewing trainings, SOP changes, remediation plans, enacted corrective actions, and other steps that the company has taken in response to quality inspections and/or regulatory findings. Look for evidence that the company made swift, substantive, permanent changes that address not only the immediate issue but also future issues in similar situations. This is an area in which it can be especially helpful for an FDA regulatory and compliance attorney to benchmark the target company’s remediation processes and procedures against others in the industry.
As an investor, the goal is to demonstrate that there is an effective quality and compliance program in place—and that the quality and compliance program can catch errors and fix them. Past performance in this regard can not only result in a more valuable company but also be indicative of a future ability to navigate compliance challenges.
Final Report
Upon completion of the due diligence review, just as with most other due diligence reviews, it is ideal to prepare a comprehensive summary of findings. This summary will detail the research conducted, the findings obtained, the limitations encountered during the review process, and any recommendations for improving the operation. The aim of this summary is not just to present a snapshot of the current state of affairs but also, importantly, to provide actionable insights that can help mitigate risks and enhance overall operational efficiency. Ideally, you should also list the scope of the audit and limitations thereof.
Conclusion
Conducting a meticulous regulatory and compliance due diligence review process is integral to understanding the compliance landscape of a company. This review process encompasses a wide range of steps, including understanding the regulatory strategy; inspecting internal and external audits; evaluating privacy issues, corporate compliance, and state and local registrations; and evaluating the steps taken to remedy any findings by entities such as the FDA, DOJ, and OIG, as well as assessing any outstanding issues that remain. An individual well versed in FDA-, DOJ-, and OIG-related due diligence can be an indispensable tool in this assessment.
The Federal Trade Commission (FTC) and Department of Justice (DOJ) jointly issued new Draft Merger Guidelines on July 19, 2023.[1] The Draft Merger Guidelines were created with the goal “to better reflect how the agencies determine a merger’s effect on competition in the modern economy and evaluate proposed mergers under the law.” There are significant changes from the current guidelines both substantively and in form. These changes are consistent with the Biden Administration agencies’ public statements and reflect the FTC’s and DOJ’s approach to merger investigations and enforcement actions over the last two years. The draft is subject to a sixty-day comment period that closes on September 18.
The changes come on the heels of the agencies’ proposal on June 27 to update the premerger notification form under the Hart-Scott-Rodino (HSR) Act. The proposed form update, the first of its kind in forty-five years, would substantially increase the time, effort, and cost of making the filings of buyers and sellers.[2] The FTC notice estimates that HSR filings would require an average of 144 hours to prepare as compared to the current average of thirty-seven hours. If the proposed changes are adopted, the FTC estimates that “complex” filings would require approximately 259 hours to complete. Many of the proposed changes appear aimed at providing substantial additional information related to the types of harm underlying the Draft Merger Guidelines.
Broadly, the draft confirms the agencies’ interest in increased enforcement, particularly in tech and labor markets; decreased mergers; skepticism regarding merger-related efficiencies; concern for nascent competitors; distrust of “big”; and preference for organic growth.
To better understand the proposed changes to the Merger Guidelines, we highlight some of the most significant changes below.
Reducing the threshold for a presumption of anticompetitive effects
Guideline 1 lowers the threshold for determining when a transaction results in a “highly concentrated market” to the level used by the guidelines issued in the 1980s and 1990s. Guideline 1 describes the use of the Herfindahl-Hirschman Index (“HHI”) to calculate market concentration. The HHI sums the squares of the market share of each competitor in the market. Under the 2010 merger guidelines, “[b]ased on their experience, the Agencies classif[ied] markets” with an HHI over 2,500 as “highly concentrated.” Transactions resulting in highly concentrated markets that involved an increase of more than 200 points were presumed to be likely to enhance market power.
Pursuant to draft Guideline 1, the agencies not only reduce the standard for a “highly concentrated” HHI to 1,800 from 2,500, but they also reduce the level of the post-transaction delta from 200 to 100. Accordingly, mergers in markets with HHIs greater than 1,800 and an increase of greater than 100 “cause[] undue concentration and trigger[] a structural presumption that the merger[s] may substantially lessen competition or tend to create a monopoly.”
Another change is the addition of the “structural presumption” that mergers leading to a market share in excess of 30 percent are illegal.
Creating a dominance concept under U.S. law
Dominance is not a concept enshrined in U.S. antitrust law, but it has been a part of merger analysis in Europe. Guideline 7 seeks to discourage any transaction that makes it harder for remaining competitors to compete. The guideline suggests a firm could be treated as “dominant” with a market share as low as 30 percent and also indicates that transactions that might increase switching costs, interfere with use of competitive alternatives, deprive rivals of economies of scale, eliminate a nascent competitive threat, or “in any other way” entrench the combined firm’s position could be challenged. The agencies will view any merger involving a dominant firm with intense scrutiny.
Focus on mergers that “further a trend” towards market concentration
Guideline 8 declares that the agencies will now scrutinize mergers in markets that have been trending toward concentrated, and thereby the proposed transaction may substantially lessen competition. The guideline sets forth two factors to establish this trend: (1) if a market has shown a history of consolidation, such as a market with an HHI exceeding 1,000 and approaching 1,800, or (2) if the merger would increase the rate of concentration, such as increases in HHI over 200.
Adding examination of serial acquisitions as a whole
Guideline 9 notes that the agencies have created another pathway to target mergers that might, in the past, have evaded agency scrutiny: challenging a pending transaction based on past lawfully consummated mergers and company documents reflecting a strategy of growth through acquisition. Specifically, if either of the parties has a pattern or strategy of consolidation through acquisition, the agencies will examine the impact of the cumulative strategy to determine if that strategy may substantially lessen competition or tend to create a monopoly. If the agencies find that the strategy or acquisition history of a firm is suspect, they may combine multiple acquisitions for the purposes of their analysis of other indicia of lessening competition. Many interpret Guideline 9 as a reflection of skepticism of private equity transactions.
Suggesting increased enforcement of mergers involving multi-sided platforms
In another warning shot at the tech industry, the agencies made clear in Guideline 10 that anticompetitive effects on a single platform may make a merger illegal. The agencies view such platforms as markets themselves and platform operators as having conflicts of interest to the extent they use their platform to sell products. Thus, a merger between a platform operator and a seller of goods who uses the platform will attract the attention of the agencies even if the merger would be totally innocuous if viewed only in the market of the products sold by the acquired seller.
Considering impacts on labor markets
Guideline 11 confirms that the agencies will consider labor markets as they would other supply markets in analyzing mergers, where employers are competing buyers for labor. When assessing the degree to which the merging firms compete for labor, the agencies will consider whether the merger may result in lower wages or slowed wage growth, worse benefits or working conditions, or any other degradation of workplace quality.
Market definition: Considering bundling
The agencies stated in an appendix detailing how they define markets that they will consider bundled products in a single relevant market, even if such conduct would not violate Section 2 of the Sherman Act. Bundling is conditioning the sale of a product in one market on the sale of a product in another market, or otherwise linking the sales of two products. By considering bundled products together, the agencies may be able to find that firms exceed the thresholds described above based on control of products outside the market directly affected by the transaction.
Efficiencies: Relegated to the appendix
While the current guidelines give an explanation of how efficiencies may “enhance the merged firm’s ability and incentive to compete, which may result in lower prices” and other consumer benefits, the proposed guidelines are less clear on the impact of efficiencies to the agencies’ analysis. The relevant section (IV.3.) begins with a quote from United States v. Philadelphia Nat’l Bank that “possible economies [from a merger] cannot be used as a defense to illegality.” 374 U.S. 321, 371 (1963). It goes on to identify certain “cognizable efficiencies” which “must be of sufficient magnitude and likelihood” to “prevent the creation of a monopoly.”
***
In sum, the draft Merger Guidelines should provide greater transparency to businesses considering acquisitions and enshrine evolving FTC and DOJ policies that have increased the risk of merger investigations and enforcement actions under the current administration.
Appendix of Significant Form Changes
Parties. Identification of entities within the ultimate parent entity (UPE) or acquired entity, minority shareholders, and other non-controlling entities, and create new requirements to identify certain other interest holders that may exert influence, as well as officers, directors, and board observers.
Organize the list of entities held by the UPE or acquired entity by operating company, and for each such operating company or business, provide d/b/a(s) and f/k/a(s) within the three years preceding filing.
For the acquiring UPE, report minority holders of (1) the acquiring entity, (2) any entity directly or indirectly controlled by the acquiring entity, (3) any entity that directly or indirectly controls the acquiring entity, and (4) any entity within the acquiring person that has been or will be created in contemplation of, or for the purposes of, effectuating the transaction. For entities affiliated with a master limited partnership, fund, or investment group, the “doing business as” or “street name” of that group would also be required.
For the acquiring UPE, identify certain individuals (other than employees) or entities that, in relation to the acquiring entity or any entity it directly or indirectly controls or is controlled by, who (i) provide credit in conjunction with or result of the transaction, provided credit totaling 10% or more of the value of the entity; or (ii) are holders of non-voting securities, warrants, or options would be limited to those the value of which equals or exceeds 10% of the entity or could be converted to 10% or more of the voting securities or non-corporate interests of the company.
Officers, Directors, and Board Observers. Identify the officers, directors, and board observers (or in the case of unincorporated entities, individuals exercising similar functions) of the acquired entity(s) and entities within acquiring person(s), as applicable, for the prior two years, and for each individual, identify any other companies for which those individuals would serve or have served during the prior two years as officers, directors, or board observers. Provide the same information for the prospective officers, directors, or board observers of the acquired and acquiring entities after the transaction, as well as for any officers, directors, or board observers of new entities created as a result of the transaction (and, in each case, for unincorporated entities, individuals serving those functions). If it would be impossible to identify the specific officers, directors, and board observers, filers should describe who would have the authority to choose them.
Transaction Information. The acquiring UPE will be required to briefly describe the business operations of all entities within the acquiring person to provide a clear overview of all aspects of the acquiring person’s pre-transaction business.
The acquiring and acquired person will be required to submit a narrative describing all strategic rationales for the transaction, including, those related to competition for current or known planned products or services that would or could compete with a current or known planned product or service of the other reporting person, expansion into new markets, hiring the sellers’ employees (so-called acqui-hires), obtaining certain intellectual property, or integrating certain assets into new or existing products, services or offerings. Also, identification of which documents submitted with the HSR filing support the rationale(s) described in the narrative.
Provide a diagram of the deal structure along with a corresponding chart that would explain the relevant entities and individuals involved in the transaction.
Agreements and Timeline. Require filing persons to produce (i) all agreements, inclusive of schedules, exhibits, and the like, that relate to the transaction, regardless of whether both parties to the transaction are signatories; (ii) all agreements between any entity within the acquiring person and any entity within the acquired person in effect at the time of filing or within the year prior to the date of filing, including but not limited to, licensing agreements, supply agreements, non-competition or non-solicitation agreements, purchase agreements, distribution agreements, or franchise agreements; and (iii) narrative timeline of key dates and conditions for closing.
Competition and Overlaps. In addition to the transaction-related documents currently required under Item 4(c) and 4(d) prepared by or for officers and directors, filing persons would also need to submit (i) documents prepared by or for supervisory deal team lead(s) and (ii) drafts of responsive transaction-related documents if that document was provided to an officer, director, or supervisory deal team lead(s).
Periodic Plans and Reports. Submission of (i) semi-annual and quarterly plans and reports that discuss market shares, competition, competitors, or markets of any product or service that is provided by both the acquiring person and acquired entity, if those documents were shared with a chief executive of an entity involved in the transaction, or with certain individuals who report directly to a chief executive; and (ii) all plans and reports submitted to the board of directors (or, in the case of unincorporated entities, individuals exercising those functions) that discuss market shares, competition, competitors, or markets of any product or service that is provided by both the acquiring person and acquired entity.
Submission of an organizational chart(s) reflecting the position(s) within the filing person’s organization held by identified authors, and for privileged documents, the recipients of each document submitted with the HSR filing. Identification of the individuals searched for responsive documents.
Competition Analysis. Each filing person would be required to list each current or known planned product or service that competes with (or could compete with) a current or known planned product of the other filer. For each such overlapping product or service, the filing person would provide sales, customer information (including contacts), a description of any licensing arrangements, and any non-compete or non-solicitation agreements applicable to employees or business units related to the product or service.
Supply Relationships. Filing persons would report (i) sales to the other filing person and to any other business that, to the best of the filing person’s knowledge, uses its product, service, or asset as an input for a product or service that competes or is intended to compete with the other filing person’s products or services; (ii) information (including contact information and a description of the supply agreement) for other customers that use the product, service, or asset to compete with other filing person; (iii) similar information for purchases made from the other filing person and from any other business that, to the best of the filing person’s knowledge, competes with the other filing party to provide a substantially similar product, service, or asset.
Labor Markets. Filers would need to classify their workers into occupational categories based on the Standard Occupational Classification (SOC) system, list the five largest categories of workers by the relevant 6-digit SOC classification, provide the total number of employees for each 6-digit code identified, and identify any penalties or findings that were issued against the acquiring person or acquired entity by the U.S. Department of Labor’s Wage and Hour Division, the National Labor Relations Board, or the Occupational Safety and Health Administration during the five-year period before the filing.
For each of the five largest SOC codes in which both parties employ workers, the filing persons would be required to list the overlapping Economic Research Service’s Commuting Zones from which the employees commute and the total number of employees within each commuting zone.
NAICS Information. Filing persons would need to (i) list every NAICS code that describes the products or services offered and use end notes as needed to clarify selections and any potential overlap where the same revenues are reported in more than one NAICS code; (ii) require acquiring persons and acquired entities with more than one operating company or unit to identify which entity(s) derives revenue in each code; (iii) acquiring person would be required to identify any NAICS codes for products and services under development if those codes would overlap with the codes for current or known pipeline products or services of the acquired entity(s); and (iv) acquired person would identify the NAICS codes that would apply to the products or services of the acquired entity(s) that are under development or pre-revenue and anticipated to have annual revenue totaling mo re than $1 million within the following two years.
Minority-Held Entity Overlaps. List all the minority-held entities of the acquiring person and its associates or acquired entity (as appropriate) and proposes once again to require identification of those that, to the filing person’s knowledge or belief, would derive revenue in the same NAICS codes or have operations in the same industry as the other filing person.
Prior Acquisitions. Both the acquiring person and the acquired entity will be required to provide information about prior acquisitions for the previous ten years and eliminate the threshold for listing prior acquisitions, which currently limits reporting to only acquisitions of entities with annual net sales or total assets greater than $10 million in the year prior to the acquisition.
Foreign Subsidies. Persons making an HSR filing would be required to disclose information about foreign subsidies from countries or entities that threaten U.S. strategic or economic interest.
Defense Information. Both the acquiring and acquired person would identify whether they have existing or pending defense or intelligence procurement contracts, as defined by 10 U.S.C. 101(a)(6) and 50 U.S.C. 3033(4), valued at $10 million or more, and provide identifying information about the award and relevant DoD or IC personnel.
Document Preservation. Filers would need to identify and list all communications systems or messaging applications on any device used by the acquiring or acquired person (as appropriate) that could be used to store or transmit information or documents related to its business operations and affirm that all necessary steps have taken to prevent destruction of documents and information related to the transaction, include suspension of auto-deletion protocols.
Foreign Filings. Require parties to identify the foreign jurisdictions where each has already filed or is preparing notifications to be filed as well as a list of the jurisdictions where it has a good faith belief it will file.
The first merger guidelines were issued by the DOJ, Antitrust Division, in 1968. Different iterations of have been revised and refined in 1982, 1984, 1992, 1997, and 2010. ↑
A summary of many of the key changes to the form is provided as an appendix here. ↑
This case,[1] heard before the U.S. District Court for the District of Columbia (“the court”), concerns the enforcement of an arbitral award against the Republic of Djibouti in favor of Doraleh Container Terminal SA (“DCT”), arising out of a dispute over the development and operation of a port. Parties entered into a Concession Agreement where DCT agreed to build and develop a new international container terminal on the Red Sea in Doraleh, Djibouti, in exchange for DCT’s exclusive right to handle container shipping in Djibouti and payment of royalties. The agreement also provided for arbitration of any dispute between the parties in London under London Court of International Arbitration (LCIA) Rules if it could not be amicably settled.
A dispute arose, Djibouti commenced arbitration, DCT made a counterclaim, and ultimately, an award was issued in favor of DCT. DCT commenced this action in the District of Columbia to enforce the award.
Djibouti sought to vacate the award, arguing that (i) the tribunal exceeded its authority, (ii) the tribunal violated Djibouti’s due process rights, and (iii) the award would be contrary to U.S. public policy if enforced.
The court rejected all of Djibouti’s arguments and granted DCT’s petition to confirm the award. The court did not accept Djibouti’s argument that the court lacked subject matter jurisdiction over the petition.
In respect of the tribunal’s authority, the court found that the dispute resolution clause in the parties’ contract was broad enough to encompass the counterclaims raised by DCT, and that the tribunal did not exceed its authority by deciding on those counterclaims.
There were no surprises in this decision. Addressing Djibouti’s claim of violation of due process, the court found that Djibouti had actual notice of the proceedings and was given an opportunity to be heard, but chose not to participate. Therefore, the court held that Djibouti’s due process rights were not violated. Finally, with respect to Djibouti’s argument that enforcing the award would be contrary to U.S. public policy, the court held that this argument failed because a purely compensatory award does not violate U.S. public policy. The court noted that Djibouti’s argument relied solely on a case involving specific performance, which was not applicable here.
This case is significant because it reinforces the principle of deference to arbitral awards under the New York Convention. The court emphasized the strong public policy in favor of enforcing arbitral awards and noted that a party seeking to vacate an award faces a heavy burden of proof. The court also clarified that due process rights are satisfied by actual notice and an opportunity to be heard, and that a party’s failure to participate in the proceedings will not be grounds for vacating the award. A party who takes the risk by not participating in arbitration proceedings may be bound by the outcome of the arbitration even if they disagree with the result.
This case also reinforces the principle of finality of arbitration awards and the limited grounds upon which they can be challenged. The court’s decision emphasizes that challenges to an arbitral award must be based on specific, narrow grounds provided under the New York Convention, and not on a general dissatisfaction with the award. The court pointed out that its discretion in refusing to enforce an award could only be on the grounds explicitly set forth under Article V of the Convention.
The court discredited what it called Djibouti’s “disguised attempt to challenge the award on grounds that could have been brought before the arbitrator.”[2] It noted that despite being invited to comment on DCT’s authority, Djibouti declined to respond and instead raised its argument of lack of authority before the court for the first time. In light of this, the court did not accept Djibouti’s argument as an authentic challenge to the court’s subject matter jurisdiction.
This outcome is very much in line with the consistent approach of U.S. courts to a very narrow interpretation of the scope of the few grounds for declining to enforce an arbitral award under the New York Convention. This case serves as a warning of the consequences that follow should a party choose not to participate in an arbitration when given the opportunity. A party’s refusal to participate will not be looked upon sympathetically by the court, as such a lost opportunity is “self-inflicted.”[3] Parties should therefore use every opportunity to raise all arguments before the arbitral tribunal and not expect the court to entertain new arguments which could have been raised before the arbitral tribunal.
This article originally appeared in International Law News, the quarterly magazine of the ABA International Law Section, in the Spring 2023 issue (Volume 50, Issue 3). Join the International Law Section to read the full issue and access other resources regarding international law.
Problems with lack of affordability and access to housing are longstanding in the U.S. The CFPB has indicated that “minority households… continue to lack fair and equitable access to credit,” including mortgage lending.[1] These unmet needs, along with historical and ongoing discrimination such as redlining, exacerbate the racial wealth gap and leave many communities of color overlooked and underserved. However, equity and racial justice are policy priorities of the Biden Administration.[2] Special Purpose Credit Programs (SPCPs) may fill the gaps in affordability and access to housing. Special-purpose credit programs provide unique standards to make loan qualification easier for underserved populations. While applicants must meet a clearly defined set of criteria to take advantage of these programs, the purpose of a SPCP is to provide access to credit for groups that might have a difficult time qualifying for credit because their communities were underserved in the past.
The Equal Credit Opportunity Act (ECOA) and its implementing regulation, Regulation B, permit creditors to offer or participate in SPCPs to meet special needs through:
Any credit assistance program authorized by federal or state law for the benefit of an economically disadvantaged class of persons;
Any credit assistance program offered by a non-for-profit organization for the benefit of its members or an economically disadvantaged class of persons; or
Any SPCP offered by a for-profit organization, or in which such an organization participates to meet special social needs, if:
the program is established and administered pursuant to a written plan that identifies the class of persons that the program is designed to benefit under the procedures and standards for extending credit under the program; and
the program is established and administered to extend credit to a class of persons who, under the organization’s customary standards of creditworthiness, probably would not receive such credit or would receive it on less favorable terms than are ordinarily available to other applicants applying to the organization for a similar type and amount of credit.[3]
In January 2021, the CFPB issued an Advisory Opinion (AO) indicating the content required in a written plan used by a for-profit organization that establishes and administers a SPCP under the ECOA and Regulation B.[4] In addition, the AO clarifies the data that may be appropriate to inform for-profit organizations’ determination that an SPCP is needed to benefit a certain class of persons.
Nonetheless, some stakeholders expressed uncertainty as to the treatment of ECOA and Regulation B SPCPs under the Fair Housing Act (FHA). While SPCPs are specified under ECOA, they are not specified under the FHA. However, in December 2021 the Department of Housing and Urban Development issued guidance confirming SPCPs for real estate loans or credit assistance that are compliant with ECOA and Regulation B generally would not violate the FHA.[5]
In February 2022, the CFPB joined with seven other federal agencies and released a statement appealing to lenders to consider ways to heighten credit access through SPCPs in ways that could enhance lenders’ serving historically disadvantaged communities.[6]
Homeownership is one of the primary ways in which American families build and pass on wealth to the next generation. Lenders have an interest in meeting the credit needs of underserved communities while meeting and furthering business objectives. SPCPs can be used to expand credit access for underserved borrowers who have been overlooked but can repay their debt. SPCPs are one way to address this gap and bring fair access to financial services to additional potential homeowners.
Government agencies and lenders are identifying new ways to advance equity by increasing homeownership opportunities for underserved populations. Numerous financial institutions have dedicated billions of dollars to increasing ways to meet the needs of underserved communities. Further, lenders are increasingly interested in taking more proactive means to develop lending opportunities for members of communities of color that have faced discrimination and historically been excluded from access to credit and housing. These endeavors can be a fundamental part of a financial institution’s efforts to serve a broader community. However, lenders must be cognizant to undertake these activities in compliance with the obligations of ECOA, Regulation B, and the FHA.
Note that the applicable agencies do not determine whether a program qualifies for special purpose credit status. Accordingly, financial institutions must determine whether their programs qualify for special purpose credit status.
This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.
“Advancing Equity and Racial Justice Through the Federal Government,” The White House (last accessed Apr. 5, 2023). The Biden Administration has recognized that the housing affordability crisis is disproportionately impacting low-income communities and communities of color. Second, the Biden Administration believes that lack of affordable housing is a barrier to opportunity. Third, the Biden Administration has proposed a number of policies to address the affordable housing crisis, many of which are framed as equity issues.
In his 2023 budget, President Biden proposed a number of initiatives to address racial and economic disparities in housing, such as expanding access to homeownership for Black and Hispanic families and providing rental assistance to families with children, including: (i) increasing funding for the Low Income Housing Tax Credit (LIHTC), (ii) further reforming the Affirmatively Furthering Fair Housing (AFFH) rule, and (iii) providing new Project-Based Rental Assistance (PBRA) to extremely low-income (ELI) renter households. See “FACT SHEET: President Biden’s Budget Lowers Housing Costs and Expands Access to Affordable Rent and Home Ownership,” The White House, Mar. 9, 2023. ↑
In May and June, three new states enacted comprehensive consumer data privacy laws. On May 19, 2023, Montana Governor Greg Gianforte signed the Montana Consumer Data Privacy Act into law; the act takes effect on October 1, 2024. On June 18, 2023, Texas Governor Greg Abbott signed the Texas Data Privacy and Security Act into law, with most of its provisions taking effect on July 1, 2024. And on July 18, 2023, Oregon Governor Tina Kotek signed the Oregon Consumer Privacy Act into law; it will take effect on July 1, 2024. These are the newest states to enact comprehensive data privacy laws, following California, Virginia, Colorado, Utah, Connecticut, Iowa, Indiana, and Tennessee.
The Montana, Oregon, and Texas privacy laws generally impose similar obligations to those provided for under the comprehensive privacy laws that other states have passed. However, there are key distinctions in these laws that can have a large impact on a business’s data processing. Accordingly, potentially covered businesses should carefully evaluate the law’s applicability, disclosure obligations, specific requirements related to opt-out rights, and data protection assessment requirements.
The Montana Privacy Act generally applies to entities that both:
conduct business in Montana or produce products or services that are targeted to the residents of Montana; and
control or process the personal data of:
at least 50,000 consumers; or
at least 25,000 consumers and derive more than 25% of gross revenue from the sale of personal data.
The Oregon Consumer Privacy Act applies to any person that conducts business in Oregon or provides products or services to Oregon residents that in a calendar year:
controls or processes data of 100,000 or more consumers (except to the extent such data is processed solely for the purpose of completing a payment transaction); or
controls or processes data of 25,000 or more consumers, while deriving 25% or more of the person’s annual gross revenue from selling personal data.
Unlike the revenue and data volume thresholds in the Montana and Oregon laws, the Texas Data Privacy and Security Act has a small business exclusion. The Texas Data Privacy and Security Act generally applies to persons that conduct business in Texas or produce products or services consumed by residents of Texas and excludes small businesses as defined by the U.S. Small Business Administration (which applies to businesses with fewer than 500 employees). Further, while the Texas Data Privacy and Security Act does not apply broadly to small businesses, it does include a provision prohibiting small businesses from engaging in the sale of sensitive data without receiving prior consent from the consumer. All three new consumer data privacy laws include a number of exemptions, including for financial institutions subject to the Gramm-Leach-Bliley Act.
The Texas and Montana privacy laws impose separate responsibilities on controllers and processors. Both acts define a controller as an individual or legal entity that, “alone or jointly with others, determines the purpose and means of processing personal data.” A processor “processes personal data on behalf of a controller.” Determining whether a person is acting as a controller or processor with respect to a specific processing of data is a fact-based determination. A processor must adhere to the instructions of a controller and assist the controller in meeting its obligations, including obligations related to data security and breach notification, as well as providing necessary information to enable the controller to conduct and document data protection assessments.
Both the Montana and Texas privacy laws subject controllers to purpose specification and limitation requirements, data security requirements, disclosure requirements, nondiscrimination requirements, data protection assessment requirements, and opt-in consent requirements for sensitive data.
All three consumer data privacy laws provide consumers with a number of rights related to their personal data. Consumers, by submitting a request to the controller, have the right to know whether the controller is processing the consumer’s personal data; the right to correct inaccuracies; the right to delete their personal data; the right to receive access to the data; and the right to opt out from a controller’s processing of personal data used for the sale of the data, targeted advertising, or certain profiling.
The Oregon Consumer Privacy Act contains heightened protections (i.e., a requirement that data may not be processed without a consumer’s affirmative “opt-in” consent) for “sensitive data.” This includes personal data revealing racial or ethnic background; national origin; religious beliefs; mental or physical condition or diagnosis; sexual orientation; gender identity; crime victim status; citizenship or immigration status; genetic or biometric data; and precise geolocation data. The Oregon Consumer Privacy Act also requires controllers to provide a comprehensive privacy notice that includes: the categories of data processed; purposes for processing data; how to exercise consumer rights; categories of data shared with third parties and categories of third parties receiving data; and contact information.
Notably, none of the three new consumer data privacy laws provide consumers with a private right of action. The attorney general in each state holds the exclusive authority to enforce the law. In Texas and Montana, the attorneys general must provide written notice that includes the specific provisions that have been violated and an opportunity to cure the violation. The attorney general must provide thirty days’ written notice in Texas and sixty days’ written notice in Montana. If the controller or processor fails to cure the violation within the time period, the attorney general may initiate an enforcement action. In Oregon and Texas, the attorneys general can seek civil penalties of up to $7,500 for each violation.
Mortgage originators and secondary market issuers use automated valuation models (AVMs) in determining the worth of collateral securing mortgages on consumers’ principal dwellings. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which added section 1125 to the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), Congress directed the Board of Governors of the Federal Reserve System (Board), the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Federal Housing Finance Agency (FHFA), and the Consumer Financial Protection Bureau (CFPB) (hereinafter, the “Agencies”) to develop regulations for quality control standards for AVMs.
Section 1125 of FIRREA requires that AVMs meet quality control standards designed to:
ensure a high level of confidence in the estimates produced by automated valuation models;
protect against the manipulation of data;
seek to avoid conflicts of interest;
require random sample testing and reviews; and
account for any other such factor that the Agencies determine to be appropriate.
On June 21, 2023, the Agencies published a proposed rule (hereinafter the “Proposal”) in the Federal Register to implement the required quality control standards. Under the Proposal, the Agencies would require institutions that engage in certain credit decisions or securitization determinations to adopt policies, practices, procedures, and control systems to: (i) ensure that AVMs used in transactions to determine the value of mortgage collateral adhere to quality control standards designed to ensure a high level of confidence in the estimates produced by AVMs; (ii) protect against the manipulation of data; (iii) seek to avoid conflicts of interest; (iv) require random sample testing and reviews; and, (v) comply with applicable nondiscrimination laws.
Comments must be received by August 21, 2023.
What Is an AVM?
As described in the Proposal, the term ‘‘automated valuation model’’ is “commonly used to describe computerized real estate valuation models used for a variety of purposes, including loan underwriting and portfolio monitoring.” Section 1125 of FIRREA defines an AVM as ‘‘any computerized model used by mortgage originators and secondary market issuers to determine the collateral worth of a mortgage secured by a consumer’s principal dwelling.’’ The Proposal defines an AVM as any computerized model used by mortgage originators and secondary market issuers to determine the value of a consumer’s principal dwelling collateralizing a mortgage.
Which Transactions Would Be Covered?
The quality control standards in the Proposal would be applicable only to AVMs used in connection with making credit decisions or covered securitization determinations regarding a mortgage (covered AVMs), as defined in the Proposal.
Other uses of AVMs, such as for portfolio monitoring, do not involve making a determination of collateral value and thus are not within the scope of the Proposal. The Proposal further would not cover the use of AVMs in the development of an appraisal by a certified or licensed appraiser, nor in the review of the quality of already completed determinations of collateral value (completed determinations).
The Proposal would, however, cover the use of AVMs in preparing evaluations required for certain real estate transactions that are exempt from the appraisal requirements under the appraisal regulations issued by the OCC, Board, FDIC, and NCUA, such as transactions that have a value below the exemption thresholds in the appraisal regulations. In this regard, the Proposal would not incorporate a transaction-based exemption threshold, such as loans under $400,000.
Credit decisions are defined in the Proposal to mean a decision regarding whether and under what terms to originate, modify, terminate, or make other changes to a mortgage. The proposed definition of credit decision would include a decision regarding whether to extend new or additional credit or change the credit limit on a line of credit. Monitoring the value of the underlying real estate collateral in the mortgage originators’ loan portfolios would not be a credit decision for the purposes of the Proposal.
The OCC, Board, FDIC, NCUA, and FHFA would define dwelling to mean a residential structure that contains one to four units, whether or not that structure is attached to real property. The term would include an individual condominium unit, cooperative unit, factory-built housing, or manufactured home, if any of these are used as a residence. The proposed definition of dwelling also would provide that a consumer can have only one principal dwelling at a time. Thus, a vacation or other second home would not be a principal dwelling. However, if a consumer buys or builds a new dwelling that will become the consumer’s principal dwelling within a year or upon the completion of construction, the new dwelling would be considered the principal dwelling.
The CFPB proposes to codify the AVM requirements in Regulation Z. The definition of dwelling proposed by the other agencies is consistent with the CFPB’s existing Regulation Z. Unlike the Truth in Lending Act (TILA), however, title XI generally does not limit its coverage to credit transactions that are primarily for personal, family, or household purposes. Because this rulemaking is conducted pursuant to title XI rather than TILA, the CFPB proposes to revise Regulation Z and related commentary to clarify that this rule would apply when a mortgage is secured by a consumer’s principal dwelling, even if the mortgage is primarily for business, commercial, agricultural, or organizational purposes.
The Proposal would define mortgage as fully as the statute appears to envision, in the language of section 1125(d). Consequently, for this purpose, the Agencies would adopt in part the Regulation Z definition of ‘‘residential mortgage transaction.’’
The Proposal would also cover instances where an appraisal waiver is granted by an investor (such as a government-sponsored enterprise like Fannie Mae or Freddie Mac) and the investor uses an AVM.
Prior Guidance and Which Entities Would Be Covered by Which Agencies under the Proposal
Since 2010, the OCC, Board, FDIC, and NCUA have provided supervisory guidance on the use of AVMs by their regulated institutions in Appendix B to the Interagency Appraisal and Evaluation Guidelines (hereinafter “Guidelines”).
The Guidelines recognize that an institution may use a variety of analytical methods and technological tools in developing real estate valuations, provided the institution can demonstrate that the valuation method is consistent with safe and sound banking practices. The Guidelines recognize that the establishment of policies and procedures governing the selection, use, and validation of AVMs, including steps to ensure the accuracy, reliability, and independence of an AVM, is a sound banking practice. In addition to Appendix B of the Guidelines, the OCC, Board, and FDIC have issued guidance on model risk management practices (hereinafter “Model Risk Management Guidance”) that provides supervisory guidance on validation and testing of models.
The NCUA is not a party to the Model Risk Management Guidance. The NCUA monitors the model risk efforts of federally insured credit unions through its supervisory approach by confirming that the governance and controls for an AVM are appropriate based on the size and complexity of the transaction; the risk the transaction poses to the credit union; and the capabilities and resources of the credit union. The CFPB and FHFA are also not parties to the Guidelines or the Model Risk Management Guidance. The FHFA has separately issued model risk management guidance that provides the FHFA’s supervisory expectations for its regulated entities in the development, validation, and use of models.
Section 1125(c)(1) of FIRREA provides that compliance with regulations issued under section 1125 shall be enforced by, “with respect to a financial institution, or subsidiary owned and controlled by a financial institution and regulated by a Federal financial institution regulatory agency, the Federal financial institution regulatory agency that acts as the primary Federal supervisor of such financial institution or subsidiary.’’
Section 1125(c)(1) applies to a subsidiary of a financial institution only if the subsidiary is (1) owned and controlled by a financial institution and (2) regulated by a federal financial institution regulatory agency. Section 1125(c)(2) provides that, with respect to other participants in the market for appraisals of one-to-four-unit single-family residential real estate, compliance with regulations issued under section 1125 shall be enforced by the Federal Trade Commission, the CFPB, and a state attorney general.
The NCUA has long acknowledged that subsidiaries of federally insured credit unions—also referred to as credit union service organizations (CUSOs)—and their employees are not subject to regulation by the NCUA as contemplated by Congress under statutory provisions similar to section 1125(c). Unlike the Federal banking agencies that do have supervisory and regulatory authority over subsidiaries of their regulated institutions, the NCUA does not have authority to supervise or examine subsidiaries owned and controlled by federally insured credit unions. Rather, the NCUA’s regulations only indirectly affect CUSOs. For example, NCUA’s regulations permit federally insured credit unions to invest only in CUSOs that conform to certain specified requirements.
The Proposal would not alter that position. If the Proposal is made final, given that in the context of federally insured credit unions the authority under section 1125(c)(1) applies to subsidiaries owned and controlled by a federally insured credit union and regulated by the NCUA, the NCUA would not take action to enforce the requirements of this rule under section 1125(c)(1) with respect to CUSOs. Rather, under section 1125(c)(2), the Federal Trade Commission, the CFPB, and state attorneys general would have enforcement authority over CUSOs—whether owned by a state or federally chartered credit union—in connection with a final AVM rule. Accordingly, the Proposal would provide that the NCUA’s regulations apply to credit unions insured by the NCUA that are mortgage originators or secondary market issuers.
The NCUA is also proposing to amend its regulations to clearly include the proposed AVM regulations in the NCUA’s list of regulatory provisions applicable to federally insured, state-chartered credit unions. Accordingly, the Proposal would provide that insured credit unions must adhere to these NCUA requirements.
Required Procedures and Prohibition on Discrimination
The Proposal would require adopting and maintain policies, practices, procedures, and control systems to ensure that AVMs used in relevant transactions adhere to quality control standards addressing the first four factors laid out in Section 1125 of FIRREA. This would allow mortgage originators and secondary market issuers flexibility to set quality control standards for covered AVMs “based on the size of their institution and the risk and complexity of transactions for which they will use covered AVMs.”
These quality control factors are consistent with practices that many participants in the mortgage lending market already follow and with the Guidance described above.
The Agencies considered whether to propose more prescriptive requirements for the use of AVMs and decided not to do so. The Agencies concluded that the statute does not require the Agencies to set prescriptive standards for AVMs. Further, because section 1125 provides the Agencies with the authority to ‘‘account for any other such factor’’ that the Agencies ‘‘determine to be appropriate,” the Agencies also propose to include a fifth factor that would require mortgage originators and secondary market issuers to adopt policies, practices, procedures, and control systems to ensure that AVMs used in connection with making credit decisions or covered securitization determinations adhere to quality control standards designed to comply with applicable nondiscrimination laws.
The Proposal notes that existing nondiscrimination laws apply to appraisals, and AVMs and institutions have a preexisting obligation to comply with all federal laws, including federal nondiscrimination laws. For example, the Equal Credit Opportunity Act (ECOA) and its implementing Regulation B bar discrimination on a prohibited basis in any aspect of a credit transaction. The Agencies have long recognized that this prohibition extends to using different standards to evaluate collateral, which would include the design or use of an AVM in any aspect of a credit transaction in a way that would treat an applicant differently on a prohibited basis or result in unlawful discrimination against an applicant on a prohibited basis. Similarly, the Fair Housing Act prohibits unlawful discrimination in all aspects of transactions related to residential real estate transactions, including appraisals of residential real estate.
The Agencies note that, as with models more generally, there are increasing concerns about the potential for AVMs to produce property estimates that reflect discriminatory bias, such as by replicating systemic inaccuracies and historical patterns of discrimination. Models could discriminate because of the data used or other aspects of a model’s development, design, implementation, or use. Attention to data is particularly important to ensure that AVMs do not rely on data that incorporate potential bias and create discrimination risks.
Because AVMs arguably involve less human discretion than appraisals, AVMs have the potential to reduce human biases. Yet without adequate attention to ensuring compliance with federal nondiscrimination laws, AVMs also have the potential to introduce discrimination risks. Moreover, if models such as AVMs are biased, the resulting harm could be widespread because of the high volume of valuations that even a single AVM can process.
While existing nondiscrimination law applies to an institution’s use of AVMs, the Agencies propose to include a fifth quality control factor relating to nondiscrimination to heighten awareness among lenders of the applicability of nondiscrimination laws to AVMs. Specifying a fifth factor on nondiscrimination would create an independent requirement for institutions to establish policies, practices, procedures, and control systems to specifically address nondiscrimination, thereby further mitigating discrimination risk in use of AVMs. Specifying a nondiscrimination factor may also increase confidence in AVM estimates and support well-functioning AVMs. In addition, specifying a nondiscrimination factor could help protect against potential safety and soundness risks, such as operational, legal, and compliance risks, associated with failure to comply with nondiscrimination laws.
The Agencies propose that institutions would have the flexibility to design fair lending policies, procedures, practices, and control systems that are in compliance with fair lending laws and take into account their business models regarding the first four quality control factors listed above.
Proposed Implementation Period
The Agencies propose an effective date of the first day of a calendar quarter following the twelve months after publication in the Federal Register of any final rule based on the Proposal.
One thing you can do this summer to advance the Rule of Law is to take the recently launched American Bar Association (ABA) research survey on AI & Economic Justice, and share it widely with your networks, on your listservs, and in your community forums.
The question of how AI and AI regulation impact low-income and marginalized people is important for ensuring the Rule of Law. At its core, the Rule of Law is a political ideal that all citizens and institutions within a country, state, or community are accountable to the same laws. The Rule of Law is essential to a stable and healthy business environment, as it facilitates the social, political, and legal stability necessary for such an environment. As technology fundamentally transforms what people can do and how they interact, ensuring accountability at all levels of society, across all pockets and corners of society, becomes essential to the very fabric, integrity, and stability of our legal system. As issues of access to justice most often impact those with limited means, taking extra efforts to account for equal enforcement of the laws at the margins of society helps us better assess whether our system is, in fact, holding everyone accountable to the same standards. This injects our legal system, and our society at large, with considerable stability.
This bar year, through the leadership of the ABA’s Civil Rights and Social Justice Section (CRSJ) Chair Juan Thomas, the ABA has been focused on shedding light on economic justice issues that are inextricably connected to the CRSJ’s broader civil rights agenda. In line with the theme of economic justice, through collaboration between its Economic Justice and Privacy and Information Protection committees and with support and cooperation from across the ABA, CRSJ developed a project that focused on understanding how artificial intelligence impacts low-income people and other marginalized groups. According to CRSJ Chair Thomas, the project aims to “promote public policy solutions that understand and support the important balance between technological advancement and social justice.”
Initial research by the project leadership team showed that public attention on this issue was moving from one hot topic to the next, without any information on the overall or systematic harms and benefits that AI is creating for marginalized groups. There was a palpable need for an organized mapping of the impacts and touchpoints of AI and AI regulation for low-income people and other marginalized groups. To begin the work, CRSJ designed the AI & Economic Justice Survey.
To take the survey, please visit ambar.org/ai, the online landing page for the survey. Here, you will find more information about the project, a recording of a webinar where members of the AI & Economic Justice Project provide guidance on how to take the survey, and a link to the survey itself. Project leader Marilyn Harbur, co-chair of the Economic Justice Committee, emphasizes the importance of sharing the survey broadly with others as well as filling it out yourself. Alert your friends and colleagues, especially those working with clients located in remote areas. Project leader Alfred Mathewson sees that survey “as your opportunity to help the legal profession assure that no one is unfairly burdened by the A.I. explosion.” He encourages people to take the survey and to spread the word to colleagues and friends.
According to Chair Thomas, “The ABA Section of Civil Rights & Social Justice has launched the ‘AI & Economic Justice Project’ because artificial intelligence (AI) is shaping and changing aspects of our society in innovative ways. From facial recognition to deepfake technology to criminal justice, and health care, these applications are seemingly endless, and more is to come. However, with advances in AI, we must also be focused on protecting vulnerable communities, because in recent years, algorithmic decision-making has produced unfair bias: inequitable, discriminatory, and otherwise problematic results in significant areas of the American economy.”
The survey is a first-of-its-kind ABA research survey designed to identify the ways that AI and automation are impacting low-income and marginalized populations. It is an iterative survey that works to map out what remains a relatively unknown territory. What is learned this year will contribute to improving the survey for next year. Through iterative and annual surveys, the aim is to establish the ABA as a repository for important and time-sensitive information about the impact of technological change on low-income people and other marginalized groups. In addition to helping the ABA set and fine-tune policy, from a business perspective, such a repository would also support business lawyers by flagging areas of potential business risk and opportunity.
With the support and direction of CRSJ Chair Thomas and CRSJ Section Director Paula Shapiro, the project was lifted to the attention of the broader ABA community and has, thus, benefitted from the knowledge and skill of the broader ABA membership. A call for volunteers and support resulted in more than one hundred responses from members across the ABA and an ABA-wide convening on the proposed format and content of the survey. The convening was organized and facilitated by project leaders, including Christopher Frascella, Grant Fergusson, Susan Berstein, and Rubin Roy, with coordination from CRSJ Associate Director Alli Kielsgard and help from CRSJ interns.
In addition to being supported by a sizeable leadership team with members from across various ABA Sections and committees, the survey owes particular thanks to enthusiastic and expert partners from the Cybersecurity Legal Task Force, Judge Alvin Thompson and John Stout of the Business Law Section’s Rule of Law Working Group, and the Science and Technology Law Section, among others.
As an illustration of the project‘s approach, project leader James Pierson, co-chair of the Economic Justice committee, points to comments from FTC Commissioner Rebecca Kelly Slaughter in an August 2021 article on “Algorithms and Economic Justice.” There, Slaughter points out the need for balance, as the new technology is “neither a panacea for the world’s ills nor the plague that causes them.” Slaughter cites the words of MIT-affiliated technologist R. David Edelman, “AI is not magic; it is math and code.” She goes on to caution that “just as the technology is not magic, neither is any cure to its shortcomings. It will take focused collaboration between policymakers, regulators, technologists, and attorneys to proactively address this technology’s harms while harnessing its promise.”[1]
In that spirit, the project leaders ask you to join them in focused collaboration in completing the survey and supporting the ABA AI & Economic Justice project with your expertise so that all members of society, particularly those who may be of a more vulnerable socioeconomic status or in a protected category under the law, may be beneficiaries and not targets or victims of advances in artificial intelligence.
This article is part of a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
“ESG” refers to the three broad pillars of Environmental, Social, and Governance considerations, which have become increasingly important in assessing certain for-profit businesses, especially publicly traded ones. With ever-intensifying demands from regulators, investors, and the public for attention to ESG issues, for-profit companies are increasingly focused on ESG considerations, initiatives, and compliance. ESG-related shareholder and class-action litigation, governmental investigations, and enforcement actions in the corporate world have expanded at a rapid clip. In addition, regulators both in and outside of the United States have promulgated new mandatory rules, disclosure obligations, and enforcement mechanisms for ESG-related conduct. The Securities and Exchange Commission (“SEC”), the Federal Trade Commission (“FTC”), and state attorneys general have taken the regulatory enforcement lead domestically.
While there are no universal definitions of ESG, the three primary ESG pillars generally involve the following issues, among others:
Environmental: climate change, resource depletion, waste and pollution, and deforestation.
Social: working conditions, employee relations and DEIA, health and safety, interaction with local communities (including indigenous communities), and conflict and humanitarian crises.
Governance: board diversity and structure, executive compensation, and ethics.
While ESG is a broader concept than Diversity, Equity, Inclusion, and Accessibility (“DEIA”), it includes and incorporates DEIA. DEIA programs fostering the hiring and promotion of African American employees and other underrepresented workers have been prominent in corporate America in recent years. For-profit corporations have been under enormous scrutiny of late regarding their hiring and promotion policies and practices—from both the left and right sides of the political aisle. A number of states have passed laws and issued executive orders requiring, or in some cases prohibiting, DEIA practices. Most recently, the U.S. Supreme Court’s June 2023 decision banning race-conscious college admissions—and the rationale underlying it—have raised concerns about the ruling’s potential broader implications, particularly in federal employment law, and perhaps even more broadly, such as in connection with federal funding. And even in advance of future court rulings, concerns have been raised about the possibility of some employers’ curtailing current diversity efforts in the workplace and halting new ones.
ESG and DEIA are controversial in some circles. There is a growing attack from the political right on corporate policies aimed at diversity in hiring and promotion and other social and environmental goals, with that attack taking the form of lawsuits, requesting agency investigations, congressional investigations, public pressure, and more.
So, what does any of this have to do with nonprofits? While nonprofit organizations are not subject to the specific ESG regulatory requirements and legal standards applicable to certain for-profit companies (such as those enforced by the SEC), nonprofits have incorporated DEIA into their programs, activities, governance, and operations for years, and they are increasingly voluntarily incorporating ESG principles and practices into their organizations. They may do so under pressure from their boards of directors, employees, grant-makers, donors, sponsors, advertisers, and other third parties. They also may do so in order to attract and retain a younger generation of staff that is increasingly sensitized to and mindful of ESG principles.
In doing so, nonprofits expose themselves to potential legal jeopardy in a wide array of areas. This article explains the legal risks inherent to ESG-related initiatives for nonprofit organizations and provides practical tips and guidance on how nonprofits can effectively mitigate those risks.
The Primary Legal Risks of Nonprofit ESG Programs
When a nonprofit organization voluntarily decides to weave ESG principles and practices into its organizational and operational fabric, it is taking on a certain degree of legal risk. To be sure, that risk is not anything remotely like the risk faced by for-profit companies—particularly publicly traded companies—that are subject to ESG statutory and regulatory mandates from the SEC and elsewhere. Nonprofits are not subject to such mandates. Nonetheless, nonprofits do face ESG-related legal risks. A non-exhaustive list of such risks follows.
Employment Law: ESG initiatives—particularly those that involve DEIA issues—can involve changes to hiring and promotion practices, workplace diversity, and employee compensation and benefits, which can trigger employment-related legal risks such as discrimination, harassment, and wrongful termination claims. This is nothing new, and laws like Title VII of the federal Civil Rights Act and state equivalents have been applied to nonprofit employers for more than fifty years. But what is new is the potential impact of the U.S. Supreme Court’s June 2023 ruling (Students for Fair Admissions v. Harvard and Students for Fair Admissions v. University of North Carolina) rejecting race-conscious admissions in higher education. While the new decision does not impede employers from pursuing diversity in their workforces (as it is limited solely to higher education admissions), many experts maintain that, as a practical matter, the ruling will likely discourage some employers from putting in place ambitious diversity policies in hiring and promotion—or prompt them to rein in existing policies—by encouraging new lawsuits in the employment arena under the new legal standard. In principle, the logic of the Court’s ruling on college admissions could threaten employer programs that, as of today, can take race into account if workers were previously excluded from a job category based on race or can do so to remove obstacles (such as unconscious bias) that prevent employers from having a more diverse workforce. But the more meaningful effect of the Court’s decision is likely to be greater pressure on policies that were already on questionable legal ground. These could include, for instance, staff leadership acceleration programs or internship programs that are open only to members of underrepresented groups. It also would not be surprising to see the Court use the ruling’s rationale to limit race-conscious initiatives in other aspects of nonprofit governance and management in the future, such as if federal funds are involved.
State Laws and Executive Orders Restricting DEIA Policies, Trainings, and Practices: Effective July 2022, Florida’s Individual Freedom Act, or the so-called “Stop WOKE” law, restricts diversity-related training in private Florida workplaces—including nonprofits based in Florida or (presumably) that have Florida-based employees—and also bars the teaching of critical race theory in K-12 schools and universities. That law is currently the subject of litigation that is working its way through the courts. In February 2023, Texas Governor Greg Abbott issued a memorandum to state agencies warning them to not use any DEIA programs in hiring that are “inconsistent” with Texas law, including setting diversity goals or interview targets for diverse candidates. While the memorandum is limited to public employers, it is unclear whether the governor may take similar action toward private employers in Texas. While California had adopted laws requiring certain racial, ethnic, and gender diversity on boards of directors of public companies headquartered in California, both laws have been struck down by courts, and appeals are underway. Observers widely expect a proliferation of such laws and executive orders restricting DEIA policies, trainings, and practices in a variety of “red” states. Beyond the employment realm, it would not be surprising to see new state laws and executive orders that could effectively prohibit DEIA initiatives in other aspects of nonprofit governance and management, such as board composition, volunteer leader selection, and grantmaking, as well as government grants, contracts, and cooperative agreements.
Misrepresentation and Greenwashing: There is a risk of publicly misrepresenting or overstating a nonprofit’s ESG performance, which could lead to charges of “greenwashing” or otherwise engaging in deceptive or misleading conduct. This could result in donor or funder backlash, reputational damage, and potentially even regulatory enforcement by state attorneys general, as well as private litigation. While nonprofits should always be mindful of these longstanding risks of making misleading or non-substantiated claims in connection with all of their programs and activities—well beyond ESG—the legal and public relations risks can be particularly acute here.
“Derivative” Suits:Nonprofits that incorporate ESG into their investment policy statement and base investment decisions, in part, on ESG criteria and then face material investment losses may risk being on the opposite end of “derivative”-type lawsuits alleging that the nonprofit’s board of directors and/or investment committee were not prudent stewards of the organization’s resources.
Data Privacy and Security: Nonprofits’ ESG activities often involve, in part, collecting, processing, and storing sensitive data about volunteer leaders, employees, donors, funders, and other stakeholders. There is a risk of data breaches or mishandling of information, which could result in legal action, regulatory penalties, and reputational harm. If a data breach occurs, there is an ever-increasing web of requirements imposed by state, federal, and international laws that must be followed.
Mitigating the Legal Risks of Nonprofit ESG Programs
To mitigate these legal risks, there are a number of proactive steps that nonprofit organizations can take. Below is a non-exhaustive list:
Ensure that your nonprofit’s employment policies and practices are fully compliant with all current federal and state legal standards in areas involving discrimination, harassment, wrongful termination, and otherwise. This necessarily means ensuring that any current or future employment diversity initiatives are narrowly tailored as permitted by current law and do not result in discrimination. It also means not overreacting to the June 2023 U.S. Supreme Court decision involving race-conscious college admissions but keeping a close eye on future legal developments in the employment context. For those nonprofits with remote employees in different states, remember that state employment laws generally apply to any employee who regularly works from the state, irrespective of where the organization is based. Be sure to always consult with employment counsel fluent in both federal law and the laws of the applicable states. Finally, outside of the workplace setting, keep an eye on future rulings from the U.S. Supreme Court that could apply the rationale underlying the college admission decision to other aspects of nonprofit governance and management, for instance if federal funds are involved.
While Florida’s Individual Freedom Act includes nonprofits based in Florida (and presumably those with Florida-based employees) in its restrictions on diversity-related training in private Florida workplaces, most other state laws and executive orders to date that restrict DEIA policies, trainings, and practices do not apply to nonprofits. That may well change in the coming months and years, however, particularly in certain “red” states. It is important to stay on top of all new state developments in this area—both those affecting the workplace and those potentially affecting other aspects of nonprofit governance and management—and take all necessary steps to comply with them.
Ensure that all public statements regarding your nonprofit’s ESG performance are accurate, fully substantiated with appropriate data and documentation, and not in any way overstated, misleading, or deceptive.
Working with a professional investment advisor, adopt an investment policy statement that reflects the nonprofit’s priorities, goals, risk tolerance, and financial needs but that is defensible as being reasonable, prudent, and appropriate. Be sure to revisit it on a regular basis and update it as needed.
Implement strong data privacy and security measures to protect sensitive information about nonprofit volunteer leaders, employees, donors, funders, and other stakeholders and to mitigate the risk of data breaches or mishandling of such information. If a data breach occurs, be sure to closely follow the ever-increasing requirements imposed by state, federal, and international laws.
Develop clear and consistent ESG policies and practices that align with your nonprofit’s values and mission, as well as expectations of donors, funders, and other stakeholders.
Regularly engage with stakeholders such as donors, funders, and employees to ensure that your nonprofit’s ESG initiatives are transparent and meet their needs.
Maintain up-to-date knowledge of applicable state, federal, and international ESG-related laws and regulations, and ensure full compliance with them.
As with all areas of legal risk management, work with experienced legal counsel to help your nonprofit navigate the complex and ever-changing legal landscape governing ESG initiatives.
Conclusion
While ESG initiatives are thus far not mandated for nonprofit organizations as they are for certain for-profit companies, for a variety of reasons, increasingly nonprofits are voluntarily incorporating ESG principles and practices into their organizations and operations. In doing so, nonprofits can gain certain benefits but also expose themselves to potential legal risk in a wide array of areas. That being said, if properly understood and appreciated by nonprofit executives and leaders, those risks can be effectively mitigated by incorporating a number of practical tips and suggestions.
