Background

Forever 21 is well known as a “fast-fashion” mall retailer that grew quickly from its founding in 1984 through most of the past decade, appealing primarily to a young demographic whose preferences for cutting-edge fashion would otherwise exceed their budgets. In recent years, however, the retailer has been beset by a number of controversies and, more importantly, was a latecomer to the e-commerce revolution that changed the way the world shops and, in particular, the way Forever 21’s target demographic shops. Ultimately, the woes brought on by these challenges led Forever 21 to commence chapter 11 bankruptcy proceedings early in the fall of 2019 and to close over 100 locations quickly thereafter in an attempt to restructure its remaining operations.

A few months later, a buying group consisting of Simon Properties Group, a mall landlord at nearly 100 Forever 21 stores; Brookfield Property Partners, another major Forever 21 landlord; and Authentic Brands, a brand-management company whose portfolio includes such formidable names as Judith Lieber, Hickey Freeman, and Juicy Couture, successfully bid to purchase substantially all of Forever 21’s assets for $81 million in cash and the assumption of certain liabilities through a sale conducted under the auspices of the bankruptcy court under section 363 of the Bankruptcy Code. There were no other bidders for the assets, and vendors are expected collectively to write off hundreds of millions of dollars of claims against Forever 21 that will never be repaid. The buyers, meanwhile, will chance that they can successfully rehabilitate Forever 21 around a core that includes most of the retailer’s remaining U.S. stores and, in particular, one assumes, those located within the new owner groups’ mall properties.

Analysis

Forever 21’s bankruptcy came with the usual share of victims, including hundreds of vendors owed many millions of dollars, as well as Forever 21’s mall landlords. Unlike earlier retail restructuring cycles, mall landlords are no longer able to easily replace shuttered or struggling retail dodos with surviving, fitter competitors. This is because more recent retail bankruptcies have been precipitated less by problems with the pricing, value, demand, or other qualities associated with merchandise offered for sale, but rather by the platform upon which it is sold. Even prior to the devastating nationwide lockdowns caused by the coronavirus pandemic, consumers already were increasingly eschewing physical “bricks and mortar” stores for the internet, which has required traditional retailers to reconceptualize their businesses so that their stores become complements to their online presence that usually translates into smaller and/or fewer physical locations. That has a direct, material effect on retail landlords, and mall landlords in particular, who look to the marketing and name recognition provided by marquee national retail chains to drive foot traffic to their malls. In the increasingly frequent event that any of those national retailers are faced with bankruptcy or go out of business, there may no longer be eager competitors lined up to take their place because the competition is either primarily operating from a virtual, rather than actual, premises or is itself trying to right-size its physical retail footprint and is not looking for new space of that size or scale.

Without readily available replacements, therefore, mall owners are incentivized to try to keep struggling retail chains afloat, particularly where a particular retail chain has many locations within a small number of mall owners’ portfolios. Even where a distressed retailer’s prospects are questionable or too speculative for another third-party buyer, one or more major landlords may be willing to take a leap of faith on a retailer’s post-bankruptcy business plan to avoid the cost of portfolio-wide vacancies of a name-brand retailer and the potential domino effect on other stores within the same malls.

Indeed, that appears to be exactly what happened with Forever 21. The group that included Simon and Brookfield was the only group that bid—at a price too low to permit any recovery to Forever 21’s unsecured creditors. The fact that no third party came in with a competing bid under those circumstances strongly suggests that the Simon/Brookfield bid was more defensive rather than an inherent value proposition presented by a rehabilitated Forever 21. It should also be noted that this was not the first time these landlords have bought a distressed retail chain tenant out of bankruptcy—they did essentially the same thing in the chapter 11 cases of Aeropostale, a clothing chain that targets a demographic similar to that of Forever 21.

Is the purchase of troubled mall retailers by their landlords likely to become prevalent in retail chapter 11 cases? The circumstances under which such purchases are likely to make economic sense are narrowly circumscribed, which suggests that its potential to become a trend may be limited.

First, the retailer at issue must have a Goldilocks quality about it: If its rehabilitated future looks too good, then it will either attract exit financing in an amount sufficient to fund a stand-alone plan of reorganization or, if it chooses to reorganize through a sale of its business, it will attract an array of third-party financial and strategic buyers that will bid up the business to the point where it no longer is attractive to the landlords, both because the price is too high and because the very need for the landlord bid will have been eliminated or mitigated by the going-concern purchase of the business by a third party. On the other hand, if a seller’s prospects even after an operational restructuring appear weak, then the anticipated costs of preserving it, including the likelihood of ongoing losses, quickly outweigh any benefit associated with its presence within the bidding landlords’ portfolios.

Second, in order for the cost of the landlords’ investment to offer meaningful synergies, the particular tenant footprint must have the requisite level of concentration within the mall portfolios of a small number of large landlords, all or nearly all of whom must be interested in participating in the bid.

Third, the debtor-tenant itself must be a retailer that is an attractive tenant to its mall landlord in terms of its ability to drive mall foot traffic among a desirable demographic. It is probably not a coincidence that both Forever 21 and Aeropostale market to a young, highly desirable segment of the retail market that mall owners like to see frequenting their properties. One can surmise that a retailer specializing in adult incontinence products, for example, would not draw as much interest from mall owners, regardless of how rosy its post-bankruptcy EBITDA projections.

Finally, while the long-term ramifications of the COVID-19 crisis are not yet known, for the short-to-medium term it seems likely that the pandemic will independently create deepened levels of distress and liquidity constraints for mall landlords that may preclude their employment of the Brookfield/Simon strategy, irrespective of the advantages the strategy otherwise confers.

For these reasons, among others, it seems likely that the precedent set by Forever 21 and Aeropostale has created a useful, but specialized tool in the distressed retail toolbox for successfully dealing with a narrow band of chapter 11 cases from time to time, rather than a new paradigm for resolving retail bankruptcies in the new digital economy.

As we write this article mid-summer of 2020, with a resurgence in COVID-19 cases in the South, Southwest, and Western United States, uncertainty caused by the virus abounds, including in the world of M&A transactions. Due to the unpredictability caused by the pandemic, buyers and sellers of companies have less ability to predict the earnings and future performance of the target business. As either Mark Twain or Yogi Berra supposedly said, “it is difficult to make predictions, particularly about the future.”

In this current environment, parties to M&A transactions are likely to use earnouts more frequently. For parties structuring a transaction to deal with future uncertainties caused by the pandemic, earnouts can bridge the valuation gap between buyers and sellers. The purpose of an earnout is to allocate the future risks and rewards of a target business, with both parties benefitting from a successful outcome and sharing the risk if things do not work out as hoped. Earnouts, however, are inherently difficult to design and implement because they require the parties to anticipate what might happen in the future.

Earnouts are often half-jokingly referred to as “litigation magnets.” The high stakes involved means that disputes can get particularly ugly,[1] causing the expenditure of large amounts of time and money in the ensuing litigation. An earnout that has been carefully designed and considered by the parties is worth the upfront effort if it can avoid or allow a dispute to be quickly resolved.

This article brings together the perspectives of two veteran M&A attorneys with a dispute management director at SRS Acquiom. SRS Acquiom brings a wealth of experience since it has served as the seller representative, or in another comparable capacity, in over 2,100 transactions. SRS Acquiom has seen firsthand when earnouts work as intended and when they devolve into difficult-to-resolve disputes. We will take a detailed look at the complex components of a well-structured earnout from our collective experience, and discuss some best practices for designing earnouts to minimize disputes.

Use of Earnouts Before the COVID-19 Pandemic

The use of earnouts often differs by industry. Using the MarketStandard^TM transaction database of SRS Acquiom, which includes 1,300+ private-target acquisitions from 2015 to date, we compared the use of earnouts in life sciences, technology, and other industries over the past 18 months:

There is a long tradition of earnouts in the life-science industry focusing on regulatory and other specialized milestones that are not generally used for earnouts in technology and other industries. Although there are lessons to be learned from life-science transactions, in this article we focus primarily on using earnouts outside of the life-science industry because life-science transactions are so specialized, and their milestones are not generally used for earnouts in technology and other industries.

Outside of the life-science industry, buyers and sellers are generally more wary of using earnouts. As shown in the chart above, prior to the pandemic, earnouts were used in only a relatively small portion of the transactions[2] to bridge a valuation gap. Due to the uncertainty caused by the pandemic, we expect the use of earnouts to increase across these other industries.

Is an Earnout the Right Tool to Bridge the Valuation Gap?

For some earnout disputes, the root cause of the dispute was that the earnout structure was the wrong way to bridge the valuation gap. As a result, the buyer and seller may have had different expectations for the earnout, and their interests were not aligned after closing. Whether a specific earnout structure is the right tool to bridge the valuation gap begins with an analysis of the following questions:

Will the operations or products of the target business be merged with those of the buyer, or will the business be operated on a stand-alone basis? Earnouts measured on earnings or EBITDA make more sense when the target business will be operated on a stand-alone basis after closing. It is easier to design and track whether the earnings have been achieved during the earnout period when the business is compartmentalized. On the other hand, if the operations of the target business will be merged or otherwise integrated with those of the buyer, earnouts based on earnings become difficult to manage and track because both revenues and expenses must be determined. When the acquired business operations are merged with the buyer, an earnout based only on revenues may be more appropriate. Even then, however, if the products or services of the target company are sold as a “bundle” or otherwise combined with the products or services of the buyer, revenues specific to the sold business may be difficult to determine with objective certainty.

Will the management team of the seller continue working for the buyer, and if so, will the goals of the earnout align with the roles and authority assigned to the management team? If the seller’s management team will not be working for the buyer, or will have no real influence over the buyer’s operations and decision making after closing, the seller may not have faith that the buyer will be sufficiently focused on or motivated to achieve the earnout. The seller or its representative may find it challenging to adequately monitor earnout progress absent former management’s ongoing and direct role in managing the business. The reality is that even robust milestone reporting requirements may not tell the full story.

If the seller’s management team will continue working for the buyer, does the management team have a significant equity stake in the seller so that the management team will enjoy a meaningful amount of the earnout? In many technology companies, the founders and the management team may have been diluted over multiple funding rounds and own a relatively small equity stake in the target business. Similarly, in many private equity portfolio companies, the management team may have a small amount of equity. In these situations, the management team may not have a sufficiently large interest in the earnout to have a compelling incentive to achieve it. Instead, the seller’s management team may have business objectives and compensation incentives after closing that are different from those of the earnout.

The answers to these questions may lead to the conclusion that an earnout is the wrong approach. Too often, the parties do not pay enough attention to whether an earnout works in the particular circumstances of a specific transaction—in essence “kicking the can down the road” on valuation. If the buyer and seller have different expectations on whether and how the earnout will be achieved, the result can lead to a costly dispute.

Particularly, if an earnout is a significant portion of the consideration for a transaction, the seller must recognize the inherent risks involved with an earnout. It can be difficult and expensive to challenge an unfavorable earnout report even with seller-favorable earnout terms.

What Is the Right Metric to Use for an Earnout?

Determining the right earnout metric begins with an analysis of the methodology used by the buyer to value the target business, and whether that methodology is appropriate to measure the business during an earnout period. Three common ways to value target companies are:

• multiple of prior 12 months of EBITDA, which is used for companies with earnings (this is the most common valuation methodology);
• multiple of revenues, most commonly used for software and other technology companies that have been able to build significant sales but are not at the stage of having earnings; and
• a “build versus buy” analysis, in which the buyer assesses the cost to duplicate the functionality of the seller’s product or technology from scratch, versus the cost to buy the seller and its entire workforce (this measure is most commonly used for early-stage software and other technology companies prior to achieving significant sales revenues).

Generally speaking, the valuation methodology used to value the business begins the discussion for the earnout metric that will be used. If a multiple of EBITDA was used to value the business, then an increase in EBITDA is a logical place to begin. The same for revenues. When a “build versus buy” methodology is used, then neither EBITDA nor revenue measures may fit the situation. In any event, the choice of the earnout metric will require a much deeper analysis of the value that the buyer is trying to create by buying the target business, and the buyer’s business plan to create this value after closing.

Using the SRS Acquiom MarketStandard^TM transaction database, for nonlife-science transactions over the past 18 months, the most common metrics for earnouts are shown below:[3]

Before the pandemic, we were in a seller’s market with auctions of quality companies attracting numerous bidders so that sellers could obtain high prices and favorable terms. Sellers generally prefer using revenues as a metric because revenues do not include costs and expenses and are easier to measure with less ability for the buyer to skew the results. On the other hand, buyers favor using EBITDA as a metric, which includes costs and expenses, because EBITDA is generally used to gauge a company’s true operating performance and to value a business for sale. If we shift to a buyer’s market after the pandemic, we can expect more earnouts based upon EBITDA, or a combination of EBITDA and revenues, than in the past.

Nonrevenue/EBITDA metrics are common in life-science deals where the value of a target company may be based in substantial part on the future of a particular drug. For life-science deals, revenues and regulatory milestones are the most common metrics used for earnouts, or some combination, and earnings are rarely used.[4]

Outside of life-science deals, SRS Acquiom has seen some increased use of project-based or other nonrevenue/EBITDA metrics—sometimes in conjunction with these traditional approaches. The COVID-19 pandemic will likely continue to have unpredictable effects on revenue and EBITDA, so sellers and buyers should be open to other approaches for earnouts. SRS Acquiom has seen an interesting range of nonrevenue/EBITDA metrics used in conjunction with revenue and/or EBITDA, which include the following:

• Project-based metrics providing for a payment if a certain discrete project is brought to completion. For software companies, this may mean bringing a certain product or product version to market. Obviously, the success parameters and resources to be dedicated to the project must be carefully defined.
• Sales-based earnouts where a specific number of product units must be sold.
• Earnouts tied to store openings in response to the COVID-19 crisis. This approach essentially shifts the risk to the sellers if the pandemic continues to impede retail operations.

What Are Best Practices for Defining the Metric in the Purchase Agreement?

The answer to this question can be best summed up as follows: (i) be as specific as possible, (ii) use objective measures that lend themselves to outside standards of measurement by third parties, and (iii) use illustrative examples whenever possible.

For nonrevenue/EBITDA metrics, the parties must be as specific as possible when describing the milestone, whether a milestone has been achieved, and the deadlines for achieving each milestone. Parties might use commonly used terms to describe a milestone, but fail to take into account the differing interpretations of those terms if a dispute arises years later or if unexpected scenarios arise.

For EBITDA, the definition of “EBITDA” can be complex, and it is becoming more common to define “Adjusted EBITDA”—with sometimes detailed specifications for how EBITDA is being adjusted. The analysis requires the parties to review each line item of the income statement of the target business to determine whether the specific line item will be included in the calculation of EBITDA for purposes of the earnout. The analysis also requires the parties to think about possible types of revenues or expenses that would be unfair to include in the calculation, such as gains or losses from the sale of capital assets, gains or losses caused by a change in accounting policies, and gains or losses caused by one-time events outside of the ordinary course of business. For example, if the target business has a loan under the Paycheck Protection Program, the parties will want to specify that forgiveness of the loan does not factor into the EBITDA calculation. A particularly difficult area is to determine how any shared expenses—such as insurance or other overhead—will be allocated between the target business and the rest of the buyer’s business.

It can be helpful to provide a sample EBITDA calculation as an exhibit to the purchase agreement using prior financial statements showing how EBITDA was calculated and how it will be calculated for the earnout calculation. This is commonly done for other financial metrics such as net working capital and the components of what constitutes working capital in a particular transaction. It becomes more difficult, however, if the acquired business will be integrated into a larger, possibly more sophisticated business, and the accounting will be changed to conform to the accounting practices of the buyer. In that case, it is helpful to prepare a sample template using the buyer’s accounting practices to show how EBITDA will be calculated and attach that template as an exhibit to the purchase agreement.

For a financial metric such as EBITDA, the next issue is the proper accounting principles. If the target business has audited financial statements prepared in accordance with Generally Accepted Accounting Principles (GAAP), then a typical definition of the “Accounting Policies” in a purchase agreement would be: “GAAP, applied using the same accounting principles and standards, policies, procedures and classifications used by the Company in preparing the Audited Balance Sheet.” What if there is a conflict between GAAP and the methodologies used by the Company in preparing the Audited Balance Sheet? It helps to have a controlling statement in the definition to provide which one will control if there is a conflict. This also applies if there is an accounting term specifically defined in the purchase agreement that differs from GAAP—it helps to have a controlling statement within the definition of “Accounting Policies” to provide that the defined term will control if there is a conflict with GAAP.

Conflicts also can arise when a target business is a relatively small business being acquired by a much larger company with more rigorous accounting practices. Even if the small target company has audited financial statements prepared in accordance with GAAP, there can be differing interpretations of GAAP and different policies, such as the determination of “materiality.” Accordingly, it helps if those differences in how GAAP is applied by the seller and the buyer are identified during due diligence so they can be properly dealt with in the purchase agreement definitions of the applicable accounting policies and other financial terms used for the earnout.

Another challenge is that smaller companies may not have GAAP-based financial statements, and may instead use the cash basis of accounting, the tax basis of accounting, or some hybrid. For an earnout, especially if the buyer uses GAAP, it is important to determine how the financial statements of the target business and the buyer differ, and how the earnout metrics will be determined by the buyer. In this situation, it is helpful to attach a template as an exhibit to the purchase agreement showing how EBITDA or any other metric will be calculated for purposes of the earnout.

How Else Do You Structure an Earnout to Achieve the Right Result?

Using the SRS Acquiom MarketStandard^TM transaction database, for nonlife-science transactions over the past 18 months, the earnout time periods are set forth below. Interestingly, there is a slight trend toward earnout length that is indefinite or does not expire, particularly with nonfinancial or other milestones. The lack of a deadline can remove a frequent source of dispute: whether the milestone was timely achieved, or would have been timely achieved but for some act or omission of the buyer.

Prior to the pandemic, parties generally wanted the earnout period to be as short as possible. As a result of post-pandemic uncertainty, the time period for earnouts will likely increase from the current median of 24 months to longer timeframes. Given the unpredictability of how long it will take for businesses to recover from the pandemic, most companies have no visibility into what their results will be for 2020, and even into 2021. Therefore, earnout periods may extend into 2022, 2023, and beyond to give the seller more opportunity to achieve the earnout. When the earnout period increases, this places more burden on the buyer to manage and track the earnout throughout the longer timeframe. It also increases the risks that unexpected circumstances and events will occur that affect the business and restrict the buyer’s ability to make needed changes that could potentially affect the earnout, such as merging the business with other operations of the buyer.

According to the 2020 M&A Deal Terms Study published bySRS Acquiom, in nonlife-science transactions with earnouts, the earnout potential as a percentage of the closing payment averaged 30% in 2018 and 41% in 2019, although the median was likely significantly lower, given that some outlier transactions pulled the average up. Due to the changed environment after the pandemic, the earnout potential as a percentage of the closing payment may increase from the 41% in 2019 shown in the SRS Acquiom data to 50% or higher. By doing so, buyers will shift more of the uncertainty and risk caused by the pandemic to sellers. In turn, as the size of the earnout potential increases, there is more incentive for the seller to challenge the buyer over whether the earnout has been achieved. This leads to the next structural issue of whether the earnout should be structured as “all or none” or on a sliding scale.

It is an open question whether the sliding scale may lead to more earnout disputes. When an “all or nothing” threshold applies, it is frequently clear to both seller and buyer whether the earnout metric was achieved. A disagreement becomes a formal dispute only when it will make the difference between all and nothing. If the sliding scale applies, however, the disagreement may trigger a dispute at each stage if the disagreement is material. One recent SRS Acquiom matter illustrates this dynamic. It was unclear from the earnout provision whether a specific type of customer refund should be included as revenue. The disagreement over how to interpret the provision likely would not have mattered in an “all or nothing” structure. Given that a sliding scale applied, however, the difference was sufficiently material for the parties to engage counsel and escalate to a formal dispute.

One countervailing business argument for using a sliding scale, however, is that the “all or none” structure can be demoralizing to the seller’s management team (now working for the buyer) if it becomes clear that the earnout will not be achieved, and the sliding scale would maintain the incentive. Further, use of the sliding scale could reduce the amount subject to a dispute. If a sliding scale is used, it is important to use a floor and a cap to fence in the amount of the earnout payment.

That said, when an earnout is small relative to the size of the transaction, say 10%–15% as a percentage of the closing payment, and is based on EBITDA or revenue, it is not as important whether the earnout is structured with an “all or none” threshold in which the threshold must be reached to receive any portion of the earnout. For example, if the original purchase price was justified based on a sales run rate projected by the seller that now seems questionable, the buyer may request that the earnout be paid only if the sales are actually achieved.

When the earnout potential becomes a larger portion of the total consideration, and the earnout period is longer, the parties must focus on dividing up the earnout period in shorter intervals, and providing for partial payments for each earnout period. For example, for a deal closed today, the parties could set the earnout periods as calendar years 2021 and 2022, with a portion of the earnout paid for each period based on the percentage of the earnout goal that was achieved. When a sliding scale is used, this reduces the incentive to the buyer to try to skew the results if the earnout has an “all or none” threshold and the results are close to the threshold. With the uncertainty caused by the pandemic for 2020, some parties are starting the earnout period in 2021 with the thought that earnings for 2020 will not be an accurate measure of future earnings. Further, parties using partial payments for different earnout intervals may want to allow for catch-up payments if the earnout was not achieved during the initial periods, but was caught up in the final earnout period when measured over the entire earnout period.[5]

Another issue that may arise with an increase in earnouts is determining what happens to the earnout if the buyer is acquired during the earnout period. Should the earnout accelerate upon the buyer’s change of control, or continue in effect? Using the SRS Acquiom MarketStandard^TM transaction database, for nonlife-science transactions over the past 18 months, the graph below shows the percentage of transactions that accelerate the earnout payment upon a change of control.[6]

The size of the buyer relative to the size of the target business is a big factor in whether the earnout should accelerate upon a change of control of the buyer. If the target business is a large portion of the buyer’s overall business, then the sellers have a strong argument that the change of control should trigger the earnout acceleration. On the other hand, if the buyer is substantially larger than the target business, the earnout is less likely to contain an acceleration upon a change of control. In either case, the purchase agreement should specify what happens to the earnout upon a change of control rather than leaving this silent.

In the right circumstances, the parties may consider including a buyout provision under which the buyer can pay a fixed sum, or use a different metric and time period to buy out and terminate the earnout. This can be especially helpful if the buyer believes there is a reasonable possibility that the buyer could be acquired during the earnout period and would not want the earnout to impede the sale of the buyer.

What Covenants Are Appropriate for Operating the Target Business after Closing with Respect to the Earnout?

Buyers and sellers will often vigorously negotiate whether there should be controls or other constraints on how the buyer operates the purchased business during the earnout period. Buyers naturally do not want any constraints; they argue that they need full discretion to run the business to deal with rapidly changing business conditions, such as what we are seeing right now with the pandemic. Sellers, however, want a fair shot at being able to earn the earnout, especially if the management team of the seller goes to work for the buyer. Many times, “soft” promises will be made to the seller for the financial support or other resources that the buyer will provide to the business after closing so that the earnout can be achieved, but those “soft” promises never make it into the purchase agreement and are generally unenforceable. The natural tension between the seller and the buyer over the buyer’s business decisions will be exacerbated if the earnout period is long.

The Standard Operating Covenants

Using the SRS Acquiom MarketStandard^TM transaction database, for nonlife-science transactions over the past 18 months, parties used some of the following covenants in purchase agreements in the percentages described below:

[7], [8]

Sellers often push for a covenant that the buyer will operate the purchased business in accordance with seller’s past practices.

 When sellers have a lot of leverage, they will request a covenant that the buyer will operate the business to maximize earnout payments. Although these types of covenants are sometimes agreed to by the parties to get the deal done, they must recognize the potential difficulties they are causing by using these covenants. It may not be entirely clear what the parties mean with these covenants. Many times, the buyer and seller have very different interpretations of these covenants. For the covenant to run the business in accordance with seller’s past practices, in a dispute the seller must create a factual record of how the seller operated the business prior to closing and then demonstrate that the buyer failed to do so during the earnout period.[9] If the buyer is dealing with pandemic fallout, perhaps by drastically reducing expenses due to lower customer demand, certain actions by the buyer may be prudent, but not consistent with seller’s past practices.

If the earnout period is long, buyers will be uncomfortable agreeing to any covenants that restrict their ability to run the business. Buyers will want to have a statement affirming that the buyer has full discretion to direct the management, strategy and operations of the purchased business. If buyers have negotiating leverage, they may also request a statement expressly disclaiming any fiduciary duties to the seller with respect to the earnout. This is an attempt to avoid a seller’s claim that the buyer did not abide by any implied duty of good faith with respect to the earnout. Even if the purchase agreement is silent regarding fiduciary duties, Delaware courts impose a high threshold for a seller to prevail on a claim based on an implied duty of good faith.

Although not tracked by the SRS Acquiom data, it is more common for buyers to agree to a negative covenant that the buyer will not take actions in bad faith that would reasonably be expected to materially reduce the amount of the earnout. The parties will sometimes agree to an affirmative covenant for the buyer to operate the business in a commercially reasonable manner as a middle ground compromise, but in a dispute, this type of covenant is so vague that it can be difficult to base a claim on it without a more specific definition or particularly egregious facts. Sellers should keep in mind that the gray areas created by ambiguous language like “commercially reasonable manner” may work to the buyer’s advantage because the buyer can, if challenged, provide an after-the-fact rationale to its actions. The more specific the definition, the more likely these issues can be avoided or at least mitigated. For example, the parties can combine a general “commercially reasonable efforts” clause with a more specific operating covenant.

Using specific operating covenants. Where possible and appropriate, sellers should seek to establish specific negative and affirmative operating covenants, especially where those covenants are core to the ability to achieve the earnout. For example, examples of affirmative covenants are:

• providing funds for specific capital expenditures;
• allowing the business to hire additional employees for specific purposes, such as engineers, software developers, or sales staff;
• providing resources from the buyer’s corporate staff or other business units for specific purposes, such as marketing, sales advertising spend, use of the buyer’s social media accounts to promote the business, or cross-promotion from the buyer’s other products to support the sales of the products of the purchased business; and
• operating the purchased business on a standalone basis, with financial statements maintained on a separate basis.

Examples of negative operating covenants are:

• allocating corporate overhead in a disproportionate manner;
• making major changes to the business, such as combining other business units with the purchased business or selling material assets;
• materially decreasing management or employees; and
• combining products or services of the buyer with those of the purchased business.

One covenant that SRS Acquiom has found invaluable for minimizing disputes is the obligation of the parties to negotiate in good faith if there is a material change in circumstances that potentially frustrates the earnout. This obligation motivates the parties to work collaboratively to achieve the desired outcome for the buyer and secure at least a portion of the earnout for the seller.

How Do You Determine Whether the Earnout Metric Has Been Achieved?

Earnouts require sellers to have a certain degree of trust, or at least faith, in the buyer’s good intentions, but as former President Reagan famously held: “Trust, but verify.”

• Earnout reporting requirements must be specific and precise, and provided to the seller on a regular basis. This is especially important if seller’s management is no longer working for the buyer. If former owners are still working with the purchased business after the closing, the seller representative normally works closely with those former owners who act as its eyes and ears. Absent such inside access and knowledge, it can be difficult to challenge an unfavorable earnout report because the buyer controls the facts and the business records.
• The purchase agreement should include broad rights to examine business records and documents and to interview seller’s employees who are now working for the buyer. These rights will allow the seller representative to thoroughly examine an unfavorable earnout report. The mere existence of these rights in the purchase agreement and the request to interview employees can create an incentive for the buyer to act appropriately.
• In its role as seller’s representative, SRS Acquiom has accountants on staff who will review the earnout report and supporting documentation to look for indications that items are not reported consistent with the agreed-to accounting policies or not reported in the same manner that existed pre-closing.
• The right to an audit, however, is less important to sellers than one might think. Normally, disputes arise from operating decisions made by the buyer after closing that led to the unfavorable financial outcome, rather than any actions by the buyer to unfavorably manipulate the financial results.

What Are Best Practices for the Dispute Resolution Provisions Involving an Earnout?

Perhaps more than any other part of the purchase agreement, the earnout provisions require careful attention by the parties and their respective counsel. Delaware courts will strictly review the earnout provisions and apply the plain meaning of the wording. Further, as mentioned above, Delaware courts will only rarely find that the implied covenant of fair dealing was breached and regularly admonish parties that they had full opportunities to negotiate the specific terms of the agreement, and should therefore not ask the courts to add terms or duties that the parties could have negotiated beforehand.

SRS Acquiom, in its role of seller’s representative, generally likes to see the following provisions in the dispute resolution section of the purchase agreement:

• Choice of law. Many M&A transactions are governed by Delaware law, and this is particularly the case when earnouts are included. Given that so many M&A disputes are governed by Delaware law, there is well-developed and robust case law for earnouts that may provide guidance on the legal analysis and thereby help to resolve disputes without having to resort to litigation. If laws of another jurisdiction are used, it is important to understand how the case law of the other jurisdiction may differ from Delaware. For example, unlike Delaware law, case law in certain states may impose an implied duty to operate the business in a manner to achieve the earnout.
• Assuming Delaware law is used, SRS Acquiom strongly prefers exclusive venue in the Delaware Court of Chancery. The Chancery Court judges are often experienced business lawyers who are familiar with M&A transactions and have prior experience with earnouts. Disputes in Chancery Court get to trial faster than courts in other jurisdictions (including Delaware Superior or Federal Courts), which reduces the costs and stresses of litigation. There is also no jury in Chancery Court, which leads to shorter and therefore less expensive trials. In contrast, when earnout disputes end up in courts outside of Chancery Court, there is a risk that the judge, no matter how experienced in other matters, may be unfamiliar with M&A transactions generally and have no prior experience with earnouts. If the case goes to trial before a jury, the jury almost certainly will be unfamiliar with M&A. If any venue other than the Delaware Chancery Court is specified, it is advisable to include a waiver of trial by jury.
• Resolution by accounting firm versus a court. Earnout provisions may provide for an accounting firm to resolve any dispute relating to the earnout. This stems from a belief by the parties that, just like a working capital adjustment, an earnout determination will be based on GAAP or the accounting policies that an accountant should be able to determine. In this situation, it may be unclear whether the accounting firm is acting as an accounting expert to determine the proper application of GAAP or other accounting policies, or as an arbitrator with a much broader mandate to resolve any other issues.

  In the experience of SRS Acquiom, however, the proper application of GAAP or other accounting policy is rarely the sole reason for the dispute, but instead frequently involves the buyer’s underlying business decisions and whether those business decisions breached the earnout covenants. The earnout issues may be too broad and complex for an accounting firm to arbitrate, especially when the potential earnout is a large portion of the total purchase price. Although accounting arbitration can be valuable to resolve disputes over a small earnout or working capital when less is at stake, a seller on the short end of a potentially large earnout will likely file a lawsuit anyway if it suspects the buyer made inappropriate operational decisions that caused the shortfall. A particularly bad outcome is when the buyer drives up the cost by forcing a portion of the dispute into accounting arbitration while other issues are fought in a parallel litigation or traditional arbitration.

If the earnout is a large percentage of the purchase price, SRS Acquiom prefers to see the earnout dispute resolved in the Delaware Court of Chancery, with a waiver of jury trial. Traditional arbitration through AAA, JAMS, or other similar third-party arbitrator not limited to accounting issues also can be effective if the parties are particularly sensitive about keeping the dispute confidential, but based on the prior experience of SRS Acquiom, it typically does not save time or money over the Delaware Chancery Court.

• Prevailing-party fees. Earnout disputes can be expensive to resolve. The parties should consider a provision in the purchase agreement that allows attorney’s fees to be awarded to the prevailing party in a dispute, and that provides for payment of interest on a wrongfully denied earnout payment. SRS Acquiom believes these provisions can motivate parties to resolve earnout disputes before resorting to litigation.

There is no single playbook for resolving disputes, which often depend on the type of earnout at issue and what resources the buyer and seller have available. Given that earnout disputes can be expensive, sellers must ensure that the expense fund available to the seller’s representative is sufficient to allow it to properly review the earnout report and contest the findings if necessary.

Earnouts can help buyers and sellers in the current environment creatively bridge a valuation gap between them and allocate the risks of future performance. Although earnouts can be difficult to design and implement because they require the parties to anticipate future events that are inherently uncertain, careful thought by the parties and implementing best practices can help them achieve their respective goals for the transaction and minimize the possibility of a future dispute.

[1] One of the authors reviewed the pleadings of a lawsuit in New York state court over an earnout in which none of the authors were involved. The lawsuit between two private equity firms over an $8 million earnout consumed over seven years of highly acrimonious fighting between the parties, with no doubt millions of dollars of legal fees spent by the parties.

[2] The percentages of transactions with earnouts was somewhat higher in the 2019 Private Target Mergers and Acquisitions Deal Points Study published by the Business Law Section of the American Bar Association in December 2019 (ABA 2019 Deal Terms Study), which included transactions through the first quarter of 2019. This study uses only publicly available purchase agreements filed by public companies on the Edgar website of the Securities and Exchange Commission. This study showed that earnouts were used in approximately 27% of transactions occurring from 2016 to the first quarter of 2019.

[3] The ABA 2019 Deal Terms Study had a more even split between revenue and earnings as the metric, with the earnouts for 2018–1Q 2019 transactions being based 29% on revenues and 31% on earnings. This may be due to the SRS Acquiom database of transactions more weighted toward technology companies, which are more likely to use revenue for earnouts versus the more varied group of only public companies in the ABA 2019 Deal Terms Study.

[4] Using the SRS Acquiom MarketStandard^TM transaction database, for life-science transactions over the past 36 months, the most common metrics were revenue (69%), earnings (8%), regulatory milestone (53%), and other (47%). The 2020 SRS Acquiom M&A Deal Terms Study, powered by MarketStandard, analyzes more than 1,200 private-target acquisitions, valued at over $239 billion that closed from 2015 through 2019 in which SRS Acquiom provided professional and financial services. To view or download the study, go to: https://www.srsacquiom.com/resources/2020-ma-deal-terms-study/ [srsacquiom.com]

[5] An example of this structure was used in a recent transaction announced June 22, 2020, involving a public company, LeMaitre Vascular, Inc. (Nasdaq: LMAT), in which the purchase agreement was filed with the SEC. In this transaction, the earnout was structured with three earnout periods in calendar years 2021, 2022, and 2023 based on a specified number of units of product sold during each period, using an “all or none” threshold during each period. After the final earnout period in 2023, however, the purchase agreement provided for a catch-up payment based on a sliding scale if the aggregate number of units sold exceeded a minimum threshold. As a result, even if the seller missed the earnout thresholds in 2021, 2022, and 2023, the seller could still receive a partial catch-up earnout payment based on the overall performance over the entire three-year earnout period. None of the authors was involved with this transaction.

[6] The percentage of transactions in the ABA 2019 Deal Terms Study that accelerated upon a change of control was 22% for 2018–1Q 2019 transactions, which is consistent with the SRS Acquiom data.

[7] The ABA 2019 Deal Terms Study had the following for these two covenants:

• covenant to run business consistent with past practice—10% for deals in 2018–1Q 2019, which is consistent with the SRS Acquiom data; and
• covenant to run business to maximize earnout—17% for deals in 2018–1Q 2019, which is much higher than the SRS Acquiom data.

[8] The ABA 2019 Deal Terms Study showed 15% of deals in 2018–1Q 2019 had an express disclaimer of fiduciary relationship, which is the same as the SRS Acquiom data. In addition, the ABA 2019 Deal Terms Study had a corollary statement in 29% of deals in 2018–1Q 2019 that the buyer had discretion for how to operate the target business after closing.

[9] In Edinburgh Holdings, Inc. v. Education Affiliates, Inc. (DE Chancery Court June 6, 2018), Vice Chancellor Slights refused to grant a motion to dismiss based on a covenant that the buyer conduct “activities in a reasonable manner consistent with its past practices.” He stated that the question of whether operations were conducted consistent with past practices was fact intensive and required the court to consider evidence of past practices and compare those practices to those employed by the buyer post-closing.

One of the ABA Business Law Section’s most prized publications is A Manual of Style for Contract Drafting, by Ken Adams. It was published in 2004, and it’s now in its fourth edition. It has accomplished a feat rare in legal publishing—each new edition has proven even more popular than the previous edition.

Although we have no meaningful milestone or anniversary to commemorate, we thought it appropriate to check in with Ken to see how he feels about his magnum opus. Here’s what he had to say:

What, is it Happy 16th Birthday to A Manual of Style for Contract Drafting or something? Whatever prompted your inquiry, I’m always happy to ruminate about MSCD. Here goes:

It’s Big. I started my work on contract language over 20 years ago, with the aim of figuring out what works and what doesn’t work. And I’ve been at it ever since. But when your focus is on slowly fitting one brick of analysis next to another, your perspective is narrow; step back a bit and you might realize, to your surprise, that you’ve built an edifice. That’s how I felt when I got my hands on the fourth edition.

It’s Comprehensive. Over the years I’ve refined and expanded analysis of lots of topics and added some new ones. We’re almost at the stage where in response to pretty much any question about a word or phrase commonly used in contracts, I can say, it’s in MSCD. But I routinely surprise myself by finding new and different things to write about. My 2019 article in The Business Lawyer on efforts provisions (here) will allow me to add new material to the chapter on that topic. And to choose just the most recent example, my post on the phrase hereby instructs (here) means that a section on that will appear in chapter 3 (Categories of Contract Language).

It’s Popular. People all over the world tell me they consult MSCD routinely in their daily work. That’s gratifying to hear. And heck, for a few years now I’ve been able to say that MSCD has sold tens of thousands of copies. Please have someone at the ABA tell me, in thirty years or so, when I can start saying it’s sold hundreds of thousands of copies!

It’s Leading to Change—Slowly. If you were to skim a random sample of contracts, you’d be hard pressed to find any sign that drafters are following MSCD’s recommendations. That prompted someone to suggest, in a comment on my blog, that MSCD has “failed.” (See this 2017 post.) They’re mistaken. People purchased those tens of thousands of copies for a reason. And there’s all the anecdotal evidence I hear. But beyond that, anyone expecting MSCD to prompt wholesale change in contract drafting doesn’t understand how the system works. Contracts have long been drafted by copy-and-pasting from precedent contracts. MSCD by itself isn’t going to change that. MSCD helps people become better informed consumers of contract language. Even in a copy-and-paste world, that helps people save time and money and steer clear of trouble.

MSCD Is Necessary for Major Change, But Not Sufficient. I wrote MSCD because I thought we won’t be able to turn contract drafting into a commodity task without a set of guidelines for clear contract language. We now have those guidelines, so over the past ten years I’ve sporadically looked for a way to give those who work with contracts an alternative to riding the copy-and-paste train, namely an automated library of customizable commercial contracts. The challenges facing such an initiative are old-fashioned: instead of requiring gee-whiz technology, it would require expertise, publishing, and imaginative marketing. But I’m confident that before too long I’ll be able to put MSCD guidelines to use for the purpose I originally had in mind.

A Fifth Edition Is Coming, But Not Soon. The fourth edition was published in 2017. I’m in no rush to replace it. The fifth edition will continue the process of refining and expanding, but you’ll have to wait a good while. A more pressing need is the boiled-down version of MSCD, called Drafting Clearer Contracts: A Concise Style Guide for Organizations—I’d like it to come out sometime in 2021. I originally thought that MSCD would be a style guide, but it has long been way too big to serve that function.

It’s Been a Blast. Writing MSCD has been the intellectual adventure of a lifetime. I feel very fortunate.

We already know that in this review the Law Society Gazette (published by the Law Society of England and Wales) said that the fourth edition of A Manual of Style for Contract Drafting is “extraordinary,” but we wanted to hear some feedback from readers. Here’s what Ken has seen recently in posts and messages on LinkedIn.

Last week, I recommended A Manual of Style of Contract Drafting to a co-worker. She followed up today with a reply that made my week, “[My manager] ordered one and was going to drop it off at my house, but he loved it so much he didn’t want to share. He ordered me my own copy, arriving tomorrow.” Now that is leadership.

Ken Adams is someone I’ve been reading since law school. (If you draft contracts for a living, get a copy of A Manual of Style for Contract Drafting.)

I’ve just purchased your book and I’m finding it a very useful reference tool.

Ken, I recently picked up your book and wanted to let you know that I’m enjoying it! I have found it and your blog very useful in my practice. Thanks!

I joined the group after reading your manual which should be mandatory reading for all corporate lawyers.

If you work in contracts, Ken’s book is essential.

For information about Ken’s activities, go to www.adamsdrafting.com. That’s where you’ll find his blog, as well as information about his new online course, Drafting Clearer Contracts: Masterclass. It’s built around eight live hour-long sessions held once a week and supplemented by reading, quizzes, and short assignments. It’s offered to individuals and to organizations; the course home page is here. Besides his writing and training, Ken is chief content officer of LegalSifter, an artificial-intelligence company that helps with review of draft contracts. You can reach Ken at [email protected] and [email protected].

Jurisdiction over patent licensing disputes is a tricky concept to navigate. The U.S. Code grants district courts original jurisdiction “of any civil action arising under any Act of Congress relating to patents, plant variety protection, copyrights and trademarks.”[1] However, cases involving patent license agreements implicate federal patent law issues and state contract interpretation issues. Thus, in such situations, the issue presented is determining the presence of “arising under” jurisdiction under 28 U.S.C. § 1338.

In Gunn v. Minton, the U.S. Supreme Court synthesized and applied a four-part test for “arising under” jurisdiction. The claim(s) must raise an issue of federal law that is(1) necessarily raised; (2) actually disputed; (3) substantial;[2] and (4) capable of resolution in federal court without disrupting the federal-state balance approved by Congress.[3] The second factor is typically addressed briefly because usually parties are disputing the use of a patented device, process, etc.

Gunn was a malpractice case in which the plaintiff-appellant claimed his patent was invalidated because his attorney failed to timely raise an exception to the on-sale bar.[4] Applying the above four-factor test, the Supreme Court held the malpractice claims brought were so hypothetical, backward-looking, and fact-specific that the outcome of the case would affect only the parties involved; thus, jurisdiction was proper in state court.[5] However, Gunn did not provide a road map for determining jurisdiction in patent license disputes. Thus, courts have wrestled with the four-factor test established in Gunn and its jurisdictional consequences in such disputes. It is a fact-intensive test requiring analysis of contract language to find potential avenues of resolving a dispute. The test is unforgiving—resolution of the contract issue must absolutely depend on resolution of an underlying patent issue. So, under the current regime, if there is any route that does not involve resolution of an issue unique to patent law, jurisdiction is not proper in federal court.

Jang v. Boston Scientific Corporation

Interestingly, one of the first cases to apply the Gunn test did not involve a dispute concerning state versus federal jurisdiction. In Jang v. Boston Scientific Corporation, diversity jurisdiction existed, and the issue was whether the Ninth Circuit Court of Appeals or the Federal Circuit should have jurisdiction over an appeal in a patent licensing case.[6] The Federal Circuit cited language of the agreement defining “Contingent Payment Products” as “any stent . . . the development, manufacture, use, or sale of which is covered by one or more Valid Claims of the Patents . . . or which, but for the assignment made pursuant to this Agreement, would infringe one or more Valid Claims of the Patents.”[7] The agreement further defined “Valid Claim” as “(a) a claim of any issued patent which is contained within the [licensed patents] and which has not expired, lapsed, or been held invalid, unpatentable or unenforceable by a final decision, which is unappealed or unappealable, of a court of competent jurisdiction, or of an administrative agency having authority over patents.”[8] Importantly, the court noted that (1) the contract claim itself requires resolution of the underlying issue of patent infringement, and (2) because of the diversity jurisdiction and the potential for future infringement suits to be brought, maintaining jurisdiction in the Federal Circuit was best for consistency.[9]

Levi Strauss & Co. v. Aqua Dynamics Systems, Inc.

Parties have since relied on Jang to argue jurisdiction of federal courts over state courts and other agreed forums. First, in Levi Strauss & Co. v. Aqua Dynamics Systems, Inc., the Northern District of California applied Jang to a jurisdictional dispute involving an arbitration clause in a license agreement.[10] Levi Strauss entered into a licensing agreement with Aqua Dynamics’ predecessor in interest, Earth Aire.[11] Aqua claimed that Levi breached the contract by discontinuing royalty payments. [12]

The court analyzed the relevant provisions:

10.1.1 For the use of any Licensed Ozone Process which is covered by a valid and enforceable patent [“Covered Process”], during the life of the patent as to product produced by the process claimed by that patent, but in no event for more than seventeen (17) years after the end of the Development Period.

10.1.2 For the use of any Licensed Ozone Process not covered by a valid and enforceable patent [“Uncovered Process”], for seven (7) years after the end of the Development Project. LS&CO may freely use the affected Licensed Ozone Process after the expiration of this Agreement as to it.[13]

The court then reasoned that this case required that Levi continued using the Covered Processes after its obligation to pay royalties on the Uncovered Processes had lapsed on December 14, 2001, thus requiring a finding that Levi infringed Aqua’s patents and that Aqua’s patents were valid.[14] In addition, Aqua did not dispute that (1) a validity determination was necessary, and (2) there was potential for further enforcement of the patents.[15] Thus, the court determined that it would be consistent with Jang to find that the patent issues sufficiently supported “arising under” jurisdiction, and therefore jurisdiction was proper in federal court, despite the arbitration clause.[16]

Sanyo Electric Co., Ltd. v. Intel Corporation

Next, in Sanyo Electric Co., Ltd. v. Intel Corporation, the District of Delaware decided jurisdiction in a dispute involving a cross-license agreement and the products defendant Intel was authorized to make under the agreement.[17] Hera Wireless had acquired a portion of Sanyo’s patent portfolio relating to Wi-Fi chips.[18] Hera and its authorized licensing company, Sisvel UK Ltd., sued Lenovo, a client of Intel.[19] Lenovo used Intel’s chips and Intel raised a license defense.[20] Sanyo sought declaratory judgment that Intel was not authorized to sell wireless communication modules under the cross-license agreement.[21] Intel counterclaimed that the asserted patents were invalid or unenforceable as to Lenovo computers containing the accused Wi-Fi chips, and the patent rights covering those chips were exhausted.[22]

Sanyo claimed that Intel incorrectly informed third parties that Hera’s patent rights were exhausted because Sanyo had authorized Intel to make the Wi-Fi chips.[23] Analyzing the first Gunn factor, the court reasoned that although it was possible to resolve Sanyo’s claims and Intel’s breach of contract counterclaim using patent exhaustion, the controversy could be resolved by determining the products Intel could rightfully sell pursuant to the agreement. Accordingly, an issue of federal law was not necessarily raised.[24] For much the same reason, in analyzing the third Gunn factor, the court found that the potential federal issue was not substantial because the issue revolved more around an interpretation of the contract than an interpretation of federal patent law.[25] (Note that the court determined it need not make a finding as to whether a federal issue was actually disputed to satisfy the second Gunn factor.[26])

Regarding the fourth Gunn factor, the court decided the federal-state balance would be disrupted by bringing this case into federal court because the patent issues at hand did not sufficiently outweigh the interest in having the state court resolve issues involving state contract law.[27] Unlike in Levi or Jang, where determinations of infringement or invalidity were necessary, there was at least one avenue to resolve the dispute that did not involve making a determination on a patent issue. Having made these considerations, the court granted Sanyo’s motion for remand, holding that it did not have jurisdiction because the claims and counterclaims did not satisfy the Gunn test.[28]

Inspired Development Group, LLC v. Inspired Products Group, LLC

Next, in Inspired Development Group, LLC v. Inspired Products Group, LLC d/b/a KidsEmbrace, LLC, the Federal Circuit distinguished Jang and clarified the requirements for obtaining federal jurisdiction over a licensing dispute, holding that some patent law issue must need resolution, with no alternative route offered in contract law.[29] Plaintiff Inspired Development granted KidsEmbrace an exclusive license to manufacture and commercialize car seats.[30] KidsEmbrace sought additional investment from a third party, which forced KidsEmbrace and Inspired Development into a binding letter agreement.[31] The third party forced the founder and CEO out of KidsEmbrace, which then terminated the initial license agreement.[32] Inspired Development sued KidsEmbrace in the Southern District of Florida for breach of contract (i.e., failing to pay royalties) and, alternatively, unjust enrichment.[33] The court granted summary judgment in KidsEmbrace’s favor, and Inspired Development appealed to the Court of Appeals for the Eleventh Circuit.[34] The Eleventh Circuit found that diversity jurisdiction did not exist and transferred the case to the Federal Circuit to determine whether “arising under” jurisdiction existed.[35]

KidsEmbrace argued that “arising under” jurisdiction existed because Inspired Development’s unjust enrichment claim was actually an infringement claim in that proving unjust enrichment required showing that KidsEmbrace continued to use the process described in the letter agreement.[36] The court disagreed, and much of its decision hinged on substantiality. It reasoned that the license agreement conferred a number of potential benefits on KidsEmbrace, including litigation avoidance and securing investment.[37] Thus, the patent law issue was not dispositive of the case—a negative for substantiality.[38] The lack of potential for conflicting future rulings and a dearth of government interest in the dispute further cut against substantiality, a distinguishing factor in view of Jang.[39] Finally, the court reasoned federal jurisdiction was improper because otherwise parties could insert any infringement or invalidity issue that would pull a contract dispute into federal court.[40] Taking all these factors into account, the court held federal jurisdiction was improper.[41]

Sasso v. Warsaw Orthopedic, Inc.

Most recently, in Sasso v. Warsaw Orthopedic, Inc., the District Court for the Northern District of Indiana found that federal jurisdiction was improper where two separate licensing agreements between plaintiff Dr. Rick Sasso and defendant Warsaw Orthopedic were at issue.[42] The first dispute centered on which provision applied to determine the termination of the agreement.[43] One provision required that the patents be valid, while the other merely depended on the issuance and expiration date of the patents.[44] In any event, the state court decided the governing provision was the provision dependent on the patent’s issuance and expiration date, and it held in Sasso’s favor on that ground.[45]

Under the second agreement, payment of royalties undisputedly required a device covered by a valid claim.[46] However, the plaintiff argued that the issue was not one of the validity of the patent at issue, but whether the patent at issue was covered by the agreement.[47] Given that a party offered a theory that did not require resolution of a patent law issue, no such issue was both actually disputed and substantial.[48] The decision of the Northern District of Indiana comports with the Federal Circuit and other federal district courts: If patent law is not necessary in determining the outcome, federal jurisdiction is improper.

Recommendations

To ensure jurisdiction will properly lie in federal courts, parties should ensure that their claims or counterclaims allow for resolution only by applying the tenets of patent law. IP-related agreements should be drafted so that an analysis of patent law is required to settle a dispute. For instance, a party could include a provision ensuring that the definition of a product covered by the agreement requires a valid claim, such as the provision in Jang. Further, there should be no ambiguity regarding which provision applies to determine which products are covered products, as in Sasso.

A complaint should specifically discuss provisions defining covered products and call out issues of patent validity or infringement. Current caselaw suggests that these actions land a case firmly in federal jurisdiction.

Conclusion

The Federal Circuit and district courts are clearly consistent in application of Gunn to jurisdictional issues presented by patent license disputes. As the Federal Circuit pointed out in Inspired Development, it remains to be seen how Jang would apply to a case with its particular fact pattern but requiring resolution of a jurisdictional issue between state and federal courts, as opposed to two federal courts. One thing is evident: Federal jurisdiction is improper if the dispute can be resolved without patent law.

[1] 28 U.S.C. § 1338(a).

[2] There tends to be overlap between this factor and the fourth factor because in Neurorepair v. The Nath Law Group, the Federal Circuit established a three-part test for substantiality including determination of the decision’s impact on future decisions.

[3] Gunn v. Minton, 568 U.S. 251, 258 (2013).

[4] Id. at 255.

[5] Id. at 261, 264‒65.

[6] Jang v. Boston Scientific Corp., 767 F.3d 1334, 1335 (Fed. Cir. 2014). Note that the Court of Appeals for the Federal Circuit usually handles appeals of patent issues from district courts, as opposed to the circuit courts of appeals for the district courts.

[7] Id. at 1337.

[8] Id.

[9] Id. at 1337‒38.

[10] Levi Strauss & Co. v. Aqua Dynamics Systems, Inc., 15-cv-04718-WHO, 2016 WL 1365946, at *1 (N.D. Cal. Apr. 6, 2016).

[11] Id.

[12] Id.

[13] Id.

[14] Id.

[15] Id. at *6.

[16] Id. at *5.

[17] 18-1709-RGA, 2019 WL 1650067, at *1 (D. Del. Apr. 17, 2019).

[18] Id. at *1.

[19] Id.

[20] Id.

[21] Id. at *3.

[22] Id.

[23] Id. at *6.

[24] Id.

[25] Id. at *8.

[26] Id. at *7.

[27] Id. at *9‒10.

[28] Id. at *1, 11.

[29] Inspired Development Group, LLC v. Inspired Products Group, LLC, 938 F.3d 1355 (Fed. Cir. 2019).

[30] Id. at 1358.

[31] Id. at 1358.

[32] Id. at 1358‒59.

[33] Id. at 1359.

[34] Id. at 1358.

[35] Id.

[36] Id. at 1361.

[37] Id. at 1363.

[38] Id. at 1364.

[39] Id. at 1368‒69.

[40] Id. at 1369.

[41] Id. at 1371.

[42] Sasso v. Warsaw Orthopedic, Inc., 3:19-cv-298 JD, 2020 WL 1043104 (N.D. Ind. Mar. 4, 2020).

[43] Id. at *4.

[44] Id.

[45] Id.

[46] Id. at *6.

[47] Id.

[48] Id.

While the availability of video-conferencing technology has proven to be a boon for many given the challenges of working remotely during the COVID-19 pandemic, the use of such technology is not without privacy and security risks. Unfortunately some users have fallen victim to so-called “zoom bombing” or “zoom raiding” incidents whereby their business meetings were hijacked by Internet trolls or hackers that inserted racist, anti-Semitic, sexist, and/or profane imagery on their screens and chat boxes or otherwise disrupted their audio feeds. Many video teleconferencing platform providers were seemingly caught unawares, scrambling to shore up their security settings by hastily releasing updates in order to patch critical vulnerabilities and convince users that they could continue online collaboration safely without fear of unwanted intruders.

Global privacy regulators have taken notice of the headlines and spectacular stories of security flaws, and, in response on July 21, 2020, the Office of the Privacy Commissioner of Canada, along with five other data protection and privacy authorities (The U.K. Information Commissioner’s Office, The Office of the Australian Information Commissioner, The Gibraltar Regulatory Authority, The Office of the Privacy Commissioner for Personal Data, Hong Kong, China, and The Federal Data Protection and Information Commissioner of Switzerland)(“Privacy Regulators”), published an open letter (“Letter”) to companies offering video teleconferencing services (“VTC”) reminding them of their legal obligations to handle people’s personal information responsibly. The Letter is intended for all companies that offer video conferencing services, and it has also been sent directly to Microsoft, Cisco, Zoom, House Party and Google.

The Letter plainly states that its purpose is to set out the Privacy Regulators’ concerns and clarify their expectations and the steps they should be taking as VTC companies to mitigate the identified risks and ultimately “ensure that our citizens’ personal information is safeguarded in line with public expectations and protected from any harm.” It then proceeds to provide a non-exhaustive list of the data protection and privacy issues associated with VTC services. The Letter identified various key principles that should guide VTC companies, as set out below.

Security. Not surprisingly, security is listed as the Privacy Regulators’ premier concern. Security is a “dynamic responsibility,” and security vigilance by VTC organizations is paramount. The Privacy Regulators acknowledged the worrying reports of security flaws in the VTC products leading to unauthorized access to accounts, shared files, and calls and called for minimum standard safeguards to be deployed, including effective end-to-end encryption for all data communicated, two-factor authentication, and strong passwords.  This will be especially important for VTC platforms in certain sectors that routinely process sensitive information, such as hospitals providing remote medical consultations and online therapists, or where the VTC service allows sharing of files and other media, in addition to the video/audio feed.

The Privacy Regulators also expect VTC providers to stay current, remain constantly aware of new security risks and threats to their VTC platforms, and “be agile in your response to them.” Users of the platforms should be routinely required to upgrade the version of the app they have installed, to ensure that they are up-to-date with the latest patches and security upgrades. Additionally, all information must be adequately protected when processed by third-parties, including in other countries.

Privacy-by-design and default. Consistent with the Canadian “privacy by design” approach to data protection and security, the Privacy Regulators note that data protection and privacy should be “baked into” VTC services—if they are mere afterthoughts in the design and user experience of a VTC platform, then there is a greater likelihood of failure that leads to “well documented accounts of unexpected third-party intrusion to calls.”

Accordingly, VTC companies should be taking a privacy-by-design approach to VTC platforms, making data protection and privacy integral to the services provided to customers. Practically, this means that the most privacy-friendly settings should be the default (similar to the principle of least privilege in cyber security). Settings should be prominent and easy to use (including implementing strong access controls as the default, clearly announcing new callers, and setting video/audio feeds as mute on entry); applying features that allow business users to comply with their own privacy obligations (including features that enable them to seek other users’ consent); and minimizing personal information or data captured, used, and disclosed by the product to only that information absolutely necessary to provide the service.  Additionally, VTC providers should also undertake privacy impact assessments to identify the impact of their personal information handling practices on the privacy of individuals, and implement strategies to manage, minimize, or eliminate these risks.

Know your audience. The Privacy Regulators acknowledged that during the Covid-19 pandemic many of the VTC platforms were being used in ways for which they were not originally designed, creating unanticipated risks. Therefore VTC companies should now be reviewing the new and different environments and users of their platforms, in order to better understand and identify children, vulnerable groups, and contexts where discussions on calls are likely to be especially sensitive (in education and healthcare, for example), or when operating in jurisdictions where human rights and civil liberty issues might create additional risk to individuals engaging with the VTC services. As a follow-up step, VTC companies should assess the necessary data protection and privacy and requirements for all contexts in which their platforms are now being used, and implement appropriate measures and safeguards accordingly.

Transparency and fairness.  As a result of several high-profile privacy breaches in recent years, the Privacy Regulators note that global audiences now have heightened community awareness (and expectations) regarding how companies should appropriately handle their personal information and use their data. VTC companies who fail to tell their customers how they use their information, or use the information unfairly or unreasonably, may therefore be in violation of the law in addition to forfeiting the trust of their users.

Accordingly, providers of VTC services should be up-front about what information they collect, how they use it, with whom they share it (including processors in other countries), and why. This is particularly relevant should the VTC do something with the user data that is not expected because it would not be seen as a core purpose of the VTC service. Such disclosure should be provided proactively, be easily accessible, and not simply buried in a privacy policy. Where express user consent regarding the handling of personal information is required, VTC providers should also ensure that such consent is specific and informed. VTC providers should also assess the impact any future changes to the VTC platforms will have and whether users should be made aware of these changes in order to ensure users can make informed decisions about how they use the platform going forward.

End-user control. While practically speaking end-users may often have little choice about the particular use of a VTC platform if their organization has already chosen to use or purchase a specific VTC service, users should be aware that some features of particular VTC platforms may raise the risk of covert or unexpected monitoring and should be better informed (and have more control) over these processes.

For example, users must understand if a VTC platform allows the host to collect their location data, track their engagement or the attention of participants generally, or record or create transcripts of calls. Ideally this is communicated to users through icons, pop-ups, or other measures, not just buried somewhere in the platform’s terms. Where possible, VTC companies should also include a mechanism for end-users to choose not to share that information, i.e. via opt-out, noting that opt-in mechanisms might be more appropriate in certain instances.

Conclusion. While it is clear that the Privacy Regulators recognize the value and importance of the services offered by VTC companies during the COVID-19 pandemic, the Letter reiterates that such solutions must not come at the expense of people’s data protection and privacy rights. Focusing on the key areas identified in the Letter will help VTC companies not only comply with applicable data protection and privacy laws but help build the trust and confidence of their customers and user base. The Privacy Regulators concluded the Letter by welcoming responses from VTC companies by September 30, 2020, asking them to demonstrate how they are taking these principles into account in the design and delivery of their services. Responses will be shared amongst the joint signatories to this letter. It remains to be seen whether the various VTC companies will take up the challenge posed by the Privacy Regulators.

Lisa R. Lifshitz

In Liu v. SEC, the United States Supreme Court confirmed the Securities and Exchange Commission’s (SEC) ability to seek disgorgement of ill-gotten gains as an equitable remedy in SEC enforcement actions in federal court.* However, the court limited the SEC’s ability to obtain such relief, holding that equitable principles require that a disgorgement award not exceed the wrongdoer’s net profits and be set aside to reimburse victims. This decision has clear implications for defendants charged with liability under the federal securities laws, who may now challenge any proposed disgorgement award that fails to deduct the defendant’s legitimate business expenses or does not set aside disgorged funds for fraud victims.

The Liu decision also impacts another frequent target of SEC enforcement action: so-called relief defendants, or parties who have not themselves violated the securities laws but have received some or all of the wrongdoer’s ill-gotten gains. Although Liu’s holding allows relief defendants to argue that their legitimate business expenses should be deducted from any disgorgement order, the equitable principles underlying the decision may, in certain cases at least, equip relief defendants to challenge the SEC’s ability to obtain disgorgement from them at all.  

Relief Defendant Disgorgement

In its efforts to enforce the federal securities laws, the SEC regularly seeks disgorgement of proceeds from a defendant’s alleged fraudulent conduct. Often, however, the defendant no longer possesses some or all of the ill-gotten gains, but has disbursed the property to third parties who played no role in the alleged wrongdoing. The SEC frequently seeks to obtain disgorgement from these innocent third parties on the theory that they are not being sued in their individual capacities, but are rather nominal “relief” defendants who hold assets that, in reality, are fraudulent proceeds from the violative conduct of the wrongdoer.

Relief defendants are not alleged to have engaged in any wrongdoing and are therefore not liable for any underlying securities law violations. Instead, courts have found these defendants to be simply “trustee[s], agent[s], or depositor[ies]” for the wrongdoer, with no real ownership interest in the property in their possession. Given that a relief defendant is merely a trustee for the wrongdoer’s profits, equitable principles counseling against the wrongdoer’s unjust enrichment usually apply, and the relief defendant steps into the shoes of the wrongdoer solely for the remedial purpose of recovering the wrongdoer’s ill-gotten gains.

Courts have developed a two-part test to determine the propriety of ordering disgorgement from a relief defendant. First, the SEC must show that the third party received funds from the alleged wrongdoing and, second, that the third party does not have a “legitimate claim” to those funds. Federal courts have interpreted this test expansively, requiring innocent third parties to disgorge any property derived from the liability defendant’s wrongdoing for which the third party did not pay adequate consideration. In SEC v. George, for instance, the United States Court of Appeals for the Sixth Circuit affirmed a disgorgement order requiring a wrongdoer’s fiancée to disgorge her diamond engagement ring purchased with proceeds from the wrongdoer’s Ponzi scheme and given to the fiancée as a gift. Further, the court ordered three other relief defendant investors to disgorge the entirety of the profits distributed to them by the wrongdoer from the unlawful scheme, when those investors failed to rebut the SEC’s evidence that the money they received from the scheme came from the investments of others, rather than profits of the relief defendants’ investments. The Sixth Circuit, like other federal courts that have examined the issue, held that because these relief defendants did not have a “legitimate claim” to the disputed property, disgorgement relief was both equitable and appropriate.

The Liu Decision

In Liu, the Supreme Court addressed whether federal district courts have authority to order disgorgement in SEC enforcement actions at all. This question was left open by the court’s 2017 decision in Kokesh v. SEC, holding that disgorgement is a “penalty” for the purposes of 28 U.S.C. § 2462, which imposes a five-year statute of limitations on SEC enforcement actions seeking “any civil fine, penalty, or forfeiture.” There is no statutory authority for the SEC to obtain disgorgement in federal court actions. In fact, pursuant to 15 U.S.C. § 78u(d), the SEC may seek only civil monetary penalties and “equitable relief.” Prior to Kokesh, lower federal courts routinely authorized disgorgement in SEC enforcement actions on the premise that disgorgement is a form of equitable relief. However, given that equitable relief typically does not include punitive sanctions, Kokesh left open the issue of whether the SEC could pursue disgorgement in its civil enforcement actions.

The Liu court—faced with a direct challenge to the SEC’s ability to seek disgorgement orders in federal court—upheld the practice, albeit subject to some significant limitations. Initially, the court held that disgorgement is not punitive when its effect is limited to the well-established equitable practice of “strip[ping] wrongdoers of their ill-gotten gains.” Noting that “it would be inequitable that [a wrongdoer] should make a profit out of his own wrong,” the court held that to avoid transforming disgorgement into a punitive sanction, equitable disgorgement relief must be limited to a wrongdoer’s net profits from the illegal conduct, deducting legitimate business expenses, and may be assessed “against only culpable actors and for victims.” Expansion of the practice beyond this scope runs the risk of turning an appropriate equitable remedy into an improper penalty. Though unmentioned in Liu, this equitable analysis has important implications for innocent third parties who have found themselves with assets causally connected to a wrongdoer’s illegal conduct.  

Significance of Liu for Relief Defendants

Although Liu does not expressly discuss relief defendant disgorgement, the opinion does offer relief defendants various avenues for challenging attempts by the SEC and other federal agencies to seek disgorgement awards. Most obviously, relief defendants are now relying on Liu to contest disgorgement orders in instances where the issuing court arguably failed to deduct the nominal defendant’s legitimate business expenses from its disgorgement order. Indeed, the Liu decision equips parties to challenge disgorgement orders that bar innocent investors from subtracting the amount they invested in the wrongdoer’s fraudulent scheme from the disgorgement award. Courts have ordered such relief on the premise that it is inequitable to allow these unwitting investors in a fraud scheme to recover all or the majority of their investments when other investors are unable to do the same. However, after Liu, these relief defendants may be able to argue that any disgorgement award that exceeds the investor’s net profits is punitive and therefore improper, even if other innocent investors cannot recover their initial investments.

Given the equitable principles supporting the Liu holding, however, relief defendants may in certain cases be able to rely on the opinion to challenge not only disgorgement of legitimate business expenses, but whether equitable disgorgement is even appropriate at all. The argument against disgorgement is perhaps most clear in cases like SEC v. Forex Asset Management LLC, where the United States Court of Appeals for the Fifth Circuit ordered a handful of innocent investors to disgorge not only their initial investments in the wrongdoer’s fraudulent scheme, but also their profits that were directly traceable to those investments (as opposed to gains coming from the investments of others). This practice appears to conflict with language in Liu suggesting that equitable disgorgement is unavailable where the defendant is “merely a passive recipient of profits” from the illegal scheme, rather than a partner in the wrongdoing. Going forward, we should expect to see relief defendants argue that such disgorgement is improper without a finding that the third party acted in concert with the alleged wrongdoer.

More broadly, after Liu, relief defendants may be able to argue that third-party disgorgement is punitive and therefore improper in any case where the relief defendant cannot clearly be characterized as a trustee, agent, or depository for the wrongdoer’s ill-gotten gains—regardless of whether the relief defendant paid adequate consideration for the disputed property. The Liu opinion authorizes equitable disgorgement only when such disgorgement is assessed “against only culpable actors.” Accordingly, although relief defendant disgorgement appears consistent with Liu to the extent the relief defendant is a mere trustee or agent for the culpable actor—for instance, a bank with “only a custodial claim to the [the wrongdoer’s] property”—the more attenuated the relationship between the wrongdoer and the relief defendant, the less likely disgorgement may be to pass muster under Liu.

Take, for instance, the SEC v. George case discussed above. There, the SEC was able to obtain disgorgement of an engagement ring that the wrongdoer purchased with profits from his illegal scheme and then gifted to his fiancée, with no evidence that the fiancée, in accepting the ring, was acting as a mere trustee for the wrongdoer’s ill-gotten gains. As the recipient of a gift derived from illegal profits, rather than, for instance, a fraudulent transfer of those profits, the relief defendant in George arguably does not stand in the shoes of the wrongdoer. Accordingly, any assessment against her or similar defendants may exceed the bounds of equity under Liu, even if the relief defendant failed to pay consideration for the property in her possession.

Whether lower courts will accept these and similar arguments against relief defendant disgorgement remains to be seen. Still, the Liu decision opens up several avenues for innocent third parties to challenge attempts by the SEC and other federal agencies to obtain equitable disgorgement, and we should expect to see federal agencies and courts grappling with the implications of Liu for relief defendants in the months and years to come.

*Jay Dubow is a partner in the Philadelphia office of Troutman Pepper; Ghillaine Reid is a partner in the New York office; and Kaitlin O’Donnell is an associate in the Philadelphia office.

The surveillance society is upon us. Cameras are now everywhere in the public sphere. Business Insider reports that in two years the world may have 45 billion cameras, and the video-surveillance industry is likely to be worth $64 billion.

More insidious than capturing video of all activities in cities and towns all the time, however, is the facial recognition technology used to apply a name to nearly every person found by these cameras. Activating artificial intelligence (AI) for identification in crowds threatens our civil rights, and very few lawmakers have tried to address this concern.

Although Amazon, IBM, and Microsoft have all at least temporarily limited supplying U.S. law enforcement with the tools to identify anyone captured on video, companies like Clearview AI, Japanese tech giant NEC, iOmnicient, Hert Security LLC, and Idemia are happy to sell facial recognition systems to the police. If we are concerned about allowing law enforcement to properly use this tool in the right circumstance and still protect the Constitutional rights of Americans, we cannot rely on the private sector for solutions.

The best way to address this problem is to require police to secure a warrant before applying biometric AI systems to identify people in pictures and videos. Requiring a warrant in this circumstance is a reasonable solution for law enforcement, protects the Constitutional rights of U.S. citizens, and is within the U.S. Supreme Court’s current application of the Fourth Amendment to technological change.

Obtaining a warrant is practical for law enforcement. This is the system all of our policing agencies use when they want to go somewhere or do something that might otherwise intrude on the Fourth Amendment right to be secure in our persons, homes, and papers. The officer simply must show that he or she reasonably suspects that a person has committed a crime, and then the officer is issued a warrant that allows intrusion on private spaces and information.

This keeps our police force from searching everyone and everything hoping to find something for which to arrest someone. That is why the protection was written into the Constitution by our nation’s founders. It is supposed to slow the process down so that someone can think about whether the one group in society with a legal monopoly on violence should be pushing down your front door and rifling through your underwear drawer.

Police already have the right forms to fill out. They know how the process works. Judges are addressing these matters all the time. In other words, the only extra time required will be the extra time that police are supposed to take when they intrude on a person’s privacy.

Requiring a warrant for police to run facial recognition software will protect our Constitutional rights. Assume that a crowd was lawfully demonstrating against the police force itself—perhaps because the police are enforcing restrictive gun laws or because the police have misbehaved in some way. Every color of the political spectrum is affected by this concern. Would demonstrators feel violated if law enforcement used its multiple surveillance cameras to capture their activity? Maybe, but they are likely to expect to be seen by cameras. Would they feel violated if police ran an AI program over the camera footage to take down the names of all people who demonstrated against them? You bet.

As Judge Flaum of the Seventh Circuit Court of Appeals pointed out in language later quoted by the U.S. Supreme Court,

Judge Flaum was writing in 2011 about tracking a person’s movement around town, but the same logic also applies to technology that allows police to not only see all the people in a given space at any particular time, but to apply names to all the faces that appear there as well.

We cannot simply bury our heads in the sand and pretend that these new technologies aren’t affecting the relationship between police and citizens. Replacing horses with automobiles affected policing. When photography was introduced, mug shots made identifications much easier. Computers, lapel cameras, drones, stingrays, military hardware, speech, AI, and DNA databases all changed the nature of policing. Judges across the entire political and judicial philosophy spectrum have noted the changes and how they may affect Constitutional rights.

Even the late originalist Justice Scalia wrote, “Applying the Fourth Amendment to new technologies may sometimes be difficult, but when it is necessary to decide a case we have no choice.” This, he continued, is because, “We must ‘assur[e] preservation of that degree of privacy against government that existed when the Fourth Amendment was adopted.’” In other words, if the technology allows law enforcement to intrude deeply into our lives in new ways that would have been unconsidered 250 years ago, it must be checked by the Fourth Amendment, requiring police to obtain a warrant before using the intrusive tech.

When we apply this thinking to facial recognition technology, we can require a warrant be issued to seek the identity of obvious wrongdoers. Thus, if you are caught on camera throwing a Molotov cocktail through the plate-glass window of a local business, the police can clearly and easily use a facial recognition program to find you and bring you to justice. If you are simply walking in a peaceful political demonstration, however, the police would not be allowed to run facial recognition software to place you in the crowd at that time. With no warrant requirement, law enforcement can run the identification program under no limitations.

Requiring a warrant to use this powerful tech may soon be required by the current U.S. Supreme Court. The Court has already begun to insist on Fourth Amendment protections for transformative technologies, requiring that police need a warrant to place a 30-day tracking beacon on your personal vehicle, for example, and that police need a warrant to open and review the contents of your smart phone. SCOTUS even changed their previous rule that information held by a third party was not Constitutionally protectable when they recently held that police need a warrant to request the past month’s worth of cell phone tracking records to pinpoint your location at different times.

Seventy years ago the Supreme Court held that keeping your name from being associated with political causes was part of your right to free speech and free association. You may have reason to fear the government taking note of your association, which is why that particular Supreme Court decided that the State of Alabama in the 1950s was not allowed to require a list of all local NAACP members. The unfettered technology to see who is entering gay bars, gun clubs, and political protests, and then to identify each individual, allows the government to invade and chill people’s speech and assembly rights.

This concern for privacy even in public places is echoed by our current Chief Justice, John Roberts, who wrote, “A person does not surrender all Fourth Amendment protection by venturing into the public sphere. To the contrary, ‘what [one] seeks to preserve as private, even in an area accessible to the public, may be constitutionally protected. In the past, attempts to reconstruct a person’s movements were limited by a dearth of records and the frailties of recollection. . . . [With current technology] police need not even know in advance whether they want to follow a particular individual, or when.’”

Thus, the Court has recognized that attending politically sensitive meetings anonymously is an important right covered by the First Amendment, and that limited technological intrusions on privacy is an important value of the Fourth Amendment. It seems well within the court’s present mindset to limit the government’s use of overly intrusive technology, like running facial recognition systems on people in the public sphere without specific law enforcement reason to do so.

Harkening back to one of the first important privacy opinions written in 1928, Chief Justice Roberts noted recently, “As Justice Brandeis explained in his famous dissent, the Court is obligated—as ‘[s]ubtler and more far-reaching means of invading privacy have become available to the Government’—to ensure that the ‘progress of science’ does not erode Fourth Amendment protections. Here the progress of science has afforded law enforcement a powerful new tool to carry out its important responsibilities. At the same time, this tool risks Government encroachment of the sort the Framers, ‘after consulting the lessons of history,’ drafted the Fourth Amendment to prevent.”

When will the technology rise to the level that a warrant is required? In the recent  decision, the Court held that “a Fourth Amendment search occurs when the government violates a subjective expectation of privacy that society recognizes as reasonable.” It seems reasonable that peaceful political protesters could subjectively fear being named to police during political gathering.

The Supreme Court recently addressed this precise question. “I would ask whether people reasonably expect that their movements will be recorded and aggregated in a manner that enables the Government to ascertain, more or less at will, their political and religious beliefs, sexual habits, and so on. I do not regard as dispositive the fact that the Government might obtain the fruits of [new technology] through lawful conventional surveillance techniques,” wrote Justice Sotomayor. She continued, “I would also consider the appropriateness of entrusting to the Executive, in the absence of any oversight from a coordinate branch, a tool so amenable to misuse, especially in light of the Fourth Amendment’s goal to curb arbitrary exercises of police power to and prevent ‘a too permeating police surveillance.’”

The most defensible Constitutional choice in this circumstance is for Congress or multiple state legislatures to place limits on policing power by requiring warrants to run biometric ID software. Several Justices seem to agree in that they joined Justice Alito in his sentiment in Jones: “

In November of last year, U.S. Senators Coons and Lee introduced bi-partisan legislation requiring federal law enforcement to obtain a court order before using facial recognition technology. This act provided a logical framework for protecting Americans from a powerful, new state-operated technology that has grown unchecked as a tool for intruding on citizens’ privacy.

Since that time, the Facial Recognition and Biometric Moratorium Act was introduced into both houses of Congress this summer. The act calls for a complete prohibition on police use of facial recognition software and similar biometric technology like voice recognition or gait identification systems. However, this act, like some of the city-level bans that have been enacted in the United States, overreacts to the technology. Biometric identification tools are valid and useful law enforcement implements, so banning them completely tosses the baby out with the bath water.

Requiring a warrant to use the powerful technologies, however, stops indiscriminate and likely political applications while keeping it available to help catch criminals. Warrant obligations are the right step to protect our privacy and other Constitutional rights while applying the technology to important problems. We should not wait for the right case to rise to the Supreme Court before limiting use of this technology. A legislative solution is best and most efficient.

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This article is an excerpt from The Lawyer’s Guide to Family Business Succession Planning: A Step-by-Step Approach for Lawyers, Business Owners, and Advisors, by Gregory Monday (ABA 2020). (An introduction has been added to provide context.)

In family business succession planning, it is important to consider contracts with related parties.  If a person affiliated with the owners provides goods or services to the family business, that relationship should be formalized in a written contract to the extent that the owners would want that relationship to continue after the business transitions to the successors. Consider the following examples:

Real Estate and Equipment Leases

If one of the family’s companies leases real estate or equipment from a related individual or another family-owned company, the owners should sign a written lease that will continue to apply after ownership succession. In most cases, it should be a long-term lease, with automatic renewals and periodic rate enhancers that are specified in the lease or are tied to an objective measure, such as an appropriate consumer price index.

Leases should allow one party or the other to terminate the lease obligation if a particular change of circumstances occurs. For example, it may be appropriate for a building tenant to have a right to terminate the lease if the building is sold to a buyer outside the family. Similarly, it might be appropriate to grant the lessee a right of first refusal if the leased asset (e.g., building or equipment) is sold to a buyer outside the family.

Note that if the asset and the lessee currently are owned by the same owners, then there may be tax efficiencies or cash-flow considerations that dictate the optimal lease terms as long as the ownership remains the same. (The owners should consult their accountants and tax advisor regarding these arrangements.) In such cases, the lease should be reviewed as part of the owners’ estate planning process. If ownership of the leased asset and ownership of the lessee business will or may diverge under the succession plan, then the owners should arrange for their successors to be bound by a lease that is equitable to both lessor and lessee.

Service Agreements

If one of the family companies provides services to other family companies that are owned by different owners, or by the same owners but in different proportions, then the companies should execute a service agreement to ensure that the service relationship is equitable and will continue under similar terms. For example, if the family owns a portfolio of real estate, with each property in a different LLC, and the properties are managed by a separate management company also owned by the family, then service agreements will help ensure that the management company has cash flow that it needs to compensate employees and for other expenses of operations.

Employment Agreements

Family members who have chosen to work for the family business in a substantial capacity might assume that their employment status with the business and their compensation will not be adversely affected by ownership succession, but if they do not have an employment agreement, they may be at risk of being treated as an employee-at-will who may be terminated, demoted, or geographically displaced by a successor board or new management.

Therefore, if there are family members who rely on their employment with the family business and compensation at a particular level (sometimes including a history of bonuses), it may be appropriate to protect such family members with employment agreements that state they cannot be terminated or demoted without cause and that establish a minimum level of compensation, including perhaps cost-of-living increases and terms of bonus practices. The employment agreement also can provide for severance compensation and benefits upon a change of control (such as a sale of the business to an unrelated third party) or other change of circumstance that may warrant separation without cause.

If the employee is not an owner, it may be best for the business to include confidentiality, noncompetition, and nonsolicitation language in the employment agreement, but if the employee is an owner or may become an owner, then the confidentiality, noncompetition, and nonsolicitation agreement might be better addressed in the owners’ agreement. In many states, broad noncompetition provisions in an employment agreement are harder to enforce than similar provisions in an owners’ agreement. Further, if an employee is an owner, it may be appropriate to provide that if his or her employment with the business terminates, then the business or other owners may purchase his or her ownership interest.

Finally, although it usually is desirable to include alternative dispute resolution provisions in all family business agreements, an arbitration clause in an employment agreement might not be enforceable in some states.

Debt Obligations

If the business owes any sum to an owner or other family member or affiliated business, then the existence and terms of the debt should be clearly and formally documented. This will help ensure that successor owners and management will honor the obligation; it will help ensure that the payments are treated properly for taxes; and it will help ensure that the obligation will be given proper priority vis-à-vis the business’s other creditors. Such obligations may arise, for example, if an owner lent cash to the business, or if the business purchased assets from an owner on an installment basis, or if the business redeemed an owner’s shares on an installment basis.

In some cases, it may be desirable to grant the lender security (perfected, such as by recording a mortgage or filing UCC statements) to give the lender priority as against a tort creditor or in the event of the borrower’s bankruptcy. It is likely, however, that the lender will have to agree that the obligation will be subordinate to existing third-party debt. (Commercial lenders do not want their rights to be subordinate to, or even pari passu with, insider obligations.)

Contingent Liability

If owners have personally guaranteed debt of the business, each may be at risk of a disproportionate loss under his or her guaranty, unless the owners execute a reimbursement agreement with the business and contribution agreements among one another. This is particularly important for an owner who is exiting ownership but has not been released as a guarantor.

Under most commercial loan facilities, guaranties are joint and several, and in the event of a default, the lender can proceed against any one of the guarantors for the full amount, even without trying to collect from the borrower or the other guarantors. In fact, often the lender is allowed to release the borrower or a guarantor without the consent of the other guarantors. Further, a default may be something that neither the borrower nor the guarantors can control, such as the death or bankruptcy of one of the guarantors.

For these reasons, an owner who guarantees debt of the business should execute a reimbursement agreement granting the guarantor the right to be reimbursed by the business for any losses incurred under the guaranty. The lender may need to consent to a reimbursement agreement and will probably not allow it to be enforceable until the lender is satisfied in full.

Similarly, the guarantors should execute a contribution agreement among one another. A guarantor’s common-law rights to seek contribution from other guarantors for losses he or she incurs under a guaranty usually are not particularly effective. Often, they do not reflect the guarantors’ expectations. Under a contribution agreement, however, the guarantors can be clear about what percentage of the loss each guarantor will contribute and how the loss will be measured. As with the reimbursement agreement, the guarantors may need the lender to consent to the contribution agreement, and it may not be enforceable until the lender is satisfied in full.

Tort Liability Indemnification

Owners who serve as directors and officers or managers of the business should be protected against liability for their service for acts taken in good faith. Usually such provisions appear in a company’s articles, bylaws, or operating agreement. These should be drafted to include protection for directors and officers who are no longer serving in that capacity. If such fiduciaries are covered by directors’ and officers’ insurance, either directly or as a way to fund the indemnification, the coverage should include former fiduciaries as well.