Patricia Roberts Harris was a Black woman of her time. As we honor Black History Month and pay tribute to generations of African Americans who struggled with adversity, Patricia Roberts Harris is an amazing example of a Black woman excelling through a multitude of hardships. Harris grew up in Illinois with her single mother, and she took a keen interest in academics, receiving five scholarship offers to college. She attended Howard University in Washington, D.C., and graduated summa cum laude in 1945 with a bachelor’s degree in political science and economics. After graduation, she began graduate studies in industrial relations at the University of Chicago in 1946 and continued her studies at American University. If her academic success up to this point wasn’t enough, she went on to graduate at the top of her class from the George Washington University Law School in 1960. She subsequently was admitted to the District of Columbia bar and admitted to practice before the United States Supreme Court.
However, Harris was more than her academic success; she was dedicated to civil rights and public service. While at Howard, she served in Howard’s college chapter of the National Association for the Advancement of Colored People (NAACP) and took part in one of the first sit-ins at a whites-only cafeteria. While at American University, she began to work as Assistant Director of the American Council on Human Rights, an organization dedicated to defending and protecting human rights by pushing for anti-discrimination legislation, where she stayed until 1953. Harris was also a member of a historically Black sorority, Delta Sigma Theta, and became the first executive director of the national headquarters, serving from 1953 to 1959. After graduation from law school in 1960, she worked for the criminal division of the U.S. Department of Justice. She then returned to Howard University, joining the faculty as a lecturer at the law school and becoming the associate dean of students. In 1963 she became a full professor, and she would later serve as the school’s dean.
Harris’s career continued to propel forward as she began to grab political positions, while remaining focused on advancing civil rights. In 1963, President John F. Kennedy appointed her as co-chair of the National Women’s Committee for Civil Rights, an umbrella organization of women’s groups in America supporting the advancement of civil rights. Amid her extensive work, from 1962 to 1965, Harris worked with the National Capital Area Civil Liberties Union, an ACLU affiliate, that worked to defend and expand civil liberties in the District of Columbia as an affiliate of the American Civil Liberties Union. As Harris continued to pursue politics, in 1964, she was elected as delegate to the Democratic National Convention from the District of Columbia. There, she gave the address seconding the presidential nomination of Lyndon B. Johnson. After winning the presidential election, President Johnson appointed her as Ambassador to Luxembourg in 1965, serving until 1967. She became the first African American woman named as an envoy for the United States. Though proud of becoming an ambassador, she was saddened that African American women were never considered before her. In 1969, Harris returned to Howard University School of Law and became the first Black woman to serve as a law school dean.
Harris then joined a prestigious law firm in Washington, D.C., that is now Fried, Frank, Harris, Shriver & Jacobson, where she worked as a corporate attorney, and subsequently became the first Black American woman to sit on a Fortune 500 company’s board of directors in 1971. She firmly believed corporate responsibility could positively influence social change. Harris held her position at the firm until President Jimmy Carter selected her to become the Secretary of Housing and Urban Development (HUD) in 1977. She became the first Black woman to serve in a presidential Cabinet. At her confirmation hearing, Senator William Proxmire challenged her and questioned whether she could represent the poor and less fortunate given her status of high prominence. Harris responded that she could never forget the path that brought her to where she was, reminding the senator that just eight years earlier she could not buy a house in certain parts of Washington, D.C., and even though there was respect for achievement and education, she had faced difficulties in attaining them and was still affected by racism. Harris remained active in politics, including serving as Secretary of Health and Human Services, and ended her career as a full-time law professor at George Washington University. She passed away in 1985 at sixty years old.
Patricia Roberts Harris was a pioneer for the Black community, especially Black women. Although she was the first Black woman to break down these barriers, through her extensive work in civil rights, politics, public health, and law, she ensured that she provided a rich legacy for other Black women.
Acquisitions of public companies in pharma, biotech, and other life sciences industries are increasingly using deal structures designed to bridge valuation gaps between buyers and target companies. Even though the peak biotech valuations of 2021 are now well in the rearview mirror, there is still often a significant disconnect in value expectations between buyers and sellers, especially when it comes to pipeline assets. As big pharma companies look to fill gaps in their pipelines, they are increasingly seeking solutions either to leave behind early-stage assets they do not wish to own and fund, or to pay for them only when their value proposition crystallizes. Two techniques for addressing these transactional objectives are spin-off mergers and contingent value rights (CVRs). These deal structures are getting more airtime in deal negotiations and are becoming, in the case of CVRs, a more established feature of public M&A, especially in healthcare transactions.
Spin-Off Mergers
A spin-off merger is a transaction in which the target company separates certain of its assets into a separate company (hereinafter referred to as the hypothetical “SpinCo”), then distributes the shares of SpinCo to its shareholders and, immediately after the spin-off is completed, merges with a third-party buyer. Spin-off mergers are often considered by buyers in the biopharma industry who wish to acquire a target company’s clinical or near-clinical stage products, but who are not interested in its early-stage products. They provide a means for the buyer to leave behind the assets it does not wish to own (or to pay for) and for the target shareholders to continue to realize value from those assets.[1] This is especially true for buyers facing patent expirations, who may be seeking to supplement their portfolios with revenue-generating in-market or near-market assets without the burden of cost-intensive pipeline products.
Spin-off mergers are often used in private deals to bridge valuation gaps. They are also often considered, but so far have been rarely implemented, in the public company M&A context. The first public company spin-off merger in the pharma space was Johnson & Johnson’s acquisition of Swiss-listed Actelion (announced in January 2017), in which Actelion spun out its pre-clinical drug discovery operations and early-stage clinical development assets into a separate R&D company. This was followed by a spin-off merger involving a US-listed pharma company (announced in May 2022), when Biohaven Pharmaceuticals agreed to spin out its pipeline assets before being acquired by Pfizer in an all-cash merger.
The reason spin-off mergers are so rarely pursued in practice is that they typically entail significant complexity, long implementation timetables, and continuing interdependencies between the parties. Spin-off mergers present significantly greater execution complexity relative to whole company acquisitions, in terms of defining the transaction perimeter, allocating assets and liabilities between the parties, and effecting their actual separation, which may require numerous third party and regulatory consents. Addressing shared intellectual property, including who will keep the IP and what cross-licenses may be put in place, is of particular importance and may present unique challenges in biopharma where different drug programs can be dependent upon the same or similar underlying intellectual property.
Spin-off mergers can take several months longer to complete than an acquisition of the entire company (assuming no regulatory or financing delays for the acquisition). In addition to any legwork required in connection with reorganizing the target company’s existing business to position it for the spin-off, a spin-off merger requires SpinCo to file a registration statement with the SEC, which includes IPO-level disclosure of the business being spun-off, as well as audited carve-out financial statements for the business. Preparing the registration statement and clearing the SEC review and comment process usually adds several months to the transaction timetable, given that merger proxies typically do not require the same level of SEC scrutiny. Note, however, that some of these complexities can be less burdensome in an early-stage pipeline spin-out, as the asset perimeter may be easier to define and separate, and the simplicity of business operations for the early-stage business can make the preparation of audited financial statements easier.
Another complexity that arises in spin-off mergers is the need to stand up SpinCo as a stand-alone public company—and whether this is feasible in terms of capitalization, management, public company infrastructure, and stock exchange listing eligibility. SpinCo will need to be adequately capitalized to have sufficient cash runway to operate its business and fund its activities. Given the assets that are going into SpinCo (which are often early-stage and cash-flow negative), this may not be easily achievable. One way to solve for this is for SpinCo to obtain initial financing from the buyer as part of the overall deal package. In doing so, the buyer may seek to participate in the downstream economics, e.g., through a convertible instrument or through royalty rights with respect to SpinCo products in conjunction with or as an inducement to provide the financing.
Another question that must be addressed is who will lead SpinCo and whether the management and scientific team who are familiar with the pipeline assets placed into SpinCo will go with the business that is acquired by the buyer. If the thesis of the deal is that the buyer wants the leadership team to stay with the acquired company, SpinCo may find itself without the right people to guide it to success. Finally, it may be questionable whether SpinCo, on its own, will attract sufficient investor float and will meet the eligibility criteria to be listed on a national stock exchange—the inability to list may be fatal to the ability to execute a spin-off merger.
Finally, spin-off mergers do not lend themselves to a clean break between the buyer and SpinCo. In addition to buyer financing arrangements, the parties often need to enter into transition services agreements, contract manufacturing or facilities sharing arrangements, IP licenses, and data sharing protocols. As such, they create several interdependencies between the buyer and SpinCo, which can add to the negotiation timetable at the front end and can take years to untangle post-closing.
Contingent Value Rights (CVRs)
A potential alternative to a spin-off merger in situations where the two parties have differing views as to value are CVRs. CVRs represent the right of the target company shareholders to receive payments when specified milestones are achieved. They are not typically transferable (a feature necessary so that they are not treated as securities and do not require SEC registration) and are issued to the target shareholders at the time of closing as a component of the acquisition consideration.
While contingent payments in the form of milestones and earn-outs are commonly utilized in private company M&A, contingent value rights—their counterparts in public M&A—have historically been used less frequently. However, in the current environment, CVRs can be an attractive tool in deal structuring. In 2022, there were more CVR public deals than in 2020 and 2021 combined, and in January 2023, all three public pharma acquisitions announced at the JP Morgan (JPM) Healthcare Conference—AstraZeneca’s acquisition of CinCor Pharma, Ipsen’s acquisition of Albireo, and Chiesi’s acquisition of Amryt Pharma—included CVRs.
Some buyers disfavor CVRs due to the potential for litigation with a large number of CVR holders over whether the buyer has complied with its contractual undertakings to achieve the applicable CVR triggers. CVR agreements often contain commitments by the buyer to use a specified level of efforts (usually commercially reasonable efforts or variations thereof) to achieve the payment triggers, with the exact standard of efforts being one of the most heavily negotiated points in the CVR agreement. While buyers often push back on the inclusion of an efforts clause or push to narrowly define it, public deals without efforts clauses are rare. All three of the public pharma acquisitions announced at the JPM Healthcare Conference contained efforts undertakings to achieve the applicable milestones.
Buyers who wish to have contractual certainty as to what their obligations are, but who are not able to get a “no efforts” standard, may seek in the alternative provisions which state that the buyer is not required to do certain enumerated things (e.g., additional clinical studies not previously contemplated) or “safe harbor” provisions which specify that if the buyer has devoted specific resources to achieving the trigger (e.g., minimum dollar spend), it will be deemed to have complied with the efforts undertaking.
Other mechanisms buyers have used to try to limit litigation exposure is to provide that the CVR holders can enforce their rights only through the rights agent under the CVR agreement (and not individually) and that only a minimum percentage of CVR holders (commonly ranging between 30% and majority) can direct the rights agent to bring claims for breach of the efforts covenant. While this type of mechanic does not eliminate the risk of litigation, at least it has the benefit of consolidating any claims over the CVR through one channel and proceeding.
Applications Beyond Life Sciences
Pharma, biotech, and other life sciences deals provide a natural context for the inclusion of CVRs, as the value of a particular drug may change dramatically based on the achievement or failure to achieve a major development or other milestone. They are also a natural forum for the consideration of spin-off mergers, as companies often have early-stage pipeline products they may see significant potential in, but for which buyers may not be willing to pay. Nevertheless, buyers outside these industries may soon begin to tap into these deal structures as dislocations between stock price and intrinsic value, heightened volatility, and economic uncertainly may force more parties to think about how to bridge valuation gaps in order to execute on deals that may have strong strategic sense but where it may be difficult to reach a meeting of the minds on deal price.[2]
* We wish to recognize, with immense appreciation, the assistance of Sora Park.
Buyers may not wish to acquire early-stage pipeline assets not only because they do not want to pay upfront purchase price for those assets, but also because they may not want to fund the development costs associated with those assets, which can be significant. ↑
CVRs, for example, have been used to address value gaps on account of potential litigation liabilities, where the CVR payment can be tied to the outcome of the litigation. ↑
In the week of November 7th, 2022, the digital asset ecosystem experienced an unprecedented level of market instability, as billions of dollars of value seemingly disappeared from FTX.com (“FTX”), an industry goliath, overnight. By the end of the week, a series of shocking revelations culminated in FTX itself and approximately 130 affiliated entities filing for bankruptcy. Earlier that year, FTX had been valued at $40 billion and was endorsed by celebrities and institutional investors alike, and its founder was coined “the next Warren Buffett” by Time magazine. The sudden collapse and disappearance of billions of dollars of value left many wondering whether users who had assets stored on FTX would be entitled to recovery of any of those assets, and more generally, how other users can protect themselves in the future when choosing to store their digital assets on these platforms.
Spurred by the former question, the discussion within this article will focus on the latter by considering whether a user’s relationship with companies offering digital asset related services (known as “Crypto Asset Service Providers” or “CASPs” in some jurisdictions) can be characterized as a “trust relationship.” This determination dictates whether, in the event of a bankruptcy, the user’s assets will be held outside of the bankrupt estate and protected from creditors, or whether the user will lose any special entitlement to the return of those specific assets and be treated as an unsecured creditor of the estate. In the interest of providing potential clarity to readers, this article will also highlight certain terms and provisions that may be included in the contractual documents that commonly govern the relationship between the CASP and the user.
Whether the relationship between users and CASPs can be established as a legal “trust” is also an important consideration in restoring consumer confidence in an emerging industry that has the potential to offer numerous benefits. While the concept of a purely digitalized financial market and currency may seem like a drastic departure from traditional financial methods (or, as coined by crypto enthusiasts, “TradFi”), perhaps it shouldn’t. Rather, it may be argued that the birth and evolution of the digital asset ecosystem is another step in a transition away from traditional financial methods that has transpired over the past thirty years. This transition has arisen in the pursuit of new potentials and advantages not offered by TradFi, such as the ability to definitively trace digital assets and determine their ownership history and provenance. However, for these advantages to truly outweigh the uncertainty accompanying this transition, it must first be shown that these features can actually be realized for broader stakeholder benefit. The establishment of a trust relationship may help to significantly mitigate, if not eradicate, this uncertainty.
As the reader continues through this article, bear these thoughts in mind, with consideration of how the concepts outlined herein can provide benefits to everyone, from the CASPs all the way down to the end users. The reader should further note that the statements contained herein are intended to be purely commentative and do not provide any legal advice, opinions, or positions on any past or future scenarios.
Issues of Discussion
The considerations of this article are outlined within the context of an insolvency proceeding, and they are cumulative and twofold: (1) can the relationship between the user and the platform be structured as a trust, being among settlor, trustee, and beneficiary, whereby legal/beneficial title to the digital assets remains with the user; and, if the prior question can be answered in the affirmative, (2) in the event that a CASP enters into bankruptcy or insolvency proceedings, can the user preserve their unencumbered right to “their” digital assets? Therefore, the overarching question posited by this article is whether users retain title to digital assets that they have stored on these platforms. Put simply: who actually owns the digital assets sent by users to CASPs?
Bankruptcy Scheme
Upon bankruptcy, claims against the filing party (i.e., the “debtor”) are ranked according to a priority scheme established by the governing statute of the debtor’s jurisdiction.[1] Typically, funds held by the debtor, including those provided by another party, are considered to constitute assets of the estate of the bankrupt debtor for distribution, regardless of whether the other party had any intention to become a creditor of the debtor. In this capacity, the “unintentional creditor” is deemed to be an unsecured creditor, usually ranking lower in priority in the distribution scheme behind secured creditors and certain specified parties, among others. This consequence often leaves the “unintentional creditor” with only a remote prospect of receiving some or all of their funds back.
However, there are certain exceptions to the above mechanism, including the “trust exception,” which provides that property held by the debtor in trust for any other person will not be divisible among the creditors, and the beneficiary of the trust will be able to recover the property held in trust for them.[2] Under this concept, the law recognizes that the assets/funds/property held by the debtor never belonged to the debtor, were never intended for the debtor, and thus never constituted part of the estate of the bankrupt debtor. In other words, if this exception can be established on the facts, the party that provided the digital assets is able to avoid becoming a creditor of the debtor and is often entitled to the full recovery of the assets that the debtor held on their behalf.
Establishing a Trust
(a) Overview
For a party to establish that the subject property was “trust property,” it must be capable of proving that a valid trust was in existence at the date of bankruptcy. A trust may be established through several methods, including (i) by “express trust,” whereby the settlor of the trust, by express intention, takes formal steps to have the trust constituted; (ii) by “constructive trust,” whereby a trust arises by operation of law in response to a series of events; or (iii) by “resulting trust,” where the trust is imposed as an equitable remedy when the ruling court believes it is an appropriate and equitable outcome in the circumstances.
As the latter two forms may only be imposed by a court post hoc and are highly dependent on specific context, this article will solely focus on express trusts. The reader should note, however, that this demarcation does not represent the authors’ opinion that the imposition of a constructive or resulting trust may or may not be applicable in the context of a CASP insolvency.
For a valid express trust to be established, three certainties must be present: (i) certainty of intent, specifically whether it can be said that the settlor clearly intended to create a trust; (ii) certainty of subject matter, which requires that the trust property be substantially identifiable; and (iii) certainty of objects, which requires clear and definitive identification of the beneficiaries of the trust. All certainties must be present to establish a trust (or, at the very least, a court must be able to infer their presence to some discernable degree). The scope of the following analysis considers the former two certainties in further detail, with certainty of objects being assumed in most circumstances.
(b) Certainty of Intent
For certainty of intent to be satisfied, there must be a clearly evidenced intention that the parties sought to create a trust, and the wording of the document(s) utilized to constitute the trust must indicate that the transferee is to take the property in the capacity of a trustee. However, merely including the words “in trust” or “as trustee for” in such documents is neither solely instructive nor imperative in satisfying this certainty requirement. Nor is it required that the intention be explicitly expressed; intent may be implied based on a variety of contextual factors, including the preexisting relationship between the parties and certain commercial realities.
Courts have demonstrated a reluctance to impose a trust where its imposition would not “fit” within the context and relationship of the parties.[3] For example, courts have typically concluded that the relationships of debtor/creditor and trustee/beneficiary are not ordinarily co-extensive; it is often either one or the other.[4] Similarly, transfers described as a “debt” obligation may be inconsistent with rendering a relationship of trustee-beneficiary.
The concept of commingling assets further clouds a determination of whether the requisite degree of certainty is present. Where the trustee has mixed the “trust assets” with non-trust assets, it may be inferred that the settlor never truly intended their assets to be held in trust at all. From a commercial realities perspective, assuming the presence of a trust were to be argued, the very capability of a trustee to commingle, and any actual commingling, could give rise to several difficulties in administering the trust.[5] The Supreme Court of Canada recently commented on this factor, noting that the presence of commingling is ordinarily evidence of a debt obligation rather than a trust obligation and is suggestive that the relationship is not one of a trustee and settlor.[6] However, the ability of a trustee to commingle trust assets with non-trust assets is not dispositive on this prong of certainty. As established, courts will take a holistic approach in their analysis as to whether a trust exists, with no singular factor being a sufficient condition.
(c) Certainty of Subject Matter
Certainty of subject matter requires that the assets forming the trust property be ascertained, or at least be ascertainable, at the time that the trust was created.[7] Additional specificity from case law provides that (i) the trust property be fixed or specified in the trust instrument, or (ii) there be a sufficiently clear method or formula for identifying the trust property.[8]
As with intent, the presence of commingling also creates difficulty in establishing the requisite level of certainty of subject matter, as it impairs the ability of parties to ascertain which assets are trust property transferred to the would-be trust by the settlor. However, while commingling may create practical difficulties in identifying trust assets, commingling alone does not per se destroy the trust. If trust property is initially ascertained or ascertainable, the property may yet remain traceable where it has been converted into other forms or mixed with other funds.[9]
For the purposes of this article and its discussion of whether digital assets stored on CASPs can be formulated as trust assets, the analysis of this prong of certainty takes on additional nuance. As alluded to, the novel blockchain technology upon which digital assets are based may provide stakeholders with, in some cases, arguably superior avenues for tracing and ascertainment in comparison to TradFi counterparts.
Analysis
(a) Overview
Applying the trust principles outlined above, this article now considers whether, and when, users of CASPs may be able to establish that they were the beneficiary of a trust, and that the assets stored on the CASP constituted trust assets. As noted above, if a trust can be established, those digital assets a user has stored on a CASP at the time of bankruptcy can be excluded from the estate of the debtor, and the user can be afforded special protection and entitlement to the recovery of their assets.
(b) Certainty of Intent
Recall, certainty of intent requires a clearly evidenced intention, based on holistic contextual factors, that the relationship between the parties was to be one of trustee and beneficiary. It must be clearly evidenced that there was never an intention that the assets in question would belong to the debtor or constitute the property thereof. A pertinent factor for this assessment includes the relationship between the parties, as evidenced by the words and terms used in the purported “trust-documents” establishing the relationship.
The relationship between a user and CASP is commonly set out entirely within the confines of the terms of service (“TOS”) agreed to by the user before they are fully able to access the CASP’s products and services. However, the TOS are not entirely determinative, and the relationship, as set out therein, may be modified by additional considerations, such as where the performance by the parties to the relationship is contrary to that which is set out by the TOS. For example, where a CASP has exercised unilateral control over digital assets in a manner that is inconsistent with a trust or TOS purporting to form a trust, it may contribute to a finding that no such relationship existed. TOS, being a contract, are informed by contract law and principles. Absent an “entire agreement” clause stipulating that the TOS governs the whole of the relationship, oral agreements or actions by either party may effectively modify the TOS without expressly doing so in writing.
The importance of the TOS in determining the legal status of digital assets held by CASPs has recently been illustrated in an opinion issued by the U.S. Bankruptcy Court of the Southern District of New York dealing with the chapter 11 bankruptcy of Celsius Network LLC (“Celsius”). Celsius offered a variety of digital-asset-related services, including an “Earn Account” that offered users a yield on the value of digital assets deposited and held in the accounts. The TOS of the Earn Account included, among other things, provisions governing the legal ownership of digital assets deposited therein, and the rights Celsius had with respect to exercising control over those assets.
In a memorandum opinion filed January 4, 2023, Chief Judge Martin Glenn, highlighted the following two provisions in Celsius’ TOS:[10]
“In consideration for the Rewards payable to you on the Eligible Digital Assets using the Earn Service . . . and the use of our Services, you grant Celsius . . . all right and title to such Eligible Digital Assets, including ownership rights, and the right, without further notice to you, to hold such Digital Assets in Celsius’ own Virtual Wallet or elsewhere, and to pledge, re-pledge, hypothecate, rehypothecate, sell, lend, or otherwise transfer or use any amount of such Digital Assets, separately or together with other property, with all attendant rights of ownership, and for any period of time, and without retaining in Celsius’ possession and/or control a like amount of Digital Assets or any other monies or assets, and to use or invest such Digital Assets in Celsius’ full discretion.”
“In the event that Celsius becomes bankrupt, enters liquidation or is otherwise unable to repay its obligations, any Eligible Digital Assets used in the Earn Service or as collateral under the Borrow Service may not be recoverable, and you may not have any legal remedies or rights in connection with Celsius’ obligations to you other than your rights as a creditor of Celsius under any applicable laws.”
In light of the aforementioned provisions, and the Court’s finding that the click-to-sign TOS constituted a valid and enforceable contract, the Chief Judge ruled that “the Terms unambiguously transfer title and ownership of Earn Assets deposited into Earn Accounts from Account Holders to Celsius”, resulting in those assets forming part of Celsius’ bankrupt estate.[11]
Though jurisprudence espouses that there are no “magic words” that create a trust relationship, the aforementioned opinion demonstrates that the TOS agreed to between a CASP and user will be a primary reference point for courts tasked with determining the legal status of transferred digital assets. While the number of decisions analyzing trust relationships between CASPs and users is lacking due to the relative novelty of the industry, the opinion indicates that relevant factors to consider include:
whether title to the assets remained with the user or was transferred to the CASP;
whether the CASP was overtly granted possession, ownership, or control of the digital assets, or some combination thereof; and
whether the CASP was authorized to trade, loan, encumber, hypothecate, or otherwise grant or take a secured interest in the digital assets.
For CASPs, retaining capabilities to effectively deliver their products and services is a critical issue in constructing TOS. Whether provisions transferring title to assets and rights to grant or take secured interests are required depends on specific commercial needs, but in any case, the TOS must be “clear and unambiguous” so as to clearly reflect the intent of the parties. Fundamentally, a CASP should not leave the imposition of a trust relationship to chance.
The opinion is also highly relevant for users. While there are abundant intriguing opportunities to access Web3 products and services through CASPs, users must ensure that they carefully examine the TOS before engaging. Said bluntly, read before you click “Accept”! This bears additional importance in circumstances where the user transfers digital assets from their wallet to an account or wallet governed by the CASP’s TOS. Finally, particular attention should be given to any provisions concerning title to assets transferred to the CASP, and any rights granted to the CASP regarding further transmission and hypothecation. The user will also need to provide evidence that the funds provided were not a payment to the CASP for any past or present services, or where there is a payment for the services, the user will need to be able to clearly delineate between funds that were provided as payment and any funds that were intended to be the subject matter of the trust. This delineation can similarly be grounded in the TOS.
(c) Certainty of Subject Matter
In satisfying the certainty of subject matter requirement for the purported trust assets, the unique characteristics of digital assets may allow users of CASPs to go beyond traditional approaches and more precisely identify which assets should be subject to the trust. It should be noted, however, that the ability to trace digital assets may be obfuscated in certain circumstances, including by third parties through the use of so-called “mixers” and other forms of novel technology.[12]
When dealing with tangible items of an undifferentiated mass, the traditional approach has been to require that the assets are segregated to ensure that such assets remain sufficiently identifiable.[13] However, it is possible that a user’s digital assets stored on a CASP may not need to be segregated to remain ascertainable. One technological nuance of digital assets is that they bear novel identifiers. For instance, ERC-20 tokens (which are an archetype for fungible digital assets native to the Ethereum blockchain) are accompanied by a unique contract address. A search for that unique contract address on “block scanners” like Etherscan provide a list of all transactions of that token that have been updated to the respective token’s native blockchain.[14] For permissionless blockchains, each transfer of the token generates a publicly accessible transaction hash, associating the specific transfer of the token with its location in the chain’s sequence, as well as its sender and recipient.
For fungible and non-fungible digital assets (often referred to as a “Non-Fungible Token” or a “NFT”), stakeholders can find the specific time and transaction whereby the digital asset was initially transferred from a user to a CASP-controlled wallet simply by (i) pulling the user’s wallet address and (ii) searching for the particular transaction that transferred the subject asset. Whether this is sufficient in itself to make digital assets at least “initially ascertainable” has not yet been considered in a court of law and currently remains inconclusively determined. For NFTs, free-to-use contemporary technology can go even further. Each NFT carries a unique “contract address,” like the tokens discussed above. By searching the contract address, stakeholders can pull an entire record of the transfers of the NFT, including those subsequent to the initial transfer to a CASP-controlled wallet, thereby allowing the current whereabouts of the NFT to be determined with finality.
Once a fungible digital asset (e.g., ETH) is transferred to a CASP wallet, however, the ability to definitively trace after-the-fact is less certain. For example, suppose user A transferred 5 ETH to a CASP-controlled wallet, and that 5 ETH was subsequently pooled with other ETH received by the CASP from other users B and C. Utilizing free-to-use tools like Etherscan, an examiner could pull a summary of all transactions of ETH for which a CASP is sender or receiver, but may be unable to definitively state that a subsequent transfer of ETH by the CASP to another user contained any of the 5 ETH that user A had originally transferred, was from another source (users B and/or C) or was from some combination thereof. While the authors are aware of attempts to develop technology designed to permit exact tracing of digital assets through a series of transactions, it is not yet clear that such technology readily exists. However, given the availability of real-time data and the increasing proliferation of premium blockchain analytical tools, it is reasonably foreseeable that the capacity to definitively trace fungible digital assets, even following such commingling, will become readily available.
Implications drawn from technological analysis and tracing may be deemed sufficiently persuasive to demonstrate the requisite level of segregation to establish ascertainability. Legislation recognizing the legal admissibility and reliability of evidence derived from block scanners is emerging, suggesting an openness from lawmakers to recognize the admissibility of “blockchain analysis” in the courtroom.[15] Due to this potential capability to be precisely identified through unique identifier and transaction codes, digital assets may be comparatively easier to definitively ascertain and establish certainty of subject matter for in instances of commingling, and accordingly, establish a trust relationship thereto.
Protection of Users in a Bankruptcy
Recall, where a trust relationship exists at the time of the bankruptcy, any assets that formed part of that trust are deemed to be separate and apart from the estate, entitling the beneficiary to full recovery of those assets. While the relationship between a user and CASP is determined in the same manner as with TradFi, by analyzing the factual and contractual relationship between the parties, digital assets possess the potential of being identified and ascertained through novel methods entirely unique to the digital asset ecosystem. If such capabilities can be fully realized, it may enable CASP users to insulate their assets from the remainder of the estate of the bankrupt entity and allow for the full recovery of any assets they had stored on the bankrupt CASP.
Conclusion
Born in the wake of the 2009 financial crisis, the digital asset industry remains nascent. While there is an immense amount of growth yet to come, users and CASPs alike should not overlook the potential advantages offered by the digital asset ecosystem that have already emerged. As this article concludes, readers should takeaway a sense of hopefulness, but additionally, a recognition that they must pay careful attention to their selection of which service providers they choose to engage with, and the terms that define their relationship therewith. Emergent CASPs, on the other hand, should reflect on the lessons provided through the fall of former industry juggernauts and perhaps, in an industry where present confidence is lacking, consider the ways that imposing a relationship of trust may protect the very users they propose to serve.
For Canada, see Daley v. OHR Whistler Management, 2007 BCSC 383; for the United States, see Cambridge Gas Co. v. Lamb, (1936) 117 W Va 174 (Sup. Ct. App. W. Va). ↑
Ontario v. Two Feathers Forest Products, 2013 ONCA 598. ↑
See, e.g., First Federal of Michigan v. Barrow, [1989] 878 F.2d 912 (U.S. Ct. App., 6th Cir.); In re Raymond Renaissance Theater, LLC, [2018] 583 B.R. 735 (U.S Bankr. Ct., C.D. Cal.). ↑
For Canada, see Mordo v. Nitting et al., 2006 BCSC 1761; for the United States, see In re FirstPay, Inc., [2014] 773 F.3d 583 (U.S. Ct. App., 4th Cir.). ↑
Celsius Network LLC et. al., Case No. 22-10964, Memorandum Opinion and Order Regarding Ownership of Earn Account Assets dated January 4, 2023 (Docket 1822), at pgs. 10-11 [Celsius]. ↑
A crypto mixer (also known as a “tumbler”) is a service that helps to protect users’ identity and privacy by disrupting the link between their real-world identity and their crypto wallet address. ↑
Donovan WM Waters, Law of Trusts in Canada, 5th Edition, 5 III Certainty of Subject Matter. ↑
Coming at a time of tightening credit markets, cryptocurrency business bankruptcies are making big headlines for their sudden entries into bankruptcy courts following rapid declines in the value of digital assets. From July 2022 to January 2023, there have been several bankruptcies filed by crypto brokerages, exchanges, and lenders, resulting in a significant evaporation of value. All signs suggest that more crypto bankruptcies are coming, so investors should understand the potential impact of digital assets held or invested in an exchange.
What Is Causing the Crypto Bankruptcies?
The reasons for these bankruptcies vary, including alleged fraud in the case of FTX Trading Ltd. However, the start of a broader crypto sell-off in the market began in May 2022 with the collapse of the Terra Luna coin and the related “stablecoin” TerraUSD.[1] Within a few days, Terra Luna and TerraUSD both lost substantial value, leading many crypto investors to begin seeking to withdraw their digital assets from various crypto exchanges and brokerages.[2] This led to the failure of crypto hedge fund Three Arrows Capital (or 3AC), which had significant exposure to Terra Luna.[3] Numerous future Chapter 11 filers had loaned money to 3AC, including BlockFi (a cryptocurrency lender), Celsius Network (a cryptocurrency lender), and Voyager Digital (a cryptocurrency brokerage). In particular, Voyager Digital loaned $665 million to 3AC; and when 3AC defaulted on the loan, Voyager filed for Chapter 11.[4] In May 2022, investors withdrew over $1 billion from the Celsius Network platform due to what the CEO of Celsius referred to as a generalized “distrust of cryptocurrency.”[5] Over the course of 2022, the value of Bitcoin dropped approximately 65 percent.[6]
What has followed is a wave of digital asset freezes, followed shortly thereafter by a wave of Chapter 11 bankruptcies in the United States. Celsius Network froze its platform for trading digital assets on June 12, 2022, and then filed for Chapter 11 on July 13, 2022.[7] Voyager Digital froze its trading on July 1, 2022, and then filed for Chapter 11 on July 5, 2022.[8] FTX Trading Ltd. (a cryptocurrency exchange and hedge fund) froze its platform for trading on November 8, 2022, and then filed for Chapter 11 on November 11, 2022.[9] The FTX trading freeze had a serious impact on BlockFi, which had $355 million of assets at FTX.[10] BlockFi also made loans to Alameda Research, an FTX affiliate and hedge fund, which defaulted on approximately $680 million in collateralized loan obligations.[11] BlockFi limited customer withdrawals on November 10, 2022, and then filed for Chapter 11 on November 28, 2022.[12] Genesis Global Capital (a cryptocurrency lender) froze customer redemptions on November 16, 2022, and then filed for Chapter 11 on January 20, 2023.[13] Similar to other crypto bankruptcy filers, Genesis loaned significant amounts to 3AC and Alameda Research, both of which filed insolvency proceedings in 2022.[14]
Most of these Chapter 11 filings occurred with little preplanning, which is rare in contemporary large Chapter 11 filings. Customarily, large companies will conduct weeks or months of planning and negotiations with its creditors prior to filing for bankruptcy, which typically helps to shorten the bankruptcy process and ensure greater certainty as to results. Instead, each of these crypto businesses has largely free-fallen into bankruptcy court, without a go-forward plan, following a rapid decline in value.
The FTX Collapse
The FTX bankruptcy caused significant disruption in the broader market for cryptocurrencies due to its size and perceived stability before its collapse. Sam Bankman-Fried, the majority owner of FTX and its affiliates, was arrested on December 12, 2022, for various alleged crimes connected to his operation of FTX, including wire fraud, securities fraud, and money laundering. Among the allegations by prosecutors is that Bankman-Fried diverted billions of dollars of customer funds for his personal use and to make investments. Bankman-Fried pleaded not guilty to the charges. On December 21, 2022, Caroline Ellison, the CEO of Alameda Research, and Gary Wang, FTX’s cofounder and chief technology officer, each pleaded guilty to charges that they helped Bankman-Fried in a years-long scheme to defraud investors.[15]
At 4:30 a.m. on November 11, 2022 (the day that FTX filed for bankruptcy), Bankman-Fried resigned his CEO role, and all corporate powers and authority were delegated to John J. Ray III, including the power to appoint independent directors and commence the Chapter 11 cases.[16] Ray appointed five restructuring experts as independent directors of each of the five business silos that FTX operated prebankruptcy.[17] Ray has significant restructuring experience, having worked as a chief restructuring officer or CEO on other large corporate failures, such as Enron and Residential Capital.
In the first-day affidavit filed by FTX with the bankruptcy court, Ray stated that he has never seen such a failure of corporate controls and such a complete absence of trustworthy financial information.[18] Ray indicated that he has no confidence in the financial statements produced while Bankman-Fried was in control of FTX,[19] that FTX did not have an accounting department,[20] and that FTX did not have a centralized cash-management system throughout its corporate structure.[21] Under its former leadership, FTX did not keep appropriate books and records, or even security controls, for its digital assets, and Bankman-Fried and Wang controlled nearly all access to digital assets in FTX.[22] Ray has engaged forensic analysts to assist in identifying FTX assets on the blockchain, and cybersecurity professionals to identify any unauthorized transactions.
As a sign of just how volatile these crypto bankruptcies can be, FTX filed for bankruptcy a mere twenty-three days after it sought and received bankruptcy court approval to purchase the digital assets of Voyager Digital for $1.4 billion.[23] That sale fell through and, as of December 19, 2022, BAM Trading Services Inc. (known as Binance.US) was selected as the winning bidder for Voyager Digital’s assets.[24] The deal with Binance.US is valued at $1 billion, and Voyager estimates that the sale will allow its customers to recover approximately 51 percent of the value of their digital asset deposits at the time Voyager filed for bankruptcy.[25]
When a Crypto Exchange Files Bankruptcy, What Happens to the Digital Assets?
When a company files for bankruptcy, a bankruptcy estate comprised of “all legal or equitable interests of the debtor in property as of the commencement of the case” is created by law.[26] Any and all property of the estate can be used to satisfy claims of creditors or pay expenses of the company in bankruptcy. The questions that should logically follow are these:
What happens to the digital assets deposited by customers/investors in a crypto company when the crypto company files for bankruptcy?
Are these digital assets property of the estate?
On January 4, 2023, Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York determined the answers to these questions in part in the Celsius Network bankruptcy. Judge Glenn determined that Celsius’s terms of use unambiguously established that customer funds deposited in “Earn” accounts at Celsius were property of the Celsius bankruptcy estate and were not property of Celsius’s customers.[27] The Earn account was a product offered by Celsius through which customers could earn interest on digital assets that they deposited in such accounts.[28] When Celsius filed for Chapter 11 in July 2022, there were 600,000 Earn accounts holding approximately $4.2 billion in digital assets.[29] There also were approximately $20 million in stablecoins in the Earn accounts.[30]
Celsius and the official committee of unsecured creditors took the position that the Earn accounts were property of the estate, and, as such, Celsius should be permitted to sell certain stablecoins in the Earn accounts to fund operating expenses and costs of the Chapter 11 case.[31] The Earn account holders argued that they owned the digital assets in the Earn accounts and that such funds should be returned to them.[32]
The Court determined that ownership of the digital assets in the Earn accounts was a “contract law issue.”[33] Per Celsius’s “Terms Version 8,” a clickwrap contract governed by New York law, Celsius held “all right and title to such Eligible Digital Assets, including ownership rights” in the digital assets deposited in the Earn accounts.[34] The customers participating in the Earn accounts overwhelmingly accepted the clickwrap contract terms or an earlier version of those terms.[35] The Court held that the terms of use formed a valid, enforceable contract between Celsius and its Earn account holders and that the terms unambiguously transferred title and ownership of the Earn account assets to Celsius.[36] As such, the Court ruled that the Earn account assets, including the stablecoins held therein, were property of the bankruptcy estate of Celsius and could be sold by Celsius to provide liquidity for the Chapter 11 proceedings.[37]
Importantly, the Court did not determine that holders of digital assets in the Earn accounts would receive nothing at all, but rather determined that the account holders will be considered unsecured creditors and will receive in-kind distributions under a to-be-confirmed Chapter 11 plan filed by Celsius, or under the Bankruptcy Code’s distribution waterfall in the event of a liquidation.[38] This means that the Earn account holders will have to wait a significant period—potentially years—for a recovery from the Celsius bankruptcy.
The Court also did not determine the ownership of assets in Celsius’s “Custody Program,” “Withhold Accounts,” or “Borrow Program,” or whether individual account holders have valid defenses between themselves and Celsius.[39] By contrast with the Earn accounts, the terms of use for the Celsius Custody accounts stated that title to digital assets held in such accounts “shall at all times remain with you and not transfer to Celsius.”[40] Based on the ruling on the Earn accounts, this suggests that the Custody accounts may not be property of the Celsius bankruptcy estate, and the assets therein may be returned to account holders.
On December 7, 2022, Judge Glenn ruled that a small group of Celsius customers, whose deposits were never commingled with other Celsius funds or in interest-bearing accounts, could recover their digital assets.[41]
While these decisions do not resolve all ownership issues that could arise with respect to digital assets in a crypto exchange, they do provide preliminary guidance for how an investor may protect itself in prudently storing digital assets based on the terms of use of an exchange.
Conclusion
As distress in the cryptocurrency market continues, investors should remain vigilant regarding the effects of bankruptcy on both their possession of digital assets in an exchange and the ultimate ownership of digital assets.
Declaration of Alex Mashinsky, Chief Executive Officer of Celsius Network LLC, in Support of Chapter 11 Petitions and First Day Motions ¶ 35, In re Celsius Network LLC, No. 22-10964 (Bankr. S.D.N.Y. July 14, 2022) (Doc. No. 23). ↑
Decl. of Alex Mashinsky, In re Celsius Network, No. 22-10964, Doc. No. 23, at 6. ↑
Declaration of Stephen Ehrlick, Chief Executive Officer of the Debtor, in Support of Chapter 11 Petitions and First Day Motions, In re Voyager Digital Holdings, Inc., No. 22-10943, Doc. No. 15, at 24 (Bankr. S.D.N.Y. July 6, 2022). ↑
Declaration of Mark A. Renzi in Support of Debtors’ Chapter 11 Petitions and First-Day Motions ¶ 96, In re BlockFi Inc., No. 22-19361 (Bankr. D.N.J. Nov. 28, 2022) (Doc. No. 17). ↑
Declaration of John J. Ray III in Support of Chapter 11 Petitions and First Day Pleadings ¶ 44, In re FTX Trading Ltd., No. 22-11068 (Bankr. D. Del. Nov. 17, 2022) (Doc. No. 24). ↑
Memorandum Opinion and Order Regarding Ownership of Earn Account Assets, In re Celsius Network LLC, No. 22-10964, at 4 (Bankr. S.D.N.Y. Jan. 4, 2023). ↑
In 2022, the Office of Foreign Assets Control (OFAC) announced numerous settlements with cryptocurrency exchanges. These settlements serve as “fair warnings” to all cryptocurrency service providers who are “U.S. persons” or who offer services to U.S. persons. The term “U.S. persons” is defined in 31 C.F.R. §560.314 as “any United States citizen, permanent resident alien, entity organized under the laws of the United States or any jurisdiction within the United States (including foreign branches), or any person in the United States.”
This article focuses on these “fair warnings” as they have accumulated from prior settlements and from OFAC’s published guidance on compliance requirements that have been public for some time.
This article uses two late 2022 OFAC settlement announcements—with West-Coast-based Bittrex, Inc. and Payward, Inc. d/b/a Kraken—to make clear that OFAC was adhering to a previously announced requirement on providers of financial services. Specifically, OFAC requires more than verification of identity at onboarding and periodic checking of customers against OFAC’s Specially Designated Nationals (SDN) list. Additionally, providers should employ lifetime-of-the-transaction and in-process geolocation checking in their interdiction screening. Geolocation screening in lifetime-of-the-relationship and in-process transactions raised the stakes for providers to block or reject transactions that would violate the sanctions regimes OFAC enforces.
The last part of this article walks through other fair warnings provided by settlements agreed to since March 2015 or other public guidance. Before discussing the two late 2022 settlements or the fair warnings, it may help to have the foundation of the March 2015 settlement OFAC made with PayPal, Inc.
A. OFAC’s Early Foray into In-Process Transactions in Newer Electronic Payments and Services: PayPal, Inc. (March 2015)
OFAC claimed new territory when it announced its settlement with PayPal, Inc. on March 25, 2015.[1] OFAC maintained that PayPal “did not screen in-process transactions in order to block or reject prohibited transactions.” The settlement highlighted, among other things, two types of deficiencies in PayPal’s sanctions compliance program. In the first, PayPal’s automatic interdiction filter failed to identify at least one customer as a potential SDN when OFAC made the SDN designation because its automatic interdiction filter was not “working properly.” PayPal’s agents “dismissed” on at least five occasions one customer’s SDN match and proceeded with transactions. On one other occasion, the filter “flagged” this customer’s account, but a PayPal agent again dismissed the match despite receiving additional information that showed a date of birth and place of birth identical to the SDN. These failures resulted in 136 transactions with a single individual on the SDN list that violated the “Weapons of Mass Destruction Proliferators Sanctions Regulations.”[2] The March 2015 settlement also addressed violations by PayPal of other U.S. sanctions regulations, and PayPal agreed to pay civil penalties totaling $7,658,300.[3]
B. The Late 2022 Settlements
1. Bittrex, Inc.
Bittrex, Inc. is a private company based in Bellevue, Washington. Bittrex provides both virtual-currency-exchange and hosted-wallet services. OFAC’s settlement announcement explained that from March 2014 to December 31, 2017, Bittrex operated more than 1,700 accounts, processed 116,421 virtual-currency-related transactions, and transacted $263,451,600.13 in violation of law and OFAC regulations.
Bittrex apparently showed “some understanding” of OFAC regulations by August 2015, months after OFAC settled with PayPal. However, until October 2017, Bittrex had no internal controls to screen customers or transactions for connections to sanctioned jurisdictions. OFAC described other failings in Bittrex’s compliance efforts, including:
not screening IP address or physical address information that customers were in sanctioned jurisdictions;
not paying attention to customers providing Iranian passports or identifying themselves as being in Iran at account opening;
not scrutinizing customers or transactions for nexus to sanctioned jurisdictions; and
failing to have any sanctions compliance program from March 2014 to February 2016. Ouch!
OFAC cited the absence of any sanctions compliance program for two years as one of three aggravating factors in determining the civil monetary penalty of more than $24 million. Among the penalty-mitigating factors was the “swiftness” with which Bittrex responded to OFAC’s Apparent Violations notice.
2. Kraken
On November 28, 2022, OFAC announced a settlement[4] with Kraken for violations of the Iranian Transactions and Sanctions Regulation.[5] Kraken’s parent, Payward, Inc., is based in San Francisco.
Based on IP address data, Kraken continued to deal with customers who had opened accounts outside of sanctioned jurisdictions and subsequently transacted business with Kraken from Iran, a sanctioned jurisdiction. The violations occurred between October 14, 2015, and June 29, 2019. Kraken’s violations began six months after the PayPal settlement was announced.
OFAC cited Kraken’s failure to employ geolocational in-process and after-onboarding screening as an “aggravating factor” in its penalty calculations. OFAC had concluded that Kraken had “reason to know based on available IP addresses that transactions appear to be” emanating from Iran. Ouch.
The settlement confirms that it is not sufficient to screen customers at onboarding or account opening or to perform daily checks to identify new entries on OFAC’s SDN list. Because customers may transact from sanctioned jurisdictions after establishment of accounts, daily monitoring needs to track IP addresses that are the source of transaction requests and instructions to identify transactions coming from jurisdictions that are on the sanctioned lists.
In the settlement, Kraken also agreed to implement more analytical tools such as “multiple blockchain analytics tools” (MBAT). These tools are geolocation controls including Internet Protocol (IP) address-blocking systems. MBAT may be a term or service not familiar to everyone. Prominent providers of MBAT include brand-name commercial providers such as Chainalysis and CipherTrace. MBAT tools assist with the basic identification and nationality verification requirements OFAC has implemented. Kraken has agreed to do more, including screening for OFAC’s “50 Percent Rule,” which requires detailed reports on beneficial ownership of assets and blocking of clients’ access to accounts and assets.
C. Fair Warnings Specifically Related to Crypto Entities’ Compliance Programs
OFAC’s settlements with Bittrex and Kraken are examples of enforcement actions presaged by prior enforcement actions and other OFAC guidance. These actions might still be cited as “regulation by enforcement” to the extent that prior enforcement actions frame the standards being enforced against each company. For example, OFAC made its focus on newer financial products and services clear beginning with its enforcement action against PayPal, Inc. in March 2015. These issues and statements of regulatory approach are described in section A of this article.
Since PayPal’s March 2015 settlement, managers updating and maintaining suitable interdiction-filtering procedures and programs had further fair warnings of OFAC’s approach and should have implemented screening of clients who may move to sanctioned jurisdictions, or who may be sanctioned by OFAC after accounts are opened. Kraken’s transactions mentioned in the settlement announcement all came later than OFAC’s action against PayPal, Inc.
The Bittrex and Kraken settlements provide at least five specific “fair warnings” about sufficient sanctions controls programs’ components, including warnings about (1) geolocation/IP address tools, (2) efficacy of controls, (3) being involved with facilitation of violations, (4) use of blockchain analytical tools, and (5) the totality for components of a proper sanctions compliance program. Let’s look at each.
Fair warning about geolocation tools. Kraken agreed to deploy tools such as the automated interdiction-compliance filters that commercial banks, securities firms, and insurance companies use to manage the day-to-day issues of account maintenance over the course of the provider’s relationship with its customers. For Kraken, this meant adding geolocation in-process transaction screening.
Fair warning about efficacy of controls. In addition to settlement announcements, OFAC has issued its 2021 “Sanctions Compliance Guidance for the Virtual Currency Industry” (2021 Guidance).[6] OFAC mentions two actions, both involving money laundering and one of which involved “facilitating” Russian ransomware actors. OFAC urged the virtual currency industry to “implement effective sanctions compliance controls to mitigate the risk of sanctioned persons and other actors exploiting virtual currencies to undermine U.S. foreign policy interests and national security.”
Fair warning about facilitation of violations. The OFAC 2021 Guidance also reminded actors that “for some sanctions programs, U.S. persons, wherever located, … are prohibited from facilitating actions on behalf of non-U.S. persons if the activity would be prohibited by sanctions regulations if directly performed by a U.S. person or within the United States.”
Virtual currency compliance programs, OFAC advised, should include “sanctions list and geographic screening,” among other measures. Details on “internal controls” in the 2021 Guidance include providers making more active use of users’ IP addresses. Additional details suggest controls via IP addresses that prevent persons in comprehensively sanctioned jurisdictions, such as Iran or Syria, from accessing providers’ platforms. OFAC expects that entities will “ensure [they are] utilizing all available information for sanctions compliance purposes.”
Fair warning on blockchain analytic tools and ongoing screening. The 2021 guidance document also suggests that virtual currency companies “consider conducting a historic lookback of transactional activity after OFAC lists a virtual currency address on the SDN list to identify connections to listed addresses.” Providers are encouraged to use blockchain analytic tools to identify and manage sanctions risks. OFAC also mentioned “ongoing sanctions screening and risk-based re-screening” to account for updated customer information, changes in OFAC’s SDN lists, or changes in regulatory requirements.
In 2018, OFAC included known virtual currency addresses as identifying information for persons on its SDN list and allowed searches of those addresses using the “ID #” field in it Sanctions List FAQs 562,[7] 563,[8] and 594.[9] OFAC provided more detail in its FAQs, some of which it updated in association with its 2022 press release announcing its settlement with Kraken.
Fair warning about components of a functional sanctions compliance program. OFAC also published on May 2, 2019, “A Framework for OFAC Compliance Commitments.”[10] The Framework covers foreign entities that conduct business in or with the United States or U.S. persons or that use goods or services exported from the United States. The Framework identifies five aspects of a sanctions compliance program: management commitment, risk assessment, training, internal controls, and testing/auditing. Additionally, OFAC has published and codified “Economic Sanctions Enforcement Guidelines.”[11]
Admittedly, some of the guidance that OFAC issued came after the violations covered by Kraken’s November 2022 settlement. Adding the Kraken settlement and OFAC’s FAQs updated at the time of the Kraken settlement to the universe of OFAC’s guidance provides important benchmarks for providers in the virtual currency industry.
D. A Generally Applicable Fair Warning on Voluntary Self-Disclosure of Possible Violations
OFAC seldom reveals how it becomes alerted to possible sanctions violations. It often is alerted by the entity itself through a procedure known as “voluntary self-disclosure.”[12] Companies that self-disclose violations can negotiate much lower civil penalties. Self-disclosure requires robust and risk-based internal screening and policies to deter and detect violations of sanctions regimes. The voluntary self-disclosure must reach OFAC before OFAC learns of a violation from another source, such as a bank or freight forwarder.
In the cases of Bittrex and Kraken, OFAC did not mention self-disclosures, which signals that another entity or government had alerted OFAC or its sister agency, the Financial Crimes Enforcement Network (FinCEN) of possible violations.
Accordingly, one more generic “fair warning” should be on the fair warnings list: If you identify violations, get started on your self-disclosure promptly. Or, to be more blunt: fess up when you mess up!
E. Conclusion
As the tools available to those intending to circumvent sanctions laws and their enablers improve, OFAC has expanded the range of tools it expects entities subject to OFAC’s strict liability regimes to employ. This requires U.S. person subject to OFAC’s risk-based compliance expectations to reassess their compliance tools and procedures. Although the Federal Aviation Administration may use a thirty-year-old software to run a notice to pilots before take-off, providers of financial products and services subject to OFAC’s jurisdiction should not fail to update their systems that can detect and prevent transactions with sanctioned individuals and entities or sanctioned nation-states. Finally, providers should make voluntary self-examination and self-disclosure protocols key parts of their OFAC compliance programs.
Sarah Jane Hughes is the University Scholar and Fellow in Commercial Law at the Maurer School of Law, Indiana University in Bloomington, Indiana. Before joining the faculty as a visiting professor in 1989, Ms. Hughes was an Attorney-Advisor at the Federal Trade Commission focusing on retail payments, consumer credit protection (including the enforcement of the Truth-in-Lending Act and the FTC’s trade regulation rule Preservation of Consumers’ Claims and Defenses), and financial privacy issues. Read her full bio here.
The last few years had started to see a convergence between crypto and banking, with Bitcoin appearing to rapidly grow mainstream. That momentum hit a wall with the spectacular crypto market failures of 2022, including the collapse of the crypto exchange FTX. In response to the significant volatility and the exposure of vulnerabilities in the crypto sector that resulted, the federal prudential bank regulators (the Board of Governors of the Federal Reserve System [Fed], the Federal Deposit Insurance Corporation [FDIC], and the Office of the Comptroller of the Currency [OCC]) have recently taken coordinated moves to, with an increasingly firmer hand, delineate the types of risks related to the crypto sector that banks should be aware of—and, in certain instances, that do not belong in the banking system, in their view.
The policy lines being drawn are critical because banks continue play a dominant role in mainstream, day-to-day financial activities. A bank’s expansion into crypto activities or offerings underpinned by distributed ledger technology (DLT), particularly in partnership with a fintech company, could amplify adoption of these technologies. A fintech company offering crypto services or a DLT-based platform may find its own scale, reach, and reputation in augmented by partnering with a bank. If done carefully and cautiously, these partnerships could also help safely integrate certain crypto and DLT-based innovations into more mainstream uses. What that could look like and the supervisory expectations around such offerings are starting to take shape, as reflected by recent actions by the federal prudential regulators. As the Biden Administration has emphasized, these actions reflect “the imperative of separating risky digital assets from the banking system.” Even still, not all crypto and DLT-based activities are off the table.
We are at an important turning point in the industry, with riskier crypto enterprises failing and banking regulators stepping up to make their expectations clearer. It is important for fintech companies that partner with or are looking to partner with banks to offer crypto or DLT-based services, investors in these companies, and their legal advisers to stay abreast of where the prudential overseers are beginning to draw a red line with respect to crypto activities and the opportunities for responsible innovation that remain.
Recent Crypto Developments
The Fed, FDIC, and OCC had jointly announced in November 2021 that they conducted a series of interagency “policy sprints” focused on crypto, but only recently have they started to paint clearer boundaries for the types of crypto activities that banks may engage in. These recent announcements include their joint statement on crypto-asset risks to banking organizations, issued January 3, 2023; the Fed’s policy statement to promote a level playing field for all banks with a federal supervisor, regardless of deposit insurance status, issued on January 27, 2023; and the Fed’s announcement of its denial of the application by Custodia Bank, Inc. to become a member of the Federal Reserve System, also made on January 27, 2023.
Here are some practical takeaways for fintech companies that are partnering with or are looking to partner with banks in connection with crypto- or DLT-based offerings:
Banks are not barred from providing crypto custody services: The Fed explicitly stated that it is not taking off the table for its supervised banks the ability to provide safekeeping services, in a custodial capacity, for crypto—if conducted in a safe and sound manner and in compliance with consumer protection, anti-money laundering, and anti-terrorist financing laws. The OCC has previously concluded that a national bank may provide crypto custody services on behalf of customers.
Banks are unlikely to be holding crypto assets for their own account (“as principal,” such as for investment or market-making activity): The joint statement noted that holding as principal crypto-assets that are underpinned by an open, public, or decentralized blockchain is “highly likely to be inconsistent with safe and sound banking practices.”
The Fed went further in its policy statement, noting that it would “presumptively prohibit” its supervised banks from holding most crypto as principal.[1] Overcoming this presumption will be no small feat, as the Fed’s policy statement includes a litany of safety and soundness concerns.
There is a path for banks to issue “dollar-denominated tokens” underpinned by DLT: A bank seeking to issue a dollar token would need to demonstrate, to the satisfaction of its supervisor, that it has controls in place to conduct the activity in a safe and sound manner, and it must receive a supervisory nonobjection.
It seems highly unlikely that a bank would receive a greenlight to issue tokens underpinned by an open, public, or decentralized blockchain. Additionally, where the bank does not have the ability to obtain and verify the identity of transacting parties, and therefore may not have a sufficient risk management framework to mitigate money laundering and terrorism financing risks, supervisors are highly likely to conclude that its activities are inconsistent with safe and sound banking practices.
These guardrails still leave room for innovation. For example, the New York Innovation Center, a division of the Federal Reserve Bank of New York established in partnership with the Bank for International Settlements Innovation Hub, announced its participation in a proof-of-concept project with a number of major banks to explore the feasibility of an interoperable network of digital central bank liabilities and commercial bank digital money using a shared, permissioned DLT.
The purely crypto-centric bank business model is likely to be a relic of history: The agencies have expressed significant safety and soundness concerns with business models that are concentrated in crypto activities or have concentrated exposures to the crypto sector. At the same time, crypto companies are not being shunned from the banking system; banks are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.
More generally, the prudential regulators’ crypto actions are a reminder that banks are a “special” type of entity, and the banking system is bounded by a shifting federal regulatory perimeter. That is, banks are supervised and highly regulated institutions, and there are important guardrails with respect to the crypto-related activities they can engage in.
Unique Aspects of Bank-Fintech Partnerships
As a threshold matter, banks are limited in the activities they can engage in by “legal permissibility”—that is, before a bank can engage in new activities of any kind, including crypto-related activities, it must ensure that the specific activity is permissible under applicable banking law and regulation. In addition, prudential oversight means that banks have to operate with safety and soundness in mind, as well as have appropriate measures and controls in place to manage risks. Banks must also ensure compliance with all relevant laws, including those related to anti-money laundering/countering the financing of terrorism and consumer protection. The Fed, FDIC, and the OCC have each instructed their supervised banks to follow specific notice requirements if they are seeking to engage in crypto-related activities.
A bank-fintech partnership in offering crypto or DLT-based services can yield unique benefits when executed safely and within these guardrails. A fintech company that partners with a bank could leverage the bank’s resources, infrastructure, and regulatory compliance experience to safely offer crypto services to a larger audience. A bank might rely on the fintech company for back-end technology services or front-end user interfaces to support the crypto services it can offer to its banking customers. Robust integration of crypto functionality and DLT with traditional banking systems, with sound risk controls and consumer education, would also make it safer and easier for the general public to use these technologies.
Takeaway
We are entering a new chapter in the evolution of crypto, DLT, and the businesses around them. Crypto is not vanishing any time soon, and technologies like DLT continue to present a unique and potentially promising opportunity for fintech companies and banks to collaboratively upgrade the outdated underpinnings of our financial system. Rather than keeping innovation out of the banking system, the industry and its regulators would do better to figure out the best way to integrate it safely and incrementally. The bank-fintech partnerships that are most advanced in addressing legal uncertainties, mitigating risk, and building strong compliance infrastructures will be best positioned for success. Critical to that success is good legal counsel on how to intelligently navigate the novel and evolving regulatory issues raised by crypto and DLT.
The Fed also noted that the OCC has gone so far as to require a national bank to divest crypto held as principal that it acquired through a merger with a state bank: “Specifically, the OCC conditioned its recent approval of the merger between Flagstar Bank, FSB and New York Community Bank into Flagstar Bank, NA on the divestiture of holdings of ‘Hash,’ a crypto-asset, after a conformance period, as well as a commitment not to increase holdings of any crypto-related asset or token ‘unless and until the OCC determines that . . . Hash or other crypto-related holdings are permissible for a national bank.’” See also OCC Conditional Approval Letter No. 1299, at 9 (October 27, 2022). ↑
The Rule of Law is “a durable system of laws, institutions, norms, and community commitment” based on “four universal principles”: “just law”; “open government”; “accessible and impartial justice”; and “the government as well as private actors are accountable under the law.”[1] The cornerstone of that system in this country is the United States Constitution.
“There is a story, often told, that upon exiting the Constitutional Convention Benjamin Franklin was approached by a group of citizens asking what sort of government the delegates had created. His answer was: ‘A republic, if you can keep it.’”[2] I came across no record of Franklin elaborating on this provocative statement. But what I take away from it is that we can only keep our republic if we are willing and able to do the hard work it takes to maintain it. In writing about Franklin’s statement, Professor Richard Beeman concludes: “If there is a lesson in all of this it is that our Constitution is neither a self-actuating nor a self-correcting document. It requires the constant attention and devotion of all citizens.”[3] The focus of this piece is the aspect of the above definition of the Rule of Law that pertains to community commitment.
Franklin’s views did not always carry the day during the Constitutional Convention. In fact, he observed: “I confess that there are several parts of this Constitution which I do not at present approve, but I am not sure I shall never approve them. For having lived long, I have experienced many instances of being obliged by better information, or fuller consideration, to change opinions even on important subjects, which I once thought right, but found to be otherwise.”[4] However, as discussed below, Franklin’s statement about “A republic, if you can keep it” does reflect a shared concern and understanding of the Founders.
Moreover, that concern is a continuing one on the part of thoughtful commentators, and empirical evidence demonstrates that there is substantial cause for concern today. The beneficial effects of civic education are not only desirable but necessary for our well-being as a nation. Consequently, as members of the legal profession, we should engage in and promote civic education that will support and strengthen the Rule of Law. Doing so is one of the ways we can deliver on the solemn promise we made when we took an oath to support and defend the Constitution and laws of the United States of America.
Other Founders Shared Franklin’s Concern
“[W]hat the American Founders did not do—could not do—was guarantee the success of their creation. Franklin and the other Founders knew that their experiment depended on future generations, which meant the education of future citizens.”[5] “Shortly after the Constitution was signed, Jefferson wrote from Paris: ‘Wherever the people are well informed, they can be trusted with their own government.’”[6] In his first inaugural address, George Washington stated: “The preservation of the sacred fire of liberty, and the destiny of the Republican model of Government, are . . . staked on the experiment entrusted to the hands of the American people.”[7] “For his part, John Adams observed that ‘liberty cannot be preserved without a general knowledge among the people.’”[8] It is telling that on May 19, 1821, Adams wrote to Jefferson: “A free government is a complicated piece of machinery, the nice and exact adjustment of whose springs, wheels, and weights, is not yet well comprehended by the artists of the age, and still less by the people.”[9]
In a piece titled “Civic Illiteracy and the Rule of Law,” in which he recounts the story about Franklin’s statement when exiting the Constitutional Convention, Judge Don R. Willett writes that “[t]he survival of freedom depends on people, not parchment.”[10] Willett goes on to direct our attention to the very beginning of the Constitution, reminding us that “We the People of the United States” is “supersized on the page for all the world to see.”[11] Thus while the words “civic education” may not have been used, the necessity of it is something that has been recognized since the founding of our nation.
A Similar Concern Today about the Need for Civic Education; We Should be Very Concerned
In his 2019 year-end report, Chief Justice John Roberts, Jr. called on us to live up to our responsibilities with respect to civic education. He wrote: “Civic education, like all education, is a continuing enterprise and conversation. Each generation has an obligation to pass on to the next, not only a fully functioning government responsive to the needs of the people, but the tools to understand and improve it.”[12]
Others have highlighted the consequences of neglecting civic education. In “Civic Illiteracy: A Threat to the American Dream,” Michael Ford wrote: “The effects of civic illiteracy take their toll over time, and while Americans are almost defiantly indifferent about their lack of civic understanding, the consequences to our basic rights and freedoms and the general health of our republic could be dire. The American Dream, which requires the rule of law and civic understanding to protect the freedoms and opportunities we value, could be deeply damaged.”[13] A report by the Educating for American Democracy Initiative describes our country’s situation as standing “at a crossroads of peril and possibility.”[14] Peril because “[i]n recent decades, we as a nation have failed to prepare young Americans for self-government, leaving the world’s oldest constitutional democracy in grave danger, afflicted by both cynicism and nostalgia, as it approaches its 250th anniversary.”[15] Possibility because “[o]ur civic strength requires excellent civic and history education to repair the foundations of our democratic republic” and we are capable of doing something about this situation.[16]
The consequences of civic illiteracy will be felt sooner than we might suspect. For “the middle and high school students of today will be tomorrow’s jurors, judges, court staff, lawyers, litigants, and journalists.”[17] And tomorrow is just around the corner.
In a 2018 lecture on civic education, Judge Robert A. Katzmann lamented that “[u]nfortunately, the Constitution’s ideals—and the way our system of government puts them in action—are lost on millions of Americans. Surveys show many have only a dim idea of how our government makes and applies laws. Most could not pass the test administered to prospective citizens.”[18] Also unfortunately, there is considerable evidence to support that statement.
In April of 2020, the National Center for Education Statistics released the results of the 2018 National Assessment of Educational Progress (NAEP) civics assessment. This civics assessment was first given in 1998 and has been administered every four years since 2006 to fourth-, eighth-, and twelfth-grade students. The results from the 2018 tests show that “about 24 percent of eighth-grade students performed at or above the NAEP Proficient level on the civics assessment, which was not significantly different from the 23 percent of students performing at this level in 2014, the previous assessment year. There was no significant change in the percentage of students performing at this level compared to 1998, the first assessment year.”[19] Studies show that the situation does not improve as students progress through high school. “Considerable evidence exists that appallingly large numbers of students would not pass the exam of basic civic knowledge required for naturalization. . . . By contrast, 92 percent of immigrants passed on their first try.”[20]
Nor does the situation improve as people move into adulthood. A national survey conducted by Xavier University’s Center for the Study of the American Dream revealed “that one in three native-born citizens failed the civic literacy test, based on the INS passing score of 6 out of 10 correct answers. This pass rate is 32 percent less than the average immigrant passing rate. In and of itself, these numbers don’t appear alarming because we have heard them before. However, our persistence in civic unawareness is no comfort simply because it is consistent.”[21]
Nor do we do better when presented with a relatively simple set of questions. The Annenberg Public Policy Center conducts an annual survey assessing Americans’ civic knowledge. During the period from 2006 through 2019, the percentage of people who could name the three branches of government remained below 40 percent.[22] Then, apparently as an unanticipated consequence of the pandemic, when the 2021 survey was taken 51 percent of the participants involved could name all three branches; this was up from the previous all-time high of 39 percent in 2020.[23] While that is an improvement, that is still a perturbingly low percentage, and post-pandemic our performance is likely to regress. This modest improvement does not undermine the accuracy of the statement that “We the People’s civic illiteracy is staggering.”[24]
Some of the Important Benefits of Civic Education
By our actions (or inaction) today we help create our nation’s citizenry of tomorrow. They will either have the knowledge, skills, and values that serve to support and strengthen the Rule of Law, or they will not. But there is no question but that they will definitely be in need of such knowledge, skills, and values, because it is no simple task to maintain a properly functioning system of laws and institutional norms.
Professor Beeman, writing about the Founders, observed that “they had not yet worked out fully the question that has plagued all nations aspiring to democratic government ever since: how to implement principles of popular majority rule while at the same time preserving stable governments that protect the rights and liberties of all citizens.”[25] Similarly, Professor Robert B. Talisse has written about the fact that “[d]emocracy imposes a substantial moral burden on citizens.”[26] He observes that as a consequence of the fact that “[d]emocracy is self-government among equals . . . , democracy runs on political disagreement.”[27] Thus, “democracy requires us to see our fellow citizens as our political equals, people who do not merely get an equal say in political decision-making but are entitled to an equal say. This of course is easy among those that agree. But there’s no easy way to regard our political opponents as equal citizens with an equal entitlement to political power.”[28]
Our system of laws and institutional norms has flaws because we, the human beings who designed that system, are flawed. Civic education can help counteract cynicism about and disillusionment with the legal system and the Rule of Law by helping people embrace the idea that living in a democracy means that you do not always get your preferred outcome, as well as understand that the fact that our legal system does not function perfectly is no reason to abandon that system instead of working to improve it. Civic education provides students and adults the opportunity to “observe and come to grips with the real-life complexities of doing justice.”[29]
Also, members of the legal profession can and should be exemplars of “the importance of civility and civil discourse,” and engaging in civic education is an opportunity for us to model and teach about that.[30] Civic education is an opportunity to “provide students with the skills to communicate effectively with others, even when they disagree.”[31]
Law professors Linda McClain and James Fleming wrote an essay in the Boston University Law Review about why “civic education is crucial to remedying what Jack Balkin, in The Cycles of Constitutional Time, diagnoses as ‘constitutional rot’ in the United States.”[32] They observed that civic education “helps to equip people for forms of democratic participation (including in social movements) necessary to the health of constitutional democracy.”[33] They explained that civic education “aspires to inculcate civic virtues and develop capacities for responsible constitutional self-government, for example:
tolerance and respect for others who are different from ourselves;
reciprocity in our relationships with others, including those with whom we disagree;
mutual forbearance and trust . . . ;
a willingness to meet people halfway (rather than to insist on our own way); and
a disposition and capacity to give reasons (rather than merely to make assertions).”[34]
So I hope we can all agree that “[w]hen civics education is taught effectively, it can equip students with the knowledge, skills, and disposition necessary to become informed and engaged citizens.”[35]
One of the Things You Can Do
At the Business Law Section’s Spring Meeting in Seattle (April 27 to 29) we will be supporting Reading Partners Seattle by (i) donating to students books on topics related to Rule of Law, and (ii) arranging for some Section members to visit a school to read and talk about topics related to the Rule of Law.
This activity is being organized by the Pro Bono Committee and the Rule of Law Working Group, and you will learn more about it in the next issue of Business Law Today.
Robert A. Katzmann, Civic Education and the Federal Courts, Thomas E. Fairchild Lecture, 2019 Wis. L. Rev. 397, at 400, https://wlr.law.wisc.edu/wp-content/uploads/sites/1263/2020/02/Katzmann-Final.pdf (citing John Adams, A Dissertation on the Canon and Feudal Law No. 3, Bos. Gazette (Sept. 30, 1765)) (last visited 2/14/23). ↑
Rebecca Fanning, Involve, Inform, Inspire: Through Robust Civics Education Offerings, Federal Courts and Judges Teach the Next Generation About the Judiciary, 106 Judicature, Vol. 1, at 14 (2022), https://judicature.duke.edu/articles/involve-inform-inspire/ (last visited 2/14/23). ↑
Rebecca Fanning, Involve, Inform, Inspire: Through Robust Civics Education Offerings, Federal Courts and Judges Teach the Next Generation About the Judiciary, 106 Judicature, Vol. 1, at 15 (2022), https://judicature.duke.edu/articles/involve-inform-inspire/ (last visited 2/14/23). ↑
Robin L. Rosenberg, Beth Bloom, & Hayley Lawrence, Critical Life Skills Through Courtroom Experiences, 106 Judicature, Vol. 1, at 34 (2022). ↑
Linda C. McClain & James E. Fleming, Civic Education in Circumstances of Constitutional Rot and Strong Polarization, Abstract, 101 B.U. L. Review 1771 (2021). ↑
This article is part of a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
Delaware recently enacted significant amendments (the 2022 Amendments) to the General Corporation Law of the State of Delaware (the DGCL), enhancing Delaware’s corporate governance regime for directors and officers, while also expanding stockholder rights. However, one of the most significant changes to the DGCL—the authorization of exculpatory charter provisions for officers—has been the subject of litigation in recent cases involving public companies with dual classes of common stock. In addition, the major proxy advisory firms have begun issuing policy guidelines, signaling that management will need to make a strong case for the adoption of the proposals by stockholders to garner institutional stockholder support in some cases. Nevertheless, there are several reasons for public companies to remain optimistic about officer exculpation and the other changes to the DGCL effected by the 2022 Amendments. Beyond authorizing exculpatory charter provisions for officers, the 2022 Amendments have important implications for stock issuances and option grants, stockholder meetings, appraisal rights, and the conversion or domestication of Delaware corporations to other entities.
Exculpatory Provisions for Officers
Section 102(b)(7) of the DGCL (Section 102(b)(7)) now permits Delaware corporations to include exculpatory provisions in their certificates of incorporation to limit or eliminate the personal liability of executive officers of the corporation for monetary damages for breaches of the fiduciary duty of care in direct but not derivative proceedings. Under the 2022 Amendments, a Section 102(b)(7) provision may exculpate as an “officer” any person who (i) is the president, chief executive officer, chief operating officer, chief financial officer, chief legal officer, controller, treasurer, or chief accounting officer, and officers performing similar functions; (ii) is or was identified in the corporation’s public filings with the United States Securities and Exchange Commission as one of the corporation’s most highly compensated executive officers; or (iii) has consented to service of process in Delaware by written agreement. Like directors, officers may not be exculpated for breaches of the duty of loyalty; actions or omissions in bad faith; knowing violations of law; and in connection with transactions from which any such officer derived an improper personal benefit. However, unlike directors, officers may not be exculpated for monetary damages incurred in derivative proceedings.
The amendments to Section 102(b)(7) respond to an increase in litigation asserting violations of the fiduciary duty of care against an officer of a corporation as a means to avoid a dismissal of the complaint at the motion to dismiss stage by reason of the application of a Section 102(b)(7) exculpatory provision to the corporation’s director defendants.
Because exculpatory provisions for officers must be included in a corporation’s certificate of incorporation, board and stockholder approval will be required to expand Section 102(b)(7) coverage to officers. Many public companies have protected their director exculpatory provisions with supermajority provisions, raising issues for counsel as to whether a supermajority vote is necessary to revise the provisions to cover officers. However, in many cases, a Section 102(b)(7) exculpatory charter provision covering officers can be added to a certificate of incorporation with a simple majority vote.
While many issuers have already successfully adopted amendments to their certificates of incorporation that add exculpatory provisions for officers with the support of the proxy advisory firms, recent policy guidelines issued by Institutional Shareholder Services (ISS) and Glass Lewis signal that management will need to provide a compelling rationale for the adoption of such provisions to their stockholders to garner institutional investor support in the future. The ISS and Glass Lewis guidance states that management proposals to adopt officer exculpation provisions will be reviewed on a case-by-case basis by such firms, with ISS suggesting that it would focus on whether the proposals purport to eliminate monetary liability for breaches of fiduciary duty other than the fiduciary duty of care. Glass Lewis’s guidelines take a more negative stance, stating that the firm would generally recommend voting against officer exculpation proposals.[1] It remains to be seen how these policy guidelines will impact exculpatory officer provisions submitted for stockholder action during proxy season in the spring. Key institutional investors, such as BlackRock and State Street Global Advisors, have not yet adopted voting policies specifically addressing exculpation proposals.
Public companies with dual classes of common stock also need to be careful about the votes sought from stockholders to implement such proposals given claims by stockholders holding a class of non-voting common stock that the implementation of the proposals requires a class vote under Section 242(b)(2) of the DGCL (Section 242(b)(2)). Section 242(b)(2) affords stockholders of a class with a separate class vote on charter amendments that alter or change “the powers, preferences, or special rights of the shares of such class so as to affect them adversely” even if such stockholders hold non-voting stock. Stockholders holding non-voting, public company stock are taking the position in various lawsuits[2] that the elimination of their ability to bring direct actions for breach of fiduciary duty against officers alters or changes “the powers, preferences, or special rights of the shares of such class so as to affect them adversely” and therefore their approval is required to implement officer exculpation.[3] While existing case law provides strong arguments that the position taken by the plaintiffs in the actions is without merit, public companies with multiple classes of common stock should consider either waiting to adopt Section 102(b)(7) provisions until after the litigation has been resolved or subjecting the approval of any such proposals to a separate class vote of each outstanding class of common stock.
Stock, Options, and Other Rights to Purchase Stock
Sections 152, 153, and 157 of the DGCL have been amended to harmonize the rules governing the board’s ability to delegate to persons or bodies other than a board committee (such as officers or a sales or placement agent) the authority to issue stock under Section 152 of the DGCL and to make grants of rights or options to purchase stock under Section 157 of the DGCL.
Specifically, the 2022 Amendments to Section 157 of the DGCL expand the board’s power to delegate the authority to issue options or other rights to purchase stock using the framework that applies to the delegation of issuance of stock under Section 152 of the DGCL.
With respect to grants of rights or options to purchase stock, the board resolutions must establish (i) the maximum number of rights or options that may be granted, and the maximum number of shares issuable upon exercise thereof, (ii) a time period during which such rights or options, and during which the shares issuable upon exercise thereof, may be issued, and (iii) a minimum amount of consideration (if any) for which such rights or options may be issued and a minimum amount of consideration for the shares issuable upon exercise thereof. Assuming the board sets these broad parameters, the board may delegate to any person or body the authority to determine the precise timing of the grants, the exercise price, and the number of options or rights to be granted, as well as the other terms of the grants, such as the vesting schedule or expiration date. Under the prior version of Section 157 of the DGCL, the board could not delegate to any officer the authority to determine any of the terms of the grants other than the total number of options or rights to be awarded to officers and employees other than such officer subject to a cap set by the board.
In addition, the consideration paid for options or rights to purchase stock may be set by reference to a formula provided in the board resolution, such as by reference to the trading price of the company’s stock. Amended Section 157 of the DGCL also eliminates the requirement that the terms of a right or option be set forth or incorporated by reference in a written instrument, paving the way for electronic forms of rights and options.
The DGCL limitations on a corporation’s ability to delegate the power to grant rights and options to officers and others do not apply to board committees. Properly empowered board committees may exercise the full power and authority of the board to make grants of rights and options to purchase stock. It was common practice prior to the 2022 Amendments for the board to constitute the chief executive officer as a one-person board committee (provided such person was also a director) for the purposes of making grants under equity compensation plans. Given the complexity of the new delegation rules under amended Section 157 of the DGCL, many corporations are continuing the practice of delegating the authority to make grants of equity awards to a one-person board committee.
Stockholder Meetings and Notices
The 2022 Amendments effect a number of changes that facilitate stockholder meetings, including by eliminating some impediments to virtual meetings. During the pandemic, many public corporations held their meetings virtually but found it difficult to comply with Section 219 of the DGCL, which required that the stockholder list be available on the virtual meeting platform or at the corporation’s principal place of business for a period of at least ten days prior to the meeting, as well as during the whole time of the meeting. The 2022 Amendments eliminate the requirement that a corporation make the list of stockholders available for inspection during the stockholders’ meeting.
The 2022 Amendments also clarify that a notice of a meeting of stockholders may be given in any manner permitted by Section 232 of the DGCL, which specifies that notice of a meeting may be given by electronic transmission, including by e-mail, and generally deems such notice to be given when directed to a stockholder’s electronic mail address. Other amendments to Section 222 of the DGCL facilitate the adjournment of a meeting due to a technical failure such as a crash of the virtual meeting platform. In such event, the meeting may be adjourned to another time and virtual space not only by oral announcement during the meeting but also by virtual display on the meeting platform or in advance, as specified in the original meeting notice.
Appraisal Rights
The 2022 Amendments to the DGCL modify Section 262 of the DGCL in a number of important respects. Under the 2022 Amendments, (1) beneficial owners may demand appraisal rights in their own names without having to cause the record owner (i.e., Cede & Co., in most cases) to demand appraisal rights on their behalf, (2) stockholders will now be able to exercise appraisal rights in connection with the conversion of the corporation to another entity or a foreign corporation unless the market-out exception applies (which generally denies appraisal rights for holders of public company stock in certain all-stock mergers), and (3) domestications under Section 388 of the DGCL no longer give rise to appraisal rights. The decision to make appraisal rights available in connection with the conversion of Delaware corporations to other entities was made in tandem with amendments to reduce the voting threshold necessary to effect such a conversion from unanimous to majority stockholder approval.
Corporations may now include in a notice of appraisal rights information directing stockholders to a publicly available electronic copy of Section 262 of the DGCL, including the website maintained on behalf of the State of Delaware, in lieu of including a copy of Section 262 of the DGCL. The revisions are intended to help reduce the unintentional inclusion of outdated versions of the appraisal statute in notices of appraisal rights. If a corporation mistakenly includes an outdated copy of Section 262 of the DGCL in a notice of appraisal rights, stockholders have the right to bring a breach of fiduciary duty claim against the corporation’s directors and are generally entitled to quasi-appraisal rights as a remedy for breach of such fiduciary duty. The 2022 Amendments will help to eliminate these risks.
SPACs
In response to the increased popularity of special purpose acquisition companies (SPACs) as a vehicle to take a private company public through a business combination with a public shell company, amendments have been made to the dissolution provisions of the DGCL. A SPAC typically includes in its certificates of incorporation a provision authorized by Section 102(b)(5) of the DGCL, limiting the corporation’s existence to a specific period during which the SPAC seeks to effect an initial business combination. However, prior to the 2022 Amendments, the DGCL did not require a SPAC to file any document with the secretary of state of the State of Delaware confirming that its existence had ceased. Under new Section 275(f) of the DGCL, the SPAC must file a certificate of dissolution with the secretary of state within ninety days of the date on which the corporation’s existence ceased. However, a SPAC’s failure to file a certificate of dissolution does not operate to extend the corporation’s existence.
Exemptions from registration have long been a cornerstone of the U.S. federal securities laws that have helped facilitate capital formation among private companies. The line drawing required to effectuate these exemptions has evolved over time and requires a delicate balance of the tensions between investor protection and capital formation. In the last decade, significant legislative and regulatory developments have expanded access to capital for private companies, particularly early stage businesses.
Significantly, the Jumpstart Our Business Startups Act (JOBS Act), enacted April 5, 2012, effected profound changes to U.S. federal securities laws and ushered in sweeping changes for the conduct of IPOs, in addition to other accommodations for private and public companies. Under the JOBS Act, the Securities and Exchange Commission (SEC) allowed for general solicitation and general advertising in private placements conducted pursuant to Rule 506 under Regulation D (provided that all purchasers are “accredited investors”) and in Rule 144A placements (provided that all purchasers are qualified institutional buyers).
The JOBS Act also increased the number of record holders of a class of equity securities that triggers an issuer’s obligation to register and become a reporting company under the Securities Exchange Act of 1934 from 500 holders to either 2,000 persons or 500 persons who are not accredited investors (with some meaningful exclusions from these calculations, including certain recipients of employee equity grants). The JOBS Act also expanded the maximum size of Regulation A offerings (i.e., Reg A+) and created a new exemption from registration for “crowdfunding” by private U.S. companies. Collectively, these developments have significantly expanded access to capital, particularly for early stage private companies, through means not requiring a formal IPO registration process.
The impact of the JOBS Act extends beyond exempt offerings. Moving along the company lifecycle, the JOBS Act also created an “IPO on-ramp” that affords several accommodations for emerging growth companies, or “EGCs” (generally defined as companies with total annual gross revenues of less than $1.07 billion—increased from $1 billion in April 2017, and subject to further adjustment for inflation every five years), in the process of going public. These include accommodations for reduced financial statement, MD&A, and executive compensation disclosure.
More recently, in 2020, the SEC adopted a host of rule amendments designed “to harmonize, simplify, and improve the multilayer and overly complex exempt offering framework.” Those amendments acknowledged that “[f]or many small and medium-sized business[es], our exempt offering framework is the only viable channel for raising capital.” To that end, these amendments increased the offering limits for Regulation A+, Regulation Crowdfunding, and Rule 504 offerings. They also modified the definition of “accredited investor” to expand those eligible for inclusion in this investor status and established a new framework to make it easier for companies to make integration determinations when conducting private offerings in parallel or close in time.
Notwithstanding the evolution of the exemption framework, challenges remain, and the debate continues as to whether additional modifications are necessary to further enhance the current exemption framework. Some contend that navigating the myriad of available exemptions with differing requirements remains unduly challenging. Others have focused more on the funding sources available to entrepreneurs to take advantage of the existing exemption frameworks. For example, when considering trends in capital raising and access to capital, disparity between rural and urban locales is just one topic under discussion. Changes among state regulations of securities are also relevant considerations to this ecosystem and any future adjustments thereto at the federal level. Relatedly, as retail investors come ever into the fore of investing and the types of offered securities become more complex, some have expressed concern about the need for additional protections for these investors, including whether further modifications to the accredited investor definition, or other or different regulatory requirements, are merited.
Much has been done over the years to protect Main Street investors, and enforcement actions and commentary from the SEC have kept them a priority. Nevertheless, there are indeed risks, including those arising from “bad actors,” illustrating the need for continued enforcement in the private offering contexts, which includes its own challenges. In that same vein, the role of gatekeepers remains of critical importance and significant policy interest at the SEC and more broadly in Washington. Recent enforcement actions underscore this point.
Looking forward, these and other questions in the ever-changing environment for private companies will contribute to the evolving discussion around the federal regulation of securities and the future of the SEC and the exempt offering framework. Continued input from all stakeholders will be critically important to supporting the evolution of the exempt offering framework while preserving the core principles upon which it is grounded.
This article is excerpted from Say the Right Thing: How to Talk About Identity, Diversity, and Justice (Atria Books), released on February 7, 2023. Kenji Yoshino and David Glasgow co-founded NYU School of Law’s Meltzer Center for Diversity, Inclusion, and Belonging, and have years of experience working with attorneys and other business and cultural leaders on these topics. Their book offers seven research-backed chapters about how to tackle tough topics with neighbors, friends, family members, co-workers, and anyone else you care about. Say the Right Thing will help readers have better conversations that lead to deeper understanding and a fairer society. Learn more about Say the Right Thing.
The children’s book The Magical Yet addresses a child who can’t get the hang of riding a bike and gives up trying. In the book’s illustrations, the child walks along a bike path sulking until she happens upon a glowing pink orb in the bushes known as The Magical Yet. With the Yet’s help, the child learns to persist whenever she makes a mistake, whether it involves playing a musical instrument, learning a language, or riding a skateboard. “No matter how big (or old) you may get,” the book observes, “you’ll never outgrow—you’ll never forget—you can always believe in the magic of Yet.”
The Magical Yet tracks psychologist Carol Dweck’s celebrated argument that people should move from a “fixed mindset” to a “growth mindset.” Individuals with a fixed mindset believe their basic qualities—their intelligence, personality, talents, and moral character—are basically unchangeable. If they’re not good at something, they probably never will be and should give up trying. Individuals with a growth mindset, in contrast, believe they can cultivate their qualities through effort. Across a variety of fields, from relationships to sports to business leadership, Dweck shows that a growth mindset leads to greater success. It prevents people from treating every setback as a verdict on their innate competence and moral worth.
This simple and crucial concept has taken over institutions from corporations to preschools, helping people recover from mistakes and improve their skills. Yet as our NYU colleague and social psychologist Dolly Chugh points out, the concept is glaringly absent from discussions of identity. She explains that people get mired in a fixed mindset on identity issues because the costs of making a mistake seem catastrophic. If you make a mistake when learning a musical instrument, you probably won’t be traumatized. Yet if you make a mistake on an identity issue, you haven’t just made an error—you’ve become a racist, a sexist, or a homophobe. Something you did comes to describe who you are. The perceived threat is so huge it’s no wonder you’re panicked. But that terror means you won’t even try to learn. Imagine if we began a class by saying: “Our one requirement for the semester is that you not make any mistakes.”
As Chugh argues, you won’t make progress until you let go of the fixed-mindset outlook that you’re either a good or bad person and embrace the growth-mindset idea that you’re a “good-ish” person. If you insist you’re a good person, you’re likely to react with overwhelming discomfort when you make a mistake that would reveal your imperfections. If, by contrast, you acknowledge you’re a “good-ish” person who falters like everybody else, you’re less likely to see mistakes as judgments of your character. You can then respond by treating mistakes as opportunities to learn.
Social science research backs up the idea that a fixed mindset derails identity conversations. In a series of experiments, Dweck and her colleagues found that participants with the fixed-mindset view that prejudice was unchangeable were less interested in having cross-racial interactions or learning about bias than people who believed prejudice could change through effort. In one experiment, white participants were put in a room and told they were about to speak with either a Black or white partner. When they expected a Black partner, those with a fixed mindset tended to place their seats farther away from the other person and expressed a desire for shorter interactions than those with a growth mindset. In another experiment, white participants with a fixed mindset made less eye contact, smiled less, and had a faster heart rate in cross-racial interactions. These findings held true even when controlling for the participants’ racial attitudes.
A fixed mindset might also trip you up in a sneakier way. In a separate study, Dweck and her colleague gave college students who did poorly on a test the opportunity to look at the completed tests of other students. Students with a fixed mindset tended to look at the tests of students who performed worse than they did. They didn’t think they could do better, so they settled for easing their discomfort. Students with a growth mindset tended to look at the tests of students who performed better than they did. Because they knew they could improve, they eagerly explored how to do so. A telltale sign of a fixed mindset in identity conversations is the urge to compare yourself to people more biased or gaffe-prone than you. In a growth mindset, you compare yourself to people who display the most inclusive behavior, not the least. Next time you’re at a family dinner and you mess up, watch out for those downward comparisons: “At least I’m not as bad as Aunt Edith!” Try to inspire yourself with role models instead: “What would Aunt Nell say to make this right?”
When you slip into a fixed mindset, we recommend two techniques. The first is to summon The Magical Yet from the bushes and add the word “yet” to the end of negative self-talk. It’s not: “I’m not good at talking about race.” It’s: “I’m not good at talking about race yet.” Educators use this technique a lot. Kenji’s children are not allowed to utter the words “I’m not good at math” at school. Their teachers insist they say: “I’m not good at math yet.”
The second technique is to do a self-comparison. Instead of “My younger colleagues find it so much easier to talk about mental health than I do,” you might say, “I find it easier to talk about mental health than I did a year ago.” We realize this recommendation sits in tension with our other recommendation to engage in upward comparisons to others. But here—and in general—our strategies aren’t mutually exclusive. Take whichever one works for you. If you find it inspiring to compare yourself to role models, do so. If you find it stressful or demoralizing, make self-comparisons instead. Regardless of the technique, the goal is to catch yourself when you’re feeling fatalistic and substitute thinking that’s both more honest and more compassionate.
When she visited our center, civil rights lawyer Chai Feldblum discussed her own struggles with this mindset shift. Feldblum is an iconic figure in American law and a principal author of the Americans with Disabilities Act. Despite her credentials, she told us during an event how she used to dread making mistakes in identity conversations. Whenever she made an error in the past, she said, “all I would do is berate myself.” Yet over a period of years, she learned to focus on growing from the mistake instead of letting it define her.
Feldblum asked us to imagine saying something inadvertently hurtful to a person with a disability. “If you’re not in the disability culture,” she said, “I assure you, you may not know that something you said just did not feel good to that person.” She then shared her recommended form of self-talk in response to that mistake: “Wow, I guess I just wasn’t ever taught that or thought about that.” This shift—from “I’m a terrible human being” to “I just wasn’t ever taught that”—offers you the gift of redemption. Just as importantly, as Feldblum noted, it grants you the opportunity to behave differently next time. If you didn’t learn it before, you can learn it now.
Connect with a global network of over 30,000 business law professionals
