The successful pursuit of claims against directors and officers of bankrupt companies is a complicated and multi-faceted challenge requiring a hybrid skill set possessed only by practicing trial attorneys with a solid understanding of bankruptcy and insurance law. As these experienced counsel can attest, even when dealing with a prima facie meritorious claim, thorough due diligence—both legal and factual—can make the difference between a favorable outcome and a satisfied client or, what legal scholars sometimes refer to technically as, a mess.
Before one even addresses the bankruptcy-specific issues, one must of course confront the general authorities around the duty of due care (which requires management to make decisions with reasonable diligence and prudence) and the duty of loyalty (i.e., acting in the best interests of the organization rather than oneself). A careful review of exculpation clauses and the legal authorities that may limit the scope of these duties is also essential. One must understand the entire universe of potential defendants in a D&O claim including sponsors, lenders, joint venture partners, and others whose nominees occupied board positions during the time periods preceding the bankruptcy.
For plaintiff’s counsel the long list of bankruptcy-specific challenges often begins with questions of standing. Does the client creditor or a committee have standing to pursue D&O claims that at first instance belong to the estate (i.e., derivative actions)? The Delaware LLC Act, for instance, may cast doubt on whether a creditor or committee has the requisite standing to pursue such claims depending on the characteristics of the committee or creditor. If the answer is unclear, are there tactical and strategic choices around venue that can improve the odds?
An almost equally important question is whether any assets are likely to be available to satisfy a judgment. In many cases, the primary asset will be the proceeds of a directors and officers insurance policy claim. The potential value of such proceeds will depend not only on the face amount of the policy, but also on the interaction of a myriad of exclusions, including bankruptcy-specific exclusions, and on the success of other claims (i.e., the burning candle or wasting policy problem). A thorough understanding of the relevant policy and notice period(s), the availability of tail coverage, and the status of outstanding premiums are each essential.
Discovering and establishing the facts to support one’s case can be challenging at the best of times and may be all the more so when access to documents, electronic records, or individuals with firsthand knowledge of historic events can be adversely impacted by the bankruptcy itself, including hurdles like operational restructuring (i.e., layoffs) and/or the cessation of operations. Obtaining access to privileged legal advice and opinions delivered to the company prior to bankruptcy can also be uniquely problematic. Effective and creative responses to these challenges, such as third-party discovery, can make the difference between success and failure.
The calculation of damages may also be complicated by the bankruptcy. For example, should the business be valued as a going concern, or does the fact of bankruptcy make liquidation the presumptive or baseline outcome? What is the appropriate measure of damages where it is alleged that the directors and officers resulted in a debtor becoming more deeply insolvent?
Those who practice and resolve cases against current and former directors and officers of bankrupt companies possess a unique skill set and knowledge base. Developing a better understanding of each of the considerations noted above will benefit any bankruptcy attorney whether they aspire to join the ranks of plaintiff or defense counsel or simply to better understand the dynamics at play in their cases.
This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Spring Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.
At the ABA’s Business Law Section (BLS) meeting in Washington, DC, last month, Penny Christophorou, immediate past president of BLS, honored Donald R. Kirk, shareholder with Carlton Fields, with the Section Chair’s Award. This award is given to members who have made outstanding contributions to the Section and to the legal profession.
According to Christophorou, the selection of Kirk for this award was based on two areas of distinction: his committee work on the Business Bankruptcy Committee and his chairmanship of the BLS Publications Board.
“Donald’s work on the Business Bankruptcy Committee is a template for every committee member aspiring to be a strong committee leader,” said Christophorou. “Donald added to the stature of the Business Bankruptcy Committee, which in turn, has added to the stature of the Section as a whole.”
Donald Kirk at the 2019 Business Law Section Annual Meeting.
Kirk, who is based in Tampa, has demonstrated time and again his commitment to the Section and has mentored many BLS members in their legal careers.
“Donald is that rare leader who sets a goal, conceives a plan, motivates his team, and then stays out of their way as they all do their part to achieve that goal,” said Norm Powell, BLS Secretary. “Working with him is a pleasure.”
In her remarks, Christophorou also noted that Kirk achieved new heights for the BLS Publications Board, which is responsible for the development of the Section’s books—a major source of non-dues revenue for the Section. “During Donald’s tenure as chair of the Publications Board, he was responsible for producing more books than any other three-year period in the Section’s history.”
Juliet Moringiello, associate dean for Academic Affairs and professor of law at Widener University Commonwealth Law School, who has worked side by side with Kirk on the Publications Board, had this observation: “Publications Board meetings chaired by Don Kirk were always a delight. His knowledge of the Section, preparation for the meetings, and commitment to the role motivated all of us as board members to continue to build the Business Law Section book brand.”
L. Collin Cooper, who is now chair of the Publications Board, valued Kirk’s skills and characterized him as the “consummate leader.”
“I have certainly learned some valuable lessons that I intend to carry forward,” said Cooper. “Donald’s style of leadership is effective, as he always seeks to ensure that all thoughts and ideas are heard, while also safeguarding the quality of the Section’s thought leadership. The Business Law Section—and, indeed, the ABA is very lucky to have driven members like Donald who inspire others and act with a sense of urgency, while expertly guiding others to achieve quality results.”
Lawsuit settlements and judgments are taxed based on the origin of the claim, essentially the item for which the plaintiff is seeking to recover. The basic idea is, if you didn’t have to sue but had been paid in the ordinary course of events, your taxes should be the same. Claims arising in and about employment are one of the most common kinds of legal disputes.
Some disputes go to verdict, but many more eventually settle. Perhaps an even greater number of disputes are resolved pre-filing and never make it to court. Disputes may be resolved with demand letters or a draft complaint, in mediation, etc. But no matter how the dispute is resolved, there will be a settlement agreement. And no matter what, there are going to be tax issues, for both the employer and the employee.
Ideally, each side thinks about taxes in advance and tries to implement what they want in the settlement agreement. That doesn’t always happen, however, and even if the parties try, they often fail to hammer out how they want the arrangement to be taxed. The parties may misunderstand the tax issues, or they may fail to consider them entirely until the following year when IRS Forms 1099 arrive. Most employees know that they will receive an IRS Form W-2 for their wages in January for the previous calendar year.
But January is also when Forms 1099 arrive. Many litigants panic when unexpected tax forms land in their mailbox. Here are some common misconceptions about how taxes apply to employment case legal settlements.
Misconception #1: Plaintiffs Can Only Be Taxed on Their Net Recoveries, After Legal Fees
The idea that plaintiffs can only be taxed on net recoveries is a big issue, and not just for employment cases. Most plaintiffs use contingent fee lawyers, and many assume that they are only responsible for the net money they collect, after contingent legal fees. If you settle for $1 million, and your lawyer takes $400,000 off the top, isn’t your tax problem always limited to $600,000?
Hardly. Just because a portion of your recovery is paid to your attorney does not mean you do not owe tax on that portion. In Banks v. Commissioner,[1] the U.S. Supreme Court ruled that plaintiffs must include contingent legal fees in their gross income. Hopefully they can find a way to deduct or offset the fees, which in some kinds of cases can be tough.[2]
Fortunately, in employment cases, you should not need to pay taxes on the legal fees your lawyer receives if you use a contingent fee lawyer. However, you still have to report them on your tax return as gross income, or the IRS will think you are shorting them. After all, the Banks case on legal fees is from the U.S. Supreme Court.
The mechanics of claiming the deduction have been tough until recently. For 2021 tax returns, the tax return form was improved so there will hopefully be fewer problems with claiming it.[3] However, if you are using an hourly lawyer and the case spans multiple tax years, there’s no easy answer to avoid paying tax on the legal fees.[4] Historically, most legal fees could be claimed as a miscellaneous itemized deduction even if there was no related income. But miscellaneous itemized deductions were suspended by Congress starting in 2018 and continuing through the end of 2025.[5]
Misconception #2: Employment Settlements Are Exclusively Wages
Not really. A better statement would be that most—perhaps nearly all—involve some wages. That does not mean that 100 percent of the money is wages, though. Usually, a portion of the claim is for lost wages, back pay, front pay, or both, but some amount usually represents a payment for emotional distress or other non-wage damages.
The IRS recognizes not all of a settlement may be wages, making clear in its instructions to Form 1099-MISC that non-wage damages should be reported on a Form 1099, not on a Form W-2. Some employers seem surprisingly unconcerned about withholding, though their withholding obligation for at least some of the funds seems clear. On the other extreme, some employers insist on withholding on most or even all of a settlement, even though a big share of the settlement should arguably not be subject to withholding.
In my experience, if there is something reasonable in the wage category, the IRS rarely disturbs it. That is one reason it is wise for plaintiff and defendant to come to an agreement. In 2009, the IRS released a memorandum entitled ‘‘Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements.’’[6] It is not technically authority, but it is still interesting reading about IRS views on employment-related settlements and judgments.[7]
Misconception #3: All Employment Settlements Have Tax Withholding
The fact that the case arises out of an employment setting does not necessarily mean that some of the settlement must represent wages. Even if the case is between a current or former employee, the case may not be about wages. The parties may agree that all wages have been paid. If you were to sue your employer for defamation and receive a settlement or judgment, the fact that your employer is the defendant (rather than some third party) should not necessarily make the payment wages.
However, 99 percent of the time, treating a portion of the settlement as wages is wise, and an agreed allocation is best. Plaintiff and defendant should arrive at a wage figure that is large enough to make the employer comfortable that it is complying with its withholding obligations. The wage component should not be so large to cause the plaintiff to refuse to settle. In a $1 million settlement, a plaintiff and defendant might agree that $300,000 is wages subject to employment taxes, while $700,000 is non-wage damages. The wages split might be 50-50, 80-20, 90-10, or any other figure. It all depends on the facts and on the relative bargaining power of the parties.
Misconception #4: Emotional Distress Damages Are Tax-Free
Be careful with this one. Section 104 of the tax code shields damages for personal physical injuries and physical sickness. The exclusion used to be much broader. Before 1996, “personal” injury damages were tax free—so emotional distress, defamation, and many other legal injuries also produced tax-free recoveries. That changed in 1996, and since then, an injury or sickness must be physical to give rise to tax-free money.
Unfortunately, in the more than twenty-five years since section 104 was amended, there is still substantial confusion. In large numbers of tax cases that arise post-settlement, taxpayers, the IRS, and the courts continue to struggle with exactly what “physical” means. It is clear that emotional distress alone is not enough. In fact, emotional distress damages—even with physical consequences such as headaches, stomachaches, and insomnia—are taxable.
In contrast, if there are physical injuries or physical sickness first that produce related emotional distress damages, those emotional distress damages are also entitled to tax-free treatment. Many plaintiffs struggle with the chicken-or-egg issue of what comes first. But theoretically, once you have a qualifying physical injury or physical sickness, all the compensatory damages can be tax free, even though most of the damages may be for emotional distress.
Claims of post-traumatic stress disorder (PTSD) are increasing common in employment litigation, and PTSD arguably should be viewed as physical sickness. There is no definitive tax authority stating that PTSD is or is not within the scope of the section 104 exclusion. However, there is now reliable medical evidence that PTSD is a type of readily observable physical sickness and is not merely a variety of emotional distress. A diagnosis of PTSD and the appropriate assertions of PTSD claims should enough for the parties to treat it as within the section 104 exclusion.
Misconception #5: Tax-free Damages in Employment Settlements Are Impossible
Not true. Even in employment cases, some plaintiffs win on the tax front. For example, in Domeny v. Commissioner,[8] Domeny suffered from multiple sclerosis (MS). Her MS got worse because of workplace problems, including an embezzling employer. As her symptoms worsened, her physician determined she was too ill to work. Her employer terminated her, causing another spike in her MS symptoms.
She settled her employment case and claimed some of the money as tax free. The IRS disagreed, but Domeny won in Tax Court. Her health and physical condition clearly worsened because of her employer’s actions, so portions of her settlement were tax free.
In Parkinson v. Commissioner,[9] a man suffered a heart attack while at work. He reduced his hours, took medical leave, and never returned to work. He filed suit under the Americans with Disabilities Act (ADA), claiming that his employer failed to accommodate his severe coronary artery disease. He lost his ADA suit, but then sued in state court for intentional infliction of emotional distress and invasion of privacy.
His complaint alleged that the employer’s misconduct caused him to suffer a disabling heart attack at work, rendering him unable to work. He settled and claimed that one payment was tax free. When the IRS disagreed, he went to Tax Court. He argued the payment was for physical injuries and physical sickness brought on by extreme emotional distress.
The IRS said that it was just a taxable emotional distress recovery, and the fact that the state court case was brought for intentional infliction of emotional distress gave the IRS good arguments. But the Tax Court said that damages received on account of emotional distress attributable to physical injury or physical sickness are tax free. The court distinguished between a “symptom” and a “sign.”
The court called a symptom a “subjective evidence of disease of a patient’s condition.” In contrast, a “sign” is evidence perceptible to the examining physician. The Tax Court said the IRS was wrong to argue that one can never have physical injury or physical sickness in a claim for emotional distress. The court said intentional infliction of emotional distress can result in bodily harm.
Misconception #6: It is Better for Plaintiffs to Have Little or No Wages
It depends. Many plaintiffs want little or no wages. In part, it may be to save their share of employment taxes. After all, employment taxes are partially borne by the employee and partially by the employer. For the employee, the taxes at stake are 7.7 percent of the pay (for the entire year) up to the wage base of $147,000, and 1.45 percent of amount over $147,000.
Another reason plaintiffs may favor reduced wages is to get a bigger net check at settlement time. If the check is not reduced by tax withholdings, the settlement may look better. Sometimes, their lawyers are the ones pushing for little or no withholding. If the plaintiff is upset that he is settling for only $400,000 when he thinks he should get more, his lawyer may push for little or no withholding to make the current check larger.
Some plaintiffs have the sense that they are better off if they receive gross pay rather than net pay. Sometimes they even think the wage versus non-wage fight is about tax versus no tax. The plaintiff may also want to pay his own taxes, later. But the plaintiff may end up worse off at tax return time the following year if they have trouble paying their taxes. A plaintiff who has always been a wage earner may never have made estimated tax payments and may be undisciplined when it comes to financial management.
Finally, getting a Form 1099 may allow for more opportunities to claim an exclusion for physical injury or physical sickness damages. It is not easy to take this position with a Form 1099, but it is vastly easier to claim it with a Form 1099 than it is with a Form W-2. It is effectively impossible with a Form W-2. Sometimes the wage allocation issue comes down to the plaintiff trying to position physical sickness money.
Misconception #7: If You Receive a Form 1099, You Must Treat It as Taxable
Not necessarily. You certainly should address the Form 1099 on your tax return, but on the right facts, you can explain that the payment was non-taxable. I have occasionally even seen serious physical injury cases for compensatory damages reported on a Form 1099. In such a case, it is easy to explain that the payment should not be taxable. Many payments are reported on Form 1099 as part of the general default reaction that companies have when making payments.
If a payment is $600 or more, most businesses will issue the form. Indeed, if the settlement agreement is not explicit on the point, someone in the defendant’s accounting department is likely to send out a Form 1099 in January. Plaintiffs routinely object to Forms 1099 once issued, but if the settlement agreement does not expressly say that the form will not be issued, the odds of getting the defendant to correct it (with a corrected Form 1099 that zeroes out the income) are slim.
In the employment context, many plaintiffs argue that their employer caused them physical injuries or physical sickness. Sometimes there is a physical or sexual assault in the workplace. Sometimes the employee claims that the employer caused physical sickness or exacerbated an existing physical sickness. Sometimes the employee claims that the workplace gave them PTSD.
The evidence from the pleadings and correspondence, and the medical documentation of such claims varies widely, from voluminous to non-existent. Employer responses vary widely too. Often, the employer and employee reach a compromise on the wording of the settlement agreement.
That wording may stop short of a clear agreement that a payment is for physical injuries and physical sickness. However, a compromise on wording may be the best the plaintiff can do at the time. The issuance of a Form 1099 is another matter. The Form 1099 regulations and form instructions say that a payment of compensatory damages for physical injuries or physical sickness should not be reported on a Form 1099.
However, the employer may not agree with that characterization. Even the settlement agreement may be inconsistent. The employer might agree to physical injury or sickness wording in the settlement agreement, but still insist on issuing a Form 1099. The issuance of the form certainly does not help the plaintiff’s tax position, but the issuance of the form does not foreclose the plaintiff’s argument that it should not be taxed.
Misconception #8: You Don’t Need to Agree on Tax Treatment
As a legal matter, it is true that a settlement agreement is not required to address taxes. A few courts have suggested that taxes are such an essential part of the legal settlement that an agreement may fail if it does not include it.[10] In general, however, a legal settlement agreement can be enforceable even if it does not say if there will be tax withholding on some or all of the funds, and even if the agreement does not say anything about the particular IRS forms that will be issued.
Some defendants may like that, if talking about taxes before the plaintiff signs a release seems like asking for trouble. That way, the theory goes, the defendant can handle taxes however it wants, withholding on some or all, issuing Forms 1099 for some or all, etc. But why would any plaintiff or defendant want to sign a settlement agreement only to have yet another dispute about taxes later, one that could go back to court?
The risk may seem worse for plaintiffs, but it might be no fun for the defendant either. It is not merely theoretical. In Redfield v. Insurance Company of North America,[11] a man sued for age discrimination and wrongful termination. Redfield won a judgment, affirmed on appeal. The company withheld taxes, so Redfield refused to sign a satisfaction of judgment. The employer brought an action in District Court for a judicial acknowledgment that the employer had satisfied its obligations under the judgment. The employer won in District Court, but Redfield appealed to the Ninth Circuit.
The appellate court reversed, saying that withholding was not proper. Because the employer withheld when withholding was not required under tax law, the employer had not yet satisfied the judgement. So, after years of litigation, and countless dollars of expense, Insurance Company of North America remained on the hook for the settlement for the time being. To obtain its satisfaction of judgment on remand the employer would need to show that Redfield had gotten the improperly withheld amount refunded to it from the IRS and state tax authorities, or otherwise had the withheld amount credited to its account. There are a handful of other huge messes like this too.
In Josifovich v. Secure Computing Corporation,[12] an employment settlement was put on the record. The idea, they agreed, was for these basic terms to later be embodied in a formal settlement agreement to be executed by Josifovich and Secure. But while reducing the settlement to writing, the parties were unable to reach agreement on tax withholding. The court later pointed out with frustration that neither party had mentioned taxes during a seven-hour settlement conference.
Josifovich contended that none of the settlement should be subject to withholding, and yet another hearing was needed where the question of how much is wages could be fully briefed. Would anyone be happy with their lawyers in such a mess? Consider the inconvenience and cost of the plaintiff and defendant having to argue about withholding issues when one or both thought the case was resolved.
Misconception #9: The IRS Doesn’t Care About Settlement Agreement Wording
Nothing could be further from the truth. In fact, the IRS and the Tax Court both place enormous focus on what the settlement agreement says. The intent of the payor is a phrase that features prominently in tax cases, and there is no better statement of the payor’s intent in legal settlement than the wording of the settlement agreement. There are numerous cases where bad or neutral wording doomed a plaintiff’s tax claim.
For example, in Blum v. Commissioner,[13] a woman sued her lawyer for allegedly botching her personal physical injury suit. As a practical matter, it appeared that Blum was trying to get her lawyer to pay her money she failed to collect for her physical injuries because of the alleged legal malpractice. Even so, her malpractice recovery was held to be taxable.
The Blum case is a poignant reminder that settlement agreement wording is very important, an opportunity a plaintiff should never let slip by. It is worth saying this again and again before the settlement agreement is signed. In IRS audits or queries, the IRS may well be satisfied with the settlement agreement and may not ask for additional documentation. If your wording is poor or even neutral, it is almost a certainty that the IRS will ask to see more information in an audit.[14]
Misconception #10: If You Don’t Receive a Form 1099, the Payment Isn’t Taxable
This is a dangerous one. Most people know that if they receive a Form 1099 reporting a payment, they need to report it on their tax return. It is presumptively income; that’s what the IRS will think. Sometimes, you can explain if it is not income, but you at least must deal with the Form 1099 on your return.
But what if you do not receive a Form 1099? Is it like a tree falling in the forest with no one there to hear it? Hardly. Many people seem to think that if there is no Form 1099, there is no income, but that’s not true. Numerous kinds of payments are not required to be reported on a Form 1099. And even if the payment is clearly required to be the subject of a Form 1099, the fact that the defendant fails to issue one does not mean that it is not income.
There are hundreds of pages of tax rules about when companies must issue Forms 1099 for a wide array of payments. The forms come in many varieties, including for legal settlements. However, if you do not receive the form, you still must consider whether it is income, capital gain, etc.
Even if you negotiate with the defendant for no Form 1099 for physical sickness money, you should still evaluate what evidence you have and whether you should disclose the payment on your tax return, etc. The language of the settlement agreement does not bind the IRS or state taxing authorities.
Misconception #11: Employers Can Withhold Taxes on Legal Fees
I have never seen this happen and have only heard it threatened a few times. If the cause of action brought by the plaintiff requests solely lost wages, and nothing else, it is harder to argue that the settlement is not all wages. Specific claims under the Fair Labor Standards Act may be the best example of an all-wage case.
In Commissioner v. Banks, the Supreme Court held that legal fees are usually income to plaintiffs first, though they are income to lawyers too. In a pure wage case, could that mean withholding on the lawyer money too? Despite its age, the best guidance on this issue remains Rev. Rul. 80-364.[15] There, the IRS considered whether attorney fees and interest awarded with back pay are wages for employment tax purposes.
The ruling describes three situations, which are worth reading if you want to get into the weeds. In 2009, the IRS released more discussion in PTMA 2009-035.[16] Ominously, the memo states that if this issue (attorney fees as wages) arises, the IRS National Office should be contacted for guidance. More happily, in TAM 200244004, addressing an ADEA claim, the IRS concludes that the fees are not wages.
In large part, the issue seems to be ignored by tax practitioners and certainly by employment lawyers. Over many years, I have heard only a small handful of defendants even argue for withholding on fees, and I have never seen one make good on the threat. In my view, no case will settle if the lawyers are going to be shorted fees and have to try to get them back from the IRS or from their clients.[17]
Misconception #12: Most Plaintiffs Get a Tax Gross-Up for Additional Taxes
Actually, the reverse is true. Tax gross-ups are commonly requested, but not commonly awarded by courts or by agreement. Even so, some plaintiffs succeed. Eshelman v. Agere Systems, Inc.[18] is an important case about the negative tax consequences of a lump sum. Eshelman was receiving pay in one year that should have been payable over multiple years. The court was persuaded that Eshelman needed extra damages to make up for the bad tax hit she would take on a lump sum, as compared with the lower taxes she would have paid on each annual salary amount.
Conclusion
Many employment disputes are emotional and difficult, perhaps even more so than with many other kinds of legal disputes. Whenever possible, plan ahead for the tax issues, especially if you are a plaintiff or plaintiff’s lawyer. Whichever side you are on, whenever possible, be specific about taxes so there is no dispute later. And whenever possible, get some tax advice before the settlement agreement is signed.
Robert W. Wood practices law with Wood LLP (www.WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments and other books available at www.TaxInstitute.com. This discussion is not intended as legal advice.
See Wood, “New Tax on Litigation Settlements, No Deduction for Legal Fees,” Vol. 158, No. 10, Tax Notes (March 5, 2018), p. 1387. ↑
‘‘Service Explains Tax Consequences and Reporting Obligations for Employment-Related Settlement Payments,’’ Program Manager Technical Advice (PMTA), 2009-035, Oct. 22, 2008, Doc 2009-15305, 2009 TNT 129-19. ↑
For full discussion of this IRS memo, see Wood, “IRS Speaks Out on Employment Lawsuit Settlements,” Vol. 124, No. 11, Tax Notes (September 14, 2009), p. 1091. ↑
See Josifovich v. Secure Computing Corporation, 2009 U.S. District Lexis 67092 (D.N.J. July 31, 2009); and Sheng v. Starkey Laboratories, Inc., 53 F.3d 192 (8th Cir. 1995), after remand, rev’d in part and aff’d in part 117 F.3d 1081 (8th Cir. 1997). ↑
For other cases of failed section 104 arguments, see Stassi v. Commissioner, T.C. Summ. Op. 2021-5; and Collins v. Commissioner, T.C. Summ. Op. 2017-74. ↑
FN Doc 2009-15305, 2009 TNT 129-19. For further discussion, see Wood, ‘‘IRS Speaks Out on Employment Lawsuit Settlements,’’ Tax Notes, Sept. 14, 2009, p. 1091. ↑
For further discussion, see Wood, “Should Employers Withhold on Attorney Fees?,” Vol. 133, No. 6, Tax Notes (November 7, 2011), p. 751. ↑
554 F3d 426 (3rd Cir. 2009). See also Wood, “Getting Additional Damages for Adverse Tax Consequences,” Vol. 123, No. 4, Tax Notes (April 27, 2009), p. 423. ↑
Have you noticed how the pandemic has changed people’s connections and relationships? Do you think that people who now work remotely feel isolated and are concerned about their careers? My book, Focus on Now: Keys to a Wildly Successful Career (publication forthcoming), is a collection of stories that address these current issues through lessons learned over the course of my career. My goal is to help others become financially more successful in their jobs and careers—and live a happier and more meaningful life in a post-pandemic world.
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A critical component of my career success was staying in touch with former coworkers and colleagues. Staying connected built my future net worth and resulted in new opportunities, relationships, and connections, such as becoming the chief investment officer for the Minnesota Twins Major League Baseball team owner, who referred me to the Colorado Rockies Major League Baseball team owner, who became my client. I describe the compassion and charity I saw while serving as his adviser.
Through my experiences with a multitude of organizations, I honed successful leadership traits. One example is the ability to persevere through difficult times: I explain what I did as the chief restructuring officer for an international restaurant chain, COSI, trying to save over 2,500 jobs. And I explain how my tenure as president of a construction company highlighted the importance of taking responsibility and admitting mistakes. Another key to success is always being prepared, trying your best, and remembering that “good enough is not good enough.”
The backbone of my career, though, was the love and support from my family, and I share heartwarming personal stories and how I refused to change my ingrained moral compass.
Overall, Focus on Now: Keys to a Wildly Successful Career encapsulates two general principles that I believe are critical for a successful career. First, be laser-focused on achieving a goal or plan. Second, and equally important, have a sense of urgency for every task and believe that “there is no time like the present.” In other words, focus on now—a philosophy that I have always embraced and the reason for the title of my book.
Corporations continue to look to innovation to increase value and expand capabilities. Traditionally, corporations focused on internal research and development (“R&D”) and acquisitions of strategic targets. Yet, innovation through R&D can have its limitations as it is funded internally and can be restricted by internal policies and procedures that may hinder innovation. Innovation through acquisition also has its risks, as the purchaser may not identify all of the potential issues of the target when conducting its due diligence. A purchaser may also face issues when attempting to integrate the target into its existing business—particularly when the purchaser is a multinational corporation and the target is an emerging company.
To address these concerns, corporations have increasingly looked to establish a corporate venture capital (“CVC”) program to support and complement their innovation strategies and outsource strategic alignments to stay competitive. Corporations that have established a CVC program can gain invaluable market intelligence, as well as invest in and understand future acquisition targets. For emerging companies and start-ups, CVC programs offer funding as with traditional venture capital funds but can also provide such companies with market and development support. CVC programs can also form alliances with emerging companies that may be potential customers or strategic partners.
Corporate Venture Capital Programs Defined
CVC, a subset of and different from traditional venture capital, is the investment of corporate funds directly into emerging companies. CVC programs allow companies to gain insight and access to new markets, trends, and technologies.
The term CVC both broadly captures strategic investments made by large and established corporations in emerging companies and also more narrowly refers to investments that a corporation makes through a related CVC arm dedicated to sourcing and making investments in start-ups, rather than through direct strategic investments.
Objectives of a CVC Program
CVC programs are similar to traditional venture capital funds in that the goal is to invest in emerging high-growth companies that drive value back to the company. Both CVC programs and traditional venture capital funds are driven by financial returns.
However, CVC programs, once known as strategic investments, also strive to advance the company’s strategic objectives. In addition to financial returns, the other goals of a CVC program could be to (i) identify and capitalize on synergies between the corporation and emerging company, (ii) develop the corporation’s technology, (iii) acquire the emerging company’s technology, and/or (iv) create commercial partnerships.
For the emerging company, and in addition to funding, a CVC program can offer (i) access to resources, (ii) access to customers, (iii) market knowledge, (iv) brand validation, and (v) wider networks.
As such, CVC programs may look to invest in emerging companies that operate in the same or complementary industries.
Choosing a Legal Structure
A CVC program’s strategic and financial objectives will inform how closely the program will coordinate with the corporation’s current operations—that is, its legal structure. There are three main types of legal structures for CVC programs: limited partnerships, investment via an affiliate, and fully integrated programs. Many factors should be considered when establishing the appropriate structure for a CVC program, including tax considerations. These considerations are beyond the scope of this article.
1. Limited Partnerships
A CVC program can be structured as a limited partnership operating as a separate legal entity from the parent company. A limited partnership is made up of at least one general partner (“GP”) and one limited partner (“LP”). In any partnership, the GP or GPs manage the partnership. CVC programs may utilize this model of investment in two ways. First, they may look to form an independent limited partnership. Second, they may invest in a venture capital fund as a limited partner.
(a) Formation of a Limited Partnership
A corporation may look to form an independent limited partnership in which the parent company is the sole LP and a separate entity is incorporated that is the GP. Under this approach, the corporation can set the investment criteria and strategic direction of the limited partnership. This means that the CVC program can be focused on investing in portfolio companies that directly benefit the corporation. This approach can offer tax advantages, but these are beyond the scope of this article. The disadvantage is that this approach requires substantial capital investment for the corporation, and conflicts may still exist between the parent company and the investment arm.
(b) Investment as a Limited Partner
Alternatively, the corporation can invest as a limited partner in one or more independent venture capital funds. By joining as a limited partner, the corporation has quick and easy access to deal flow, invests in areas farther away from the corporation’s core business, and relies on the venture capital fund to make investment decisions. However, this structure also means limited influence and autonomy on the investments and fewer strategic incentives for the corporation. In addition, the CVC program will have limited access to information relating to the day-to-day operations of the portfolio companies.
2. Investment via an Affiliate
A CVC program may also be structured as an affiliated legal entity of the corporation or a separate business unit within the corporation. Under this approach, the day-to-day management of the CVC program can be separated from the other aspects of the corporation as the CVC program can be managed independently from the rest of the operations of the business. As such, the investment selection and decisions can be separated from the parent company. Typically, the parent company will have oversight over certain decisions by way of an executive committee.
3. Fully Integrated CVC Programs
A corporation can also form a CVC program internally, where the investment team consists of company employees. Under this structure, a specific investment department or business unit oversees and approves each investment. As this is an in-house CVC program, investments made are generally closely related to the business divisions of the parent company.
Running a Successful CVC Program
For a CVC program to succeed strategically and financially, a company should clearly define its investment goals, develop a strong program infrastructure, and establish deal sources, among other business best practices.
1. Have a Defined Investment Thesis
While strategic investments produce financial value in the long run, CVC programs often have to balance strategic and financial objectives. For instance, a CVC program’s decision to invest in a portfolio company may be driven by its interest in the portfolio company’s technology or business processes. As such, the CVC program may be willing to accept lower returns due to the potential synergies with the parent company’s operations or strategic direction. Having a clear understanding of the CVC program’s strategic direction and investment goals will inform which CVC structure would be most appropriate, though it is not critical for the CVC program to have a defined investment thesis that is aligned with the parent company’s strategy.
2. Develop a Strong Infrastructure
Once an investment thesis is established, the CVC program must have the resources and structure required to reflect the investment thesis. This includes determining the level of autonomy that the CVC program will have with respect to the parent company. Greater autonomy may allow for the CVC program to take greater risks and make investments that may fall outside of the traditional scope of the parent company’s operations. Yet, the parent company should still look to maintain a level of oversight to ensure that no conflicts of interest exist and that no investment decisions are made that might cause reputational damage to the parent company.
The parent company must also ensure that adequate resources are made available to the CVC program to support its success. This includes ensuring that individuals with expertise in venture capital financing are involved. When corporations initially consider investing in emerging companies, they may not have the internal expertise with negotiating minority investments. Without expertise in venture capital investing, corporations may treat these investments as if they were mergers and acquisitions investments. As such, the corporation may focus on ensuring that it has control of the operations and decision-making of the emerging company. In doing so, the corporation could limit the potential of an emerging company and stifle the future innovation that drove the corporation’s decision to invest in the first place.
Some additional infrastructure considerations include the following:
Who will manage the day-to-day program operations?
How will capital be allocated to the CVC portfolio and the targeted stages of investments?
What will be the compensation structure for the corporate venture team?
What will be the key performance metrics for the CVC program?
3. Establish the Deal Pipeline
The volume and quality of investment deals are important factors to a CVC program’s success. Consequently, CVC programs should establish a robust communication framework to ensure that there is an efficient investment approval process. Internal communication includes frequent meetings with the investment team and consistent oral/written connections with the parent company. External communication includes outreach efforts to relevant start-up communities and engagement with portfolio companies.
There are three main ways that CVC programs source deals:
Institutional venture capital firms: Forming relationships with institutional firms, which have a wider network and greater deal flow, is an important way for CVC programs to grow their deal pipeline.
Accelerators and incubators: Accelerators provide good sources for early-stage investments, because the participating start-ups have already undergone some sort of vetting process.
Informal networks: CVC programs often have analysts who scout start-ups on research platforms, attend venture capital events, and gain referrals.
Conclusion
CVC programs have proven to be an effective way for companies to invest capital strategically to drive future growth and leverage disruptive innovation. The structures and points discussed herein are not an exhaustive list of considerations relating to the formation of a CVC program, but this article highlights some key issues that companies should contemplate. Companies that plan to engage in CVC should seek counsel with venture capital knowledge to guide their process.
What are the ethical obligations of a transactional lawyer embroiled in litigation over the transaction when ordered by the court to turn over for a forensic analysis the hard drive of a computer containing not only information about the client before the court but also confidential information of various other clients? A lawyer facing a court order or a subpoena requiring the disclosure of client confidential information is faced with some complex and fact-intensive questions about how to respond, which are considered in a recent New York State Bar Association ethics opinion (“NYSBA Op. 1239”). Under the facts there, the client involved in the litigation had waived attorney-client privilege and consented to disclosure of confidential information, but the other clients had not.
There is some interesting rules-based history here. Nearly 30 years ago, ABA Formal Opinion 94-385 (“Formal Op. 385”) addressed issues confronted by a lawyer on the business end of such a subpoena or court order. That opinion, which was issued prior to the 2002 amendments to Model Rule 1.6, took the hard-line position that a lawyer was ethically required to seek to limit a subpoena or court order on any legitimate available grounds in order to protect documents deemed confidential under Rule 1.6.
The pre-2002 iteration of Rule 1.6(a) simply stated that a lawyer “shall not reveal information relating to representation of a client unless the client consents after consultation.” Only two exceptions were recognized by then–Rule 1.6(b), neither of which was applicable to the subpoena/court order situation.[1] The Comment to that earlier version of Rule 1.6, but not the blackletter, did recognize that a court order might supersede the lawyer’s obligation of confidentiality; however, Formal Op. 385 proclaimed that a lawyer could not be a “passive bystander” in such circumstances but had to use all legitimate means available to avoid the disclosure:
Only if the lawyer’s efforts are unsuccessful, either in the trial court or in the appellate court (in those jurisdictions where an interlocutory appeal on this issue is permitted), and she is specifically ordered by the court to turn over to the governmental agency documents which, in the lawyer’s opinion, are privileged, may the lawyer do so.
The 2002 amendments to Model Rule 1.6 included a new provision in 1.6(b) providing that “[a] lawyer may reveal information relating to the representation of a client to the extent the lawyer reasonably believes necessary . . . to comply with other law or a court order.” That principle is now enshrined in Model Rule 1.6(b)(6). Notwithstanding this authorization, there remain complex shoals for a lawyer in this situation to navigate.
In 2016, the ABA Standing Committee on Ethics and Professional Responsibility issued Formal Opinion 473 (“Formal Op. 473”), which revised the guidance given in 1994 and confronted the ethical responsibilities regarding confidential client information of a lawyer who is subject to a subpoena. There is no question, as Formal Op. 473 acknowledged, but that the lawyer must obey a court order. (That is true, incidentally, even where the court order is unlawful, as the Supreme Court held years ago in Walker v. City of Birmingham.[2]) The obligation to comply, however, does not foreclose the possibility of taking certain protective actions where required by applicable rules of professional conduct.[3]
As noted above, the proscription in Model Rule 1.6(a) against revealing confidential client information is subject to various exceptions. One of these permits, Rule 1.6(b)(6), allows turning over such information “to comply with . . . a court order” but, as limited by the introductory language of 1.6(b), only “to the extent the lawyer reasonably believes necessary” to so comply. In the situation described, Formal Op. 473 advised that the lawyer, when assessing what information needs to be disclosed and what protective measures may appropriately be undertaken, must consult with the client,[4] as contemplated by Model Rule 1.4.
The details of this consultation can certainly vary with different facts. As is clear from Model Rule 1.6(a), a client (including a former client) may, provided there is informed consent, simply authorize the lawyer to provide the materials sought by the subpoena. The lawyer should, pursuant to the “informed” prong of “informed consent,” be sure to counsel the client on available privilege and work-product protections, as well as the tenor of Rule 1.6 itself. Thus, Formal Op. 473 says, the consultation “at a minimum” must include “(i) a description of the protections afforded by Rule 1.6(a) and (b), (ii) whether and to what extent the attorney-client privilege or work product doctrine or other protections or immunities apply, and (iii) any other relevant matter.”[5] After such consultation, if so instructed by the client (or in the event the client is unavailable), the lawyer must assert all reasonable claims against disclosure and seek to limit the subpoena or other demand on any reasonable ground.
New York’s version of the confidentiality rule is substantially identical to Model Rule 1.6. There are, however, some differences in the relevant comments—in particular, Comment [15] to Model Rule 1.6 and Comment [13] to N.Y. Rule 1.6.
The New York version of the comment is more detailed. It provides:
A tribunal or governmental entity claiming authority pursuant to other law to compel disclosure may order a lawyer to reveal confidential information. Absent informed consent of the client to comply with the order, the lawyer should assert on behalf of the client nonfrivolous arguments that the order is not authorized by law, the information sought is protected against disclosure by an applicable privilege or other law, or the law is invalid or defective for some other reason. In the event of an adverse ruling, the lawyer must consult with the client to the extent required by Rule 1.4 about the possibility of an appeal or further challenge, unless such consultation would be prohibited by other law. If such review is not sought or is unsuccessful, paragraph (b)(6) permits the lawyer to comply with the order.
NYSBA Op. 1239 prescribes the following course of action:
Consult (to the extent required by New York’s version of Rule 1.4) with each other client whose confidential information is on the hard drive.[6]
The consultation with each other client (from the preceding paragraph) should involve reasonable efforts the lawyer will take to preserve the confidentiality of that client’s information stored on the hard drive.[7] If the information provided by the lawyer is adequate to meet the requirements for “informed consent” (as defined in New York’s Rule 1.0(j)[8]), the client will be able to choose between making an effective waiver of confidentiality (in which case nothing further need be done as to that client) or insisting upon its preservation.[9]
Absent waiver, the lawyer must take reasonable steps to preserve the confidentiality of each nonparty, nonwaiving client’s information. The reasonable steps identified in the opinion include
seeking to establish agreed search terms or other protocols that a mutually acceptable ESI vendor could implement;
in the event the waiving client’s electronic file has been stored in a fashion that allows for segregated duplication, securing an agreement to produce only that portion of the file that concerns the waiving client;
negotiating a confidentiality order limiting production for “attorney eyes only”;
seeking the appointment of a special master to review the privilege issues;
seeking in camera review of the confidential information by the court (citing NYSBA Opinion 1057 (2015));
in the absence of agreement, moving to reargue the motion leading to the court’s decision outlining less intrusive means by which the legitimate goals of the litigation may be advanced;
in the absence of a court order revisiting the terms of the order, moving to stay enforcement pending appeal; and
What happens, however, if all of those steps prove unsuccessful? This is where “you have to know when to hold ’em and know when to fold ’em.”[11] As NYSBA Op. 1239 forthrightly acknowledges, the lawyer “is not ethically required to be held in contempt of court to protect confidential information stored on his hard drive and may comply with the court directing the production of his hard drive for forensic analysis.”[12]
The exceptions were (1) “to prevent the client from committing a criminal act that the lawyer believes is likely to result in imminent death or substantial bodily harm” and (2) “to establish a claim or defense on behalf of a lawyer in a controversy between the lawyer and the client, to establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the client was involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of the client.” At that time, Model Rule 1.6’s prohibition against disclosure was therefore considerably broader than that of its predecessor, DR 4-101, under the Model Code of Professional Responsibility, which had authorized revealing client confidences or secrets “when . . . required by law or court order.” MODEL CODE OF PROFESSIONAL RESPONSIBILITY DR 4-101(C)(2) (1980). ↑
388 U.S. 307 (1967) (holding that an injunction issued by a court with jurisdiction and authority to issue it must be obeyed though it be erroneous; civil rights protestors who disobeyed an injunction they believed violated the First Amendment without seeking to have it modified could not attack its constitutionality at a contempt hearing for violating that order). ↑
See RESTATEMENT (THIRD) OF THE LAW GOVERNING LAWYERS [hereinafter “RESTATEMENT”] § 63 (The Am. L. Inst. 2000) (“A lawyer may use or disclose confidential client information when required by law, after the lawyer takes reasonably appropriate steps to assert that the information is privileged or otherwise protected against disclosure.”). ↑
The opinion noted that the obligation is essentially the same for current and former clients. It went on to note:
For former clients, the lawyer must make reasonable efforts to reach the client by, for example, internet search, phone call, fax, email or other electronic communications, and letter to the client’s last known address. The specific efforts required to reach particular clients will depend on the circumstances existing when the lawyer receives the demand. But these efforts must be reasonable within the meaning of Model Rule 1.0(h), and should be documented in the lawyer’s files.
Id. at 5. As an example of “other relevant matter,” Formal Op. 473 suggests the potential for criminal liability to the client arising out of disclosure of confidential information in a civil proceeding, including a possible assertion of the Fifth Amendment privilege against self-incrimination. Id.↑
Id. ¶ 11. See also RESTATEMENT § 63, cmt. b (observing that “[w]hether a lawyer has a duty to appeal from an order requiring disclosure is determined under the general duties of competence”) (citation omitted). ↑
NYSBA Op. 1239, ¶ 13. Cf. RESTATEMENT § 63, cmt. b (“If a lawyer may obtain precompliance appellate review of a trial-court order directing disclosure only by being held in contempt of court . . .,the lawyer may take that extraordinary step but is generally not required to do so by the duty of competent representation.”) (citation omitted). ↑
On its face, it appears to be counterintuitive: United States federal courts recognizing and enforcing workplace rights for employees working in an illegal industry. However, this is just the case when it comes to the marijuana industry. In fact, recent federal cases and administrative actions make it clear that, although participants in the marijuana industry may be engaging in conduct deemed illegal under federal law, cannabis companies must still comply with federal anti-discrimination laws.
Federal laws, such as Title VII of the Civil Rights Act of 1964 (Title VII), the Age Discrimination in Employment Act of 1967, and the Americans with Disabilities Act prohibit discrimination, harassment, and retaliation in the workplace. However, because the cannabis industry is still in its infancy, it should come as no surprise that there is a dearth of case law addressing how these laws will apply to the industry currently deemed illegal under federal law. One of the earliest cases to address this issue is Aichele v. Blue Elephant Holdings, LLC.[1] In Aichele, the District Court of Oregon considered retaliation claims filed by an employee who worked at a marijuana dispensary as a part-time “budtender.” After the employee complained about sexual harassment and workplace safety, her employer’s subsequent conduct and treatment of her in the workplace, the District Court ruled, constituted adverse employment actions that were reasonably likely to deter her from complaining in the future, thereby establishing a case for retaliation. Instead of addressing the legality of the workplace in the first place, or the legality of plaintiff’s own conduct by working in Oregon’s (federally prohibited) marijuana industry, the Aichele court instead squarely focused on the factors a plaintiff must necessarily allege in order to set forth a case for retaliation under Title VII, and determined that the employee had successfully done so.
More recently, the Maryland District Court ruled in favor of an African American marijuana dispensary budtender who properly pled claims for race discrimination under Title VII and successfully defeated the defendant dispensary’s motion for summary judgment in Jones v. Blair Wellness Ctr., LLC.[2] The Jones court, similar to the court’s analysis in Aichele, focused on the factual and legal elements necessary to state a claim for discrimination in violation of Title VII and ignored entirely the underlying fact that the conduct both parties were engaged with—participating in Maryland’s regulated marijuana industry—was in violation of federal law.
In addition to courts throughout the country enforcing a private person’s right to be free from workplace discrimination and retaliation, even in the context of the federally illegal marijuana industry, agencies of the federal government, while maintaining that the sale and use of marijuana is illegal, have also demonstrated that they will hold cannabis industry employers accountable for discrimination in the workplace. In EEOC v. AMMA Investment Group, LLC,[3] the U.S. Equal Employment Opportunity Commission (EEOC) filed a complaint in September 2020 against a marijuana dispensary and its parent corporation on behalf of several current and former employees. The employees claimed that a manager, who made inappropriate sexual comments and engaged in inappropriate touching, engaged in sex-based discrimination in violation of Title VII by creating a sexually hostile workplace. The parties settled the claims in the AMMA Investment Group case, with the defendant agreeing, among other things, to pay $175,000 in damages and to provide discrimination and harassment training to its employees.
What these cases demonstrate is that, although marijuana still remains illegal under federal law, both the federal government and the federal courts do not exempt cannabis industry participants from compliance with federal discrimination statutes. Discrimination in the workplace can result in significant monetary penalties, and it is therefore important that cannabis industry employers have both compliant and well-documented policies and procedures in place to address workplace discrimination issues. This is especially important because most states have passed their own workplace discrimination laws that mirror the federal laws, meaning claims could be brought against an employer at both the state and federal level for even a single instance of such misconduct.
The need for sound policies is further underscored by the fact that many states that have legalized the sale and use of marijuana (or are in the process of doing so) have also passed laws either recommending or requiring employers to provide sexual harassment and discrimination training for staff members. While these laws vary from state to state, they commonly require annual or bi-annual interactive training administered by an educator with expertise in preventing harassment, discrimination, and retaliation. Cannabis employers should be cognizant of these laws and ensure they comply with not only federal, but also additional state requirements.
Even if training is not legally required in a particular state, cannabis employers are well advised to take steps to ensure their employees are educated in this evolving area of law. Even mere allegations of workplace misconduct can be reputationally devastating for businesses in any sector. Further, not only does such proactive conduct mitigate the potential for a discrimination lawsuit in both state and federal courts, but cannabis industry participants are wary of whether courts will continue to take such a uniform approach to the application of federal workplace protections to the cannabis industry—that is, whether federal courts will continue to ignore the federal illegality of the defendant employer’s business conduct altogether. No reasonable operator in the space should knowingly provide the court an opportunity to hold their cannabis business to a less forgiving standard.
Stablecoins are cryptoassets designed to have their value pegged to an external reference asset, such as a fiat currency. Many stablecoins are “minted” in exchange for fiat currency and are then backed by a variety of “reserve assets.” Some observers have questioned whether stablecoins are, in fact, stable. This question has led to a searching policy debate about how stablecoins should be regulated. This article briefly reviews that debate.
On November 1, 2021, the President’s Working Group (“PWG”), Federal Deposit Insurance Corporation (“FDIC”), and Office of the Comptroller of the Currency (“OCC”) issued a report on stablecoins (“PWG Report”), which focused specifically on fiat-pegged stablecoin arrangements with the potential to be used as a means of payment.[1]
The PWG Report recommended that Congress “promptly” pass legislation regulating such payment stablecoins. In the absence of congressional action, the report recommended the Financial Stability Oversight Council (“FSOC”) take action. The report identified prudential risks associated with payment stablecoin arrangements such as “run” risks, payment system risks, and financial stability risks. Further, the report noted various investor protection and illicit finance risks that may be implicated from stablecoin activities.
The PWG Report recommended legislation that, among other things, limits stablecoin issuance, redemption, and maintenance of reserve assets to insured depository institutions (“IDIs”); subjects custodial wallet providers to federal oversight and regulation; requires risk management standards for entities performing activities critical to the functioning of stablecoin arrangements; and addresses concerns of concentration of economic power by considering limits on payment stablecoin issuers’ and custodial wallet providers’ affiliation with commercial entities. The PWG Report’s recommendation to the FSOC, meanwhile, focused on the FSOC’s authority to designate systemically important payment, clearing, and settlement (“PCS”) activities under Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Designation would permit the establishment of risk-management standards for stablecoin activities, including requirements regarding reserve assets, the operation of the stablecoin arrangement, and “other prudential standards.” Financial institutions engaging in designated PCS activities would be subject to an examination and enforcement framework.[2]
Since the issuance of the PWG Report, several pieces of legislation have been proposed to regulate payment stablecoins, including possible alternatives to the regulatory framework outlined in the PWG Report.[3] Notably, limiting stablecoin issuers to be IDIs would require them to be subject to federal banking supervision and regulation at the issuing entity level by one of the OCC, Federal Reserve Board (“FRB”), or FDIC, and typically at the consolidated holding company level by the FRB. To date, most of the bills proposed would provide stablecoin issuers with additional licensing options. For example, in April 2022, Senator Pat Toomey (R-PA) released a discussion draft of the Stablecoin TRUST Act, which would allow institutions to be licensed as a money transmitting business, a national limited payment stablecoin issuer, or an IDI.[4] The Stablecoin TRUST Act would provide the OCC with the authority to license, supervise, examine and regulate national limited payment stablecoin issuers under a more tailored regulatory regime, limiting the OCC’s authority to regulations that cover: (1) capital requirements, not to exceed six months of operating expenses; (2) liquidity requirements; and (3) governance and risk-management requirements tailored to the business model and risk profile of the issuers. IDIs would have the option to segregate payment stablecoin issuances and reserves from their other activities like lending. Any IDI that chooses to segregate its stablecoin activities would benefit from the same regulatory standards as national limited payment stablecoin issuers. The bill would require stablecoin issuers to maintain assets with a market value equal to at least 100% of the outstanding value of the stablecoins.
More recently, Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) introduced the Lummis-Gillibrand Responsible Financial Innovation Act. The bipartisan bill aims to empower various agencies with responsibility for regulating cryptoassets and also contains stablecoin provisions that hit on many of the same themes covered in the Stablecoin TRUST Act. Among other things, the Lummis-Gillibrand Responsible Financial Innovation Act would permit IDIs, limited purpose trust companies, and non-depository payment stablecoin issuers operating under a state or federal charter or license to issue, redeem, and conduct incidental activities related to stablecoins, provided they follow the requirements set forth in the bill, including maintaining liquid asset reserves valued at 100% or greater of the value of outstanding stablecoins and redeeming stablecoins at par in legal tender. Stablecoin issuers operating under a new national limited purpose trust charter would be restricted from engaging in activities like lending, but would benefit from a more tailored regulatory regime, including a simplified capital framework, appropriate standards for a community contribution plan, tailored recovery and resolution plan, and tailored holding company supervision.
Other key issues covered in the Stablecoin TRUST Act, the Lummis-Gillibrand Responsible Financial Innovation Act, and other stablecoin bills proposed to date include reporting, disclosure and audit, Bank Secrecy Act/anti-money laundering (“BSA/AML”), insolvency treatment, federal deposit or similar insurance, access to Federal Reserve accounts and services, and the scope of how “stablecoin” or “payment stablecoin” is defined. An overview of various legislative proposals is included in the Appendix.
Stablecoin issuers currently may operate under charters or licenses issued at the state level. For example, the New York Department of Financial Services (“NYDFS”) permits licensed virtual currency businesses (“BitLicensees”) and New York limited purpose trust companies to issue stablecoins with NYDFS approval. The NYDFS recently issued guidance on stablecoins emphasizing certain requirements, including that the market value of the assets backing the stablecoin must be equal to or greater than the nominal value of all outstanding units of the stablecoin at the end of each business day, the assets in the reserve backing the stablecoin must be separated from the proprietary assets of the issuer and held by FDIC -insured state or federally chartered institutions or by asset custodians approved by NYDFS, and issuers must have “timely” redemption policies in writing (approved in advance by the NYDFS).[5] The NYDFS also requires monthly and annual examinations of management attestations by an independent Certified Public Accountant (CPA).
As stablecoins have become more popular, they have faced increasing scrutiny from policymakers. This scrutiny is illustrated by the PWG Report, proposed legislation, and state regulatory actions. It seems almost certain that the focus on and policy activity regarding stablecoins will continue.
Report On Stablecoins, President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (November 2021). ↑
Summary Chart re: Proposed/Pending Stablecoin Legislation and Recommendations
This summary chart shows how key policy choices are addressed in various proposals to regulate stablecoins. As the policy debate continues, these issues likely will be among the key points that are addressed and negotiated. As a result, this summary chart demonstrates possible alternatives for stablecoin regulation, including how “stablecoin” is defined. The proposals in some cases may include internal inconsistencies or ambiguities that may be resolved as the drafts are further developed.
Heroes and heroines have origin stories. Goddesses and gods have origin stories. These stories give context, offer explanations, answer some questions, and may raise others.
Lawyers who do pro bono work have origin stories, too—and not only because these lawyers are the unsung heroines and heroes of the legal profession. Their motivation and opportunity came from somewhere. Maybe it was planned, maybe it was pure serendipity—maybe it was a bit of both.
My own pro bono origin story dates back to my first assignment as a brand-new litigation associate at a leading New York law firm, fresh from a one-year clerkship with US District Judge A. David Mazzone. As a very junior litigator with a year of district court law clerk experience under my belt, I was assigned to the trial team in a big, “impact litigation” pro bono case in which we represented New York City in a civil action against the US Commerce Department and the Census Bureau. Our claim was that the decennial census undercounted New Yorkers. It just wasn’t designed to get that count right. But with proven methods of statistical adjustment, the census counts could be—demonstrably—made more accurate, or closer to the true figures. And after several years of litigation, the case was just weeks away from trial.
So, I dove in. There was a lot to do, and a lot to learn. It was clear from my first day on the case that every professional on the team, from the partner—a brilliant, intense, even legendary litigator—to the trio of associates, whom I admire to this day, to the two utterly dedicated paralegals, was passionate about the case, and the cause. Undercounting New Yorkers hurt the city. It reduced the amounts of federal funds and benefit programs that were allocated to New York and New Yorkers, sometimes significantly.
Many litigation associates at large firms never see a trial. Within two months of starting practice, I was back in court—as part of the team on a pro bono trial. I learned about the importance of preparation, and I saw the results of excellent preparation every day. I also saw how a sense of humor can come in handy when the judge was having an off day. And I saw firsthand how the kind of teamwork that is part of every client representation is enhanced when the firm is representing a client not to be paid, but because it is the right thing to do.
I learned a lot about the different roles that lawyers can have in the legal profession as well. Our co-counsel and our adversaries alike were brilliant and dedicated public servants. We shared our side of the counsel table with senior lawyers representing New York City from the Corporation Counsel’s office, or “Corp Counsel.” The defendants in the case, including the Commerce Department and the Census Bureau, were represented by the United States Attorney’s Office for the Southern District of New York. In a way, they were just as committed to the integrity of the census process as we were. Notably, the lead counsel on the government’s team later became a federal judge.
I learned something else from this pro bono experience, and this was quite unexpected. Sometimes even when you lose, you win. Our claim was that the 1980 decennial census figures should be adjusted. And we lost. But remember, the lawyers for Census Bureau—and the Bureau’s own senior staff and experts—shared the goal that the decennial census should be as good as it could be. The undercount hurts exactly the same people who may well be most likely to be missed—or undercounted. These are people without regular addresses, people who may not speak English as a first language (or at all), undocumented people and other people who may be fearful of authority, and people in the shadows and at the margins of urban life. Perhaps the lawyers representing the Census Bureau were as troubled by this as we were.
I’d like to think that this team of pro bono lawyers and experts made a pretty compelling case that statistical tools could be used prospectively to improve the accuracy of the census counts, and to bring the undercounted out of the shadows. And for the 1990 decennial census, the Census Bureau made the determination that these kinds of lessons and tools would be part of the process from the outset. Sometimes even when you lose, you win. Sometimes, eventually, everybody wins.
From that point on, a pro bono matter was pretty much always part of my practice. As an associate, these matters included representing an African American woman in her Title VII discrimination claim against her former employer, and representing an inmate on his Second Circuit appeal of the dismissal of his claim that the state prison disciplinary system was racially biased.
As a partner, my role shifted to encouraging and promoting and supervising countless pro bono matters, from political asylum cases to housing court matters to uncontested divorces. The lessons from my pro bono origin story stayed with me and guided me in those matters. Maybe they helped others find their own pro bono origin story as well.
And now, as a judge in a court with many unrepresented parties, I’m still thinking about pro bono—and I still love pro bono origin stories, especially when they are unlikely. One of my pro bono heroes is a bankruptcy and litigation partner at a national firm—and over the years, alongside his litigation and restructuring practice and managing his firm, he has represented death row inmates in challenging their capital sentences. It’s one thing to help your client. It’s another to save his life.
Another of my pro bono heroes is actually a firm that is known for its cutting-edge work representing the tech industry. Big clients, big issues, industry-leading work. And this firm gives back by fostering opportunities for its lawyers to advise small startups—enterprises that would never, not ever, find their way into a leading law firm’s lobby, never mind the firm’s conference rooms. As they explain it, their attorneys are as excited about this work as they are about the largest deal or financing.
Yet another of my pro bono heroes is a program—and here, I’ll name names. The program is ABA Free Legal Answers, and it partners with state bars to connect lawyers around the country who have the capacity to respond to the occasional question about the law and legal rights with people who just need a little help. Recently, ABA FLA volunteers answered their two hundred thousandth question—that’s two hundred thousand people who got information they needed, for free, from a lawyer. Just as important, that’s two hundred thousand times that a lawyer got to make a difference, and perhaps, begin to write their own pro bono origin story.
So, what’s your pro bono origin story? Is it like mine, the revelation of being part of a team on major pro bono impact litigation? Or are you that rare and extraordinary attorney who takes on the capital appeal alongside their commercial practice? Is your narrative like that of the associate who bills time to a major tech deal in the morning and sits down with a fledgling entrepreneur in the afternoon? Are you, or could you be, the lawyer who stepped up and offered a Free Legal Answer to some of those two hundred thousand people with a question? Once you do pro bono, in whatever way works for you, I predict that you’ll be back. I don’t think many people do pro bono just once. They are hopeless—actually, hopeful—recidivists. And then you can write your own pro bono origin story. You’ll be glad you did.
Hon. Elizabeth S. Stong is a U.S. Bankruptcy Judge for the Eastern District of New York, sitting in Brooklyn.
Globally, we saw record levels of investment in 2021. In 2021, emerging companies, particularly in the technology sector, enjoyed increased valuations driven by greater competition among investors and greater access to capital.
Although record-breaking investments continued into the first quarter of 2022, it was clear this trend was beginning to slow as venture capital funds and investors altered their investment strategies in anticipation of changes in market conditions. Higher interest rates and a tightening of the credit markets, among other reasons, have driven these changes in market conditions.
In light of the changes, emerging companies may find raising capital difficult due to a reduction in the availability of both equity and debt financing. Securing financing may also take longer than expected, so emerging companies must consider scaling back spending to reduce their “burn rate.”
With a softening in valuations, startups and emerging companies may also need to consider raising funds at the same valuation, known as a “flat round,” or a lower valuation than their previous round, known as “down round” financing.
What Is a “Down Round”?
Down rounds are often the result of numerous factors, which include the slowing of economic trends as we are currently seeing, the need for a company to reset or pivot, the emergence of a new competitor in the market, or simply a shift in the market.
For founders of start-ups, down rounds can be a matter of survival whereby an immediate need for funding outweighs the possible negative connotations that a down round carries for the company. Down rounds are often seen as a last resort for growth companies. For venture capital investors, down rounds can reflect lower confidence in the company and a riskier investment.
Key Terms in a Down Round
While down rounds can also be an opportunity for companies to reset and refocus, it is important to understand that the contractual terms of the financing will also likely shift, giving investors additional leverage to negotiate more favorable and protective terms. As such, founders and emerging companies must understand the types of deal protection measures that investors will likely be requesting. Negotiating unfavorable terms may not only negatively impact existing investors, but may also limit the company’s ability to secure future financings.
Below is a summary of key issues startups and emerging companies should be aware of in down-round financings. For a more thorough analysis of these implications, it is important to consult your legal advisor.
Liquidation Preference
Generally, preferred shares have priority over common shares upon the liquidation, dissolution, or winding up of a company (each of these events is referred to as a “Deemed Liquidation Event”). Before any distribution or payment can be made by the corporation to the holders of common shares or any other junior preferred shares, the holders of the class (or series) of preferred shares are entitled to be paid first.
In the event of a Deemed Liquidation Event, holders of preferred shares will receive the liquidation preference for each preferred share along with the payment of any accrued and unpaid dividends before any amounts are paid to the common shareholders, who are typically the founders. The liquidation preference of each preferred share is typically the original purchase price the investor has paid for each preferred share. In riskier rounds, such as a down round, the liquidation preference may be set as a multiple of the original purchase price. In addition to the liquidation preference, preferred shareholders may be entitled to an additional payment depending on if their preferred shares are participating or non-participating:
Non-participating – Once the liquidation preference is paid, the investor would not be entitled to any additional payments from the company. As such, any remaining assets of the company would then be distributed among the common shareholders and any junior preferred shareholders based on liquidation priority. Non-participating is the approach seen in the bulk of financings.
Participating – In addition to the liquidation preference, the investor also has the right to share in any remaining proceeds of the company with the common shareholders pro rata on an as-converted basis.
Participating is also referred to as the “double-dip” preference and could be considered a windfall gain depending on how the company is liquidated. Founders should be cautious when negotiating terms surrounding liquidation preference as the consideration they receive is typically sweat equity, and they may receive salaries at below market.
In the event that the investor has negotiated a liquidation preference in which it would receive a multiple of the original purchase price, the investor may walk away with more than they have invested, whereas the founders, and other common shareholders, may end up with little or no payments. The risk is further compounded where the preferred shares are also participating because the investor would be entitled to share in any remaining proceeds of the company with the common shareholders pro rata on an as-converted basis. Emerging companies should look to limit an investor’s liquidation preference where possible. To balance the investor’s desire to protect its investment with the emerging company’s desire for a fair distribution of assets in the event of a Deemed Liquidation Event, the parties may also consider including a cap on the total amount the investor can receive in the event of a Deemed Liquidation Event. This may be a compromise that meets both parties’ interests.
Anti-Dilution Protection
Investors in venture capital financings are typically issued preferred shares that are, at the option of the investor, convertible into common shares based on a predetermined formula. If certain events occur, such as a down round or a dilutive share issuance, the conversion ratio or price may be adjusted so that the number of common shares the investor will receive on the conversion of preferred shares would increase. There are two main types of calculation for this down-round protection: full-ratchet adjustment and weighted-average adjustment.
Full-Ratchet Adjustment – A full-ratchet anti-dilution provision leads to the greatest amount of adjustment and is not typically seen in venture capital financings. For a full ratchet, the conversion price of the preferred shares will be set at the lowest price for the company issued common shares (or shares convertible into common shares) following the investment no matter how many shares are sold at the lower price. For example, if the price per share in a future round goes down 50 percent, then the conversion price at which the investor could convert all their preferred shares into common shares would be reduced 50 percent. Full-ratchet anti-dilution provisions are seen as punitive as they can be triggered by an insignificant issuance of shares.
Weighted-Average Adjustment – Weighted-average adjustments may be calculated on a broad or narrow basis: Weighted-average anti-dilution provisions take into consideration the number of common shares (or shares convertible to common shares) that are subsequently issued at a lower price. Weighted-average adjustments lead to significantly smaller adjustments, as they take into account the size and price of the down round in relation to the capitalization of the company immediately before the down round. Broad-based weighted-average adjustments are more commonly seen in venture capital financings.
Anti-dilution provisions can lead to unintended consequences and can be triggered by certain issuances that are unrelated to the economic condition of the company. Fortunately, certain types of issuances, such as shares issued upon the conversion of options issued under a stock option plan, are typically excluded from anti-dilution protections. However, emerging companies should carefully review what types of issuances are excluded to ensure that there are no unexpected consequences.
When considering conducting a financing at a lower valuation, emerging companies must consider the anti-dilution protection of existing investors to understand how these will impact the company’s capitalization table. Companies can look to renegotiate anti-dilution provisions and other key terms with investors before conducting the financing so as to limit this dilution.
Cumulative Dividends
Investors may also have a right to a distribution of the company’s earnings by way of a dividend. Dividends may be either cumulative or non-cumulative. In most instances, dividends will be non-cumulative, i.e., paid only as declared by the company’s board of directors. That said, in instances where the investor may deem the investment to be risky, the investor may insist on cumulative dividends. In contrast to non-cumulative dividends, cumulative dividends will accrue at a specified rate, regardless of whether or not the company actually declares dividends on those shares and generally carry a right to receive those accrued dividends in priority over any other shares ranked junior to such preferred shares. Emerging companies must carefully consider the impact of any cumulative dividends on future cash flows of the company along with their impact on distributions in the event of a Deemed Liquidation Event of the company.
Tranche Financing
Where there are concerns about the company’s performance, investors may agree to advance funds only when certain milestones are met. For example, investors may agree to advance a certain portion of their investment only after the successful accomplishment of a milestone, such as securing a key client. Where there are concerns about the future success of the emerging company, an investor may look to tranche financing to limit their exposure. Although this may seem like a balanced option, emerging companies must carefully consider the attainability of any milestones they set. Milestones should be specific and attainable. If the company fails to meet a milestone, then it will be in a weak bargaining position with the investor should it require any additional investment before meeting any specific milestone.
Conclusion
With rising interest rates and the possibility of a looming recession, emerging companies may need to make tough decisions when raising capital. Emerging companies must take steps to limit their cash burn to what is necessary to maximize their runway. Ensuring that emerging companies also understand the terms of any financing documents they agree to will help protect the interests of all stakeholders going forward. Before conducting a down-round financing, companies should consider if there are any alternatives available, such as convertible debt or bridge financing. Venture debt may also be an option that could provide a much-needed injection of cash that could allow the company to meet its short-term objectives.
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