The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished former Business Law Section Chair Mendes Hershman (1974–1975) lends his name to this legacy. See the abstract of this year’s second-place winner, Benjamin Seymour of Yale Law School, Class of 2021, below. The full article (available on SSRN) is forthcoming in Volume 36 of the BYU Journal of Public Law.
Despite its intense focus on inter-jurisdictional competition, corporate law scholarship has thus far overlooked the influence of inter-branch competition on business organizations. This Article shows how inter-branch struggles for control over corporations catalyzed the advent of modern corporate law and helped propel Delaware to its dominant position in the market for corporate charters.
For centuries, the legislature, judiciary, and executive vied for the decisive role in dictating the means and ends of corporations. Through the nineteenth century, competition among the branches produced a dysfunctional and volatile relationship between government and private enterprise, with each branch successively assuming a leading role in corporate oversight, only to falter under the weight of its unique structural limitations. The resulting instability ultimately proved so intolerable as to prompt the creation of an entirely new paradigm of liberalized corporate codes at the dawn of the twentieth century. Delaware’s innovation of and rigorous adherence to corporate law’s newfound separation of powers gave it a crucial, yet previously unappreciated, edge in the competition for corporate charters. Moreover, modern corporate law’s system of checks and balances curbed longstanding abuses and ushered in an equilibrium among the branches that has served as a foundation for economic growth in the United States since.
Beyond illuminating a novel factor in Delaware’s ascendancy, corporate law’s separation of powers poses unappreciated problems and provides preliminary solutions for the ongoing debate over corporate purpose. A growing chorus of progressive academics and policy-makers has called on the government to impose and enforce corporations’ social obligations. This Article offers new grounds for skepticism towards these proposed reforms, because they would jeopardize corporate law’s hard-fought equilibrium among the branches by reviving the unilateralism and dysfunction that once plagued the United States’ corporate law regime. Accordingly, this Article contends that vesting the government with a proactive role in imposing and enforcing corporate purpose, whether at the state or federal level, is ill advised. Yet this Article also providers reform-minded progressives with a concrete framework for structuring an expanded power to enforce corporate purpose with minimal risk to corporate law’s separation of powers.
When you receive a loan, is the money taxable? Of course not, because you must pay back the money. That obligation prevents the loan money from being considered income. Of course, if the loan is later forgiven, that forgiveness can trigger taxation, unless you fall within one of the few exceptions to cancellation of debt income.
Can lawyers borrow just like anyone else? Of course, and for that reason, many lawyers and litigation funders are fretting about Novoselsky v. Commissioner, T.C. Memo. 2020-68 (2020). In this case, a lawyer was taxed on litigation funding loans. It’s one of those classic bad-facts bad-law situations, and for that reason, much of the hype needs explanation. In fact, this perfect storm is full of tax lessons.
David Novoselsky, a solo Chicago lawyer, raised $1.4 million with loan agreements he drafted himself. The IRS and Tax Court said they were not loans so the proceeds were taxable as income from the start. The court agreed with the IRS that he should have reported the $1.4 million in “loans” as income. Novoselsky couldn’t complain to his tax lawyer for putting this mess together because there was no tax lawyer; there was not even a business lawyer.
It was all DIY. Novoselsky was an entrepreneurial litigator, so in 2009 and 2011, he entered into “litigation support agreements” with eight doctors and lawyers around Chicago. They fell into three groups, each with a pre-existing stake in the litigation: (i) doctors who were plaintiffs in lawsuits Novoselsky was cooking up; (ii) doctors whose economic interests were aligned with the plaintiffs; and (iii) lawyers with whom Novoselsky had fee-sharing agreements.
He documented the litigation support agreements as nonrecourse loans, promising a high rate of interest or a multiple of the investment. He did not report them as income on his 2009 and 2011 tax returns, but on audit, the IRS said the $1.4 million was not a loan. When Novoselsky refused to extend the statute of limitations—standard fare in an audit—the IRS assessed taxes and penalties totaling over $600,000.
Novoselsky went to Tax Court, but proceedings were stayed when he declared bankruptcy in 2014. Novoselsky acted as his own bankruptcy lawyer too, and he emerged from bankruptcy without a discharge. Back in Tax Court—yet again pro se—he argued that nonrecourse loans were standard for litigation funders, with security on the case or cases in question.
Unfortunately, Novoselsky didn’t bother with security agreements. In their place, he put language in the litigation support agreements requiring him to pay the investor “at the successful conclusion of this litigation.” If the litigation was a bust, he would have no obligation to pay. This probably sounded like DIY common sense, but the Tax Court cited numerous cases holding that a loan is not a loan for tax purposes if it is contingent on the occurrence of a future event. That specifically includes obligations that are contingent on the outcome of litigation.
The Tax Court reasoned that the obligations under these litigation support agreements were contingent on successful lawsuits, so they were not loans. It’s not the same thing as a nonrecourse loan, even though the effect might be similar. The burden then shifted to Novoselsky to provide another justification for excluding the advances from his declared income. He claimed they were gifts or were deposits held “in trust” for investors, but the Tax Court didn’t buy either one of those explanations.
The Tax Court even went through the seven-factor test from Welch v. Commissioner, 204 F.3d 1228 (9th Cir. 2000), which the Ninth Circuit developed to help determine whether funds from a business associate were a loan or taxable income. The Tax Court said these litigation support agreements were labeled “loans,” but there was no promissory note, no payment schedule, no security, and no payments of principal were ever made. Some called for interest or a fixed-dollar premium, but no interest or other amount was ever paid. The advances were payable only out of future litigation proceeds.
The Tax Court turned to the seventh Welch factor, the most important: Had the parties conducted themselves as if the transactions were bona fide loans? Nope. Each investor agreed that Novoselsky had no obligation to pay unless the litigation was a success. In discussing the seventh Welch factor, the Tax Court referenced Frierdich v. Commissioner, T.C. Memo. 1989-393, aff’d, 925 F.2d 180 (7th Cir. 1991).
In Frierdich, a widow hired an attorney to represent her as the executor of her late husband’s estate. The widow was well acquainted with the attorney, who had been her husband’s partner in various real estate ventures. The attorney had also dealt with the widow in certain business matters, so they came to an unusual arrangement.
The widow not only hired the attorney to provide legal services, but also lent him $100,000. The attorney gave the widow a note bearing interest at 8%, but there was no fixed schedule for repayment. Instead, the principal and interest were payable when the attorney was due his fee, which was “subject to [the] closing of the estate.” The widow was authorized to deduct the loan balance from the attorney’s fee.
In Frierdich, the Tax Court re-characterized the widow’s loan as an advance payment of the attorney’s fee. The attorney’s obligation to pay under the note was not due until he was paid for closing the estate. The Tax Court found that both parties intended that repayment would be in the form of legal services. The finding in Novoselsky extended this analysis to include not only the advances received from the formal plaintiffs in Novoselsky’s cases, but also those received from the doctors and lawyers who had interests in the outcome of the various litigation.
Novoselsky’s counterparties were clients, medical professionals with interests aligned to the interests of his clients, and lawyers with fee-sharing agreements. Repayment was not required unless the litigation was successful, so the contingency determined whether any obligation arose in the first place. The Tax Court held that the investors’ advances were actually compensation for Novoselsky’s legal services.
Real Litigation Funding?
Does this case jeopardize lawyers getting real litigation funding? Not really, since in a commercial litigation funding transaction, the funder should have no pre-existing interest in the litigation. That should make it difficult for the IRS to argue that the funder’s advance is a disguised payment for the attorney’s legal services. As long as the loan documentation does not condition the borrower’s obligation on the outcome of the litigation, Novoselsky should not prevent loans from qualifying as loans, or as purchases for the deals structured that way.
Novoselsky is a reminder—if we need one—that plaintiffs and lawyers should generally not prepare funding documents themselves. They should not include any language suggesting that their obligation to repay a loan depends on the success of the litigation. They should limit the funders’ recourse to a security interest in the litigation proceeds.
Of course, “loans” are not common in commercial litigation funding in the first place. Most are purchases, often prepaid forward purchases. That fact further diminishes the impact of Novoselsky. In the few loans that come along, professional loan documentation usually includes a non-contingent payment obligation. Novoselsky also warns lawyers not to borrow from clients or anyone else with a stake in the case’s outcome.
Otherwise, there is a risk that a lender’s advance may be re-characterized as an advance payment of compensation. If the lender is a professional funder with no prior interest in the lawsuit, the risk seems low. Still, does Novoselsky warn lawyers that they may face a somewhat greater tax risk than plaintiffs who are similarly situated?
Suppose that a plaintiff sells a part of his case under a good prepaid forward contract. It may be awfully difficult for the IRS to find a way to tax the upfront money until the contract closes on the conclusion of the case. But let’s say that only the contingent fee lawyer is the seller under the contract, and the plaintiff is not even participating in the deal.
And let’s say the lawyer is entitled to 40% if the case produces money, and he “sells” his right to half of that fee. Even if the lawyer’s funding deal is documented as a legitimate prepaid forward, it may be more tempting for the IRS to seek ways to attack the arrangement. The lawyer, unlike the plaintiff, is always earning compensation income, so a successful challenge will hit the lawyer with ordinary income. And, of course, the IRS has a long history of going after lawyers to set an example.
Perhaps this is one reason many lawyer funding deals are structured with the plaintiff(s) also participating on some level. It is another reason that the tax timing issues for lawyers may be a little more sensitive than for plaintiffs. In the end, though, the strange case of Novoselsky seems like such a slam dunk for the IRS, and such an obvious loser for the DIY lawyer that it’s also a reminder to all: don’t try this at home!
When the Supreme Court handed down Taggart v. Lorenzen,[1] practitioners held their breath knowing that the decision could drastically change the landscape of sanctions law in bankruptcy courts. In the decision, the Supreme Court clarified the standard for holding a creditor in civil contempt for violating the discharge injunction afforded by 11 U.S.C. § 524(a)(2). But Taggart left unanswered questions: Has the sanctions landscape changed? Does Taggart inform the standard for stay violations? Plan violations? This article discusses the Taggart decision and addresses the case’s implications in turn.
The Case.
Mr. Taggart became embroiled in state court litigation relating to an entity in which he had an ownership interest. During this litigation, he filed chapter 7 bankruptcy and obtained his general discharge.
After this discharge, the state-court litigation continued and the other parties to the state court action sought—and obtained—an order awarding post-discharge attorneys’ fees against the debtor.[2] The debtor moved for contempt in his bankruptcy case, but the bankruptcy court—applying governing Ninth Circuit precedent—found that the debtor had “returned to the fray” in state court and, therefore, an award of post-discharge attorneys’ fees did not violate the discharge injunction.[3] On appeal, the district court found that the debtor had not “returned to the fray” and remanded the matter.[4]
The bankruptcy court, deciding the case on remand, applied a “strict liability” standard and held the creditors in civil contempt. Specifically, the bankruptcy court found that the creditors knew of the debtor’s discharge injunction and took the actions that intentionally violated the discharge injunction.[5] The state court plaintiffs appealed. The Ninth Circuit reversed the ruling and held that a “subjective good faith standard” was applicable to civil contempt proceedings.[6]
The Supreme Court rejected the reasoning of the lower courts and instead held that the proper standard for holding a creditor in civil contempt is the absence of “fair ground of doubt as to whether the order barred the creditor’s conduct. In other words, civil contempt may be appropriate if there is no objectively reasonable basis for concluding that the creditor’s conduct might be unlawful.”[7]
Has the Sanctions Landscape Changed?
Historically, the general contempt standard has been an objective one, where the subjective beliefs of the contemnor are typically unavailing to avoid a finding of contempt.[8] However, the Supreme Court has not always held subjective intent to be irrelevant. In Chambers v. NASCO, Inc.[9], the Court noted that sanctions may be warranted where a party acts in bad faith. And, in Young v. United States, the Court found that a party’s good faith may be considered in determining an appropriate sanction.[10] It is clear, however, that the “no fair ground of doubt” standard adopted in Taggart has its roots in objective reasonableness.
The Bankruptcy Code provides authority for the court to hold a party in contempt at 11 U.S.C. § 105(a) and § 524(a)(2).[11] Indeed, the contempt powers of the bankruptcy court—as provided for in the Code—find their roots in traditional principles from the “old soil” of prior law. The “no fair ground of doubt” standard has been applied to civil contempt outside of bankruptcy for more than 150 years.[12] The Supreme Court noted that civil contempt powers in bankruptcy are rooted in this same non-bankruptcy law.
Does Taggart Apply to Stay Violations?
On its face, no, Taggart does not purport to set the standard for sanctions in cases involving violations of the automatic stay. In addressing the standard championed by the petitioner, the Court scrutinized Taggart’s argument that “lower courts often have used a standard akin to strict liability to remedy violations of automatic stays.”[13] However, the Court found that the statutory framework supporting remedies for stay violations “differs from the more general language in [11 U.S.C. §] 105(a)” that provides the remedy for violation of the discharge injunction.[14] By contrast, 11 U.S.C. § 362(k)(1) provides a remedy for “an individual injured by any willful violation of [the] stay.”[15] The Court also found that the purpose of the automatic stay and the discharge injunction differ: “A stay aims to prevent damaging disruptions to administration of a bankruptcy case in the short run, whereas a discharge is entered at the end of the case and seeks to bind creditors over a much longer period.”[16]
The standard applicable to stay violations is not entirely settled. Courts have construed the “willfulness” language in Section 362(k) to mean simple intent to do the actions that constituted the violation (rather than intent to violate the stay).[17] In effect, such a standard functions similarly to strict liability. In the Eleventh Circuit, a defendant may be held in contempt where he “[1] knew that the automatic stay was invoked and (2) intended the actions which violated the stay.”[18] Other courts have applied the Taggart standard, finding a stay violation only if there was “no fair ground of doubt” about whether the conduct violated the stay.[19]
The Supreme Court in Taggart did not address the meaning of “willful” in the context of a stay violation, although Justice Breyer noted that “the automatic stay provision uses the word willful, a word that typically does not associate with strict liability but whose construction is often dependent on the context in which it appears.”[20] Despite this teaser, practitioners are left looking to their respective circuits for guidance on the sanctions standard in stay violation cases.
Does Taggart Apply to Violations of other Orders such as the Plan?
Again, on its face, Taggart applies only to violations of the discharge injunction. However, shortly after Taggart was handed down, a few bankruptcy courts looked to the objective standard defined in Taggart to inform the general sanctions landscape.
At least one bankruptcy court has held that the standard in Taggart is applicable in deciding whether to impose sanctions when a party violates a court order that is injunctive in nature.[21] In an opinion issued just weeks after Taggart, the bankruptcy court in In re Gravel applied Taggart to the violation of “Debtor Current Orders” which were entered to enjoin a certain class of creditors from seeking to collect “(i) any prepetition mortgage arrearage that the Order declared to be cured, (ii) any postpetition amounts that the Order declared to be paid, or any (iii) fees or expenses that were not properly noticed pursuant to Rule 3002.1(b) and (c).”[22] To be sure, discharge orders and the orders entered in Gravel serve the similar purpose of enjoining collection activity, which may be an important characteristic supporting the application of Taggart in this and future cases.
Other courts have applied Taggart even more broadly. In Deutsche Bank Trust Co. v. Gemstone Sols. Grp., Inc.[23], the bankruptcy court applied the no “fair ground of doubt” standard to violations of a confirmation order.[24] However, Taggart is not the universal standard for every sanctions order. Indeed, a bankruptcy court recently imposed sanctions against an attorney under the court’s inherent powers due to the attorney’s willful failure to comply with a discovery order.[25]
Conclusion.
Post-Taggart, bankruptcy courts should apply the objective “no fair ground of doubt” standard when assessing whether a party should be sanctioned for violating the discharge injunction. However, a practitioner cannot assume that the objective Taggart standard applies in cases where the violation relates to either the automatic stay or another court order. A variety of standards—objective, subjective, or even strict liability—may apply in those instances and practitioners should be aware that the Taggart standard may not apply uniformly when a bankruptcy court is considering sanctions.
[17]In re Olsen, BAP No. EP 16-058, 2017 Bankr. LEXIS 2402 (1st Cir. B.A.P. July 19, 2017).
[18]Jove Engineering, Inc. v. Internal Revenue Service, 92 F.3d 1539, 1555 (11th Cir. 1966) (reversing district court’s finding that there was no willful violation where “there was no malice and nothing approaching arrogant defiance or reckless disregard . . . [a] computer was, perhaps, not finely tuned.” ) (internal citations omitted).
[19]See, e.g., Suh v. Anderson, BAP NO. CC019-1233-STaF, 2020 Bankr. LEXIS 714, n3 (9th Cir. B.A.P. March 16, 2020) (“[W]e assume that the contempt standard applied to the discharge violation in Taggart also applies to the violation of the automatic stay.”).
[20]Taggart at *1804 (internal citations omitted).
[23] Case No. 19-30258-KLP, 2020 Bankr. LEXIS 1377, (Bankr. E.D. Va. May 26, 2020).
[24]Gemstone at *28 (“Under Taggart, if there is a ‘fair ground of doubt’ as to whether Defendants’ conduct was a violation of the Confirmation Order, then a finding of contempt is not permitted.”).
[25]In re Markus, 619 B.R. 552 (Bankr. S.D.N.Y. 2020).
During the COVID-19 pandemic, Initial Public Offerings (IPOs) and Special Purpose Acquisition Companies (SPACs) gained considerable popularity as ways to take a company public. During the multiple lockdowns, companies had lots of time to streamline their business plans and strategize to get them to the next level. As a result, many found 2020 to be the perfect time to take their company public via IPOs or SPACs to help respond to the uncertainty created by the world health crisis and raise funds for their business.
Although there was a slight SPAC slowdown in April 2021, numbers are settling out post-COVID going into the third quarter, and there are still lots of market opportunities for companies looking to show their growth and go public through IPOs and SPACs. Before opening up your business to a national exchange, it’s critical to understand how IPOs and SPACs evolved through COVID and what to expect post-pandemic.
IPOs and SPACs Post-Pandemic
The pandemic has seen its ups and downs for IPOs and SPACs, and in January 2021, issuances of SPACs, in particular, were once again on the rise. SPACs were so popular that by the end of March 2021, there were already 292 issuances, and they had raised $87.9 billion, which exceeded the $83.4 billion total raised in 2020. However, in April 2021, the Securities and Exchange Commission (SEC) announced it was considering new guidelines that would change the way SPACs report information on financial statements for investors. The rate of issuances dropped by almost 90% that month.
Thankfully, as we move into the third quarter of 2021, later in the pandemic, we see these numbers settling back to normal. For example, there was a rush at the end of the second quarter, with 13 SPACs pricing and going public in the last week of June alone. As of September 27, 2021, the total amount raised by SPAC issuances in 2021 so far was $127.1 billion according to the website SPAC Research. SPACs are transforming the entrepreneurial landscape of the world, and there are hundreds of SPACs from 2020 and 2021 still looking for targets as well as new market opportunities for companies to go public. Overall, COVID has had a stimulating effect on financial markets, since they have experienced breakneck growth over the past 15 months, with relatively few roadblocks or downturns and no signs of stopping post-pandemic.
When the SEC announced it was considering new restrictions on SPACs in early April 2021, many companies turned their attention back to the traditional IPO route. Going into the third quarter of 2021, IPOs alone in the U.S. had raised $79.9 billion in proceeds. This number is higher than every year in the past decade except for one, which means that 2021 is on track to go down as the most prolific year for IPOs on record. With the lockdowns over the past 18 or so months, bankers have been laser-focused and able to push as many deals through as possible, taking advantage of stock market highs. Furthermore, between institutional and retail investors, there is lots of money in the market right now, pushing many companies to go public earlier than they originally planned. With 761 offerings as of September 27, 2021, this year has already beaten 2020 in IPO frequency, surpassing its 480 IPOs, and had more than three times as many as 2019, which saw 232. As we look to the last two quarters of 2021, the trend of businesses taking advantage of IPOs to take their companies public is still on the rise.
Business as Usual
Although there will be some changes to the post-pandemic landscape, if you are looking to take your company public through IPOs or SPACs, now may be the perfect time, since the market of potential buyers has perhaps never been bigger. Not to mention, both SPACs and IPOs have proved their resiliency when faced with potential roadblocks such as the pandemic and the SEC statement on potential SPAC restrictions in April 2021. In fact, since April, the issuances of SPACs and IPOs continue to increase each quarter, and numbers are set to be record-breaking yet again in 2021.
This doesn’t mean there are no complications. Currently, one thing that adds a layer of complexity to due diligence efforts would be possible travel restrictions. In these cases, meetings or on-site visits would need to be done virtually, and in an international transaction, one would need to rely more heavily on local counsel. Of course, another thing to be aware of is that because of how hot the market is, the risks involved with IPOs and SPACs increase as well.
However, with so many buyers and so much money to be had within the market, the rewards outweigh the risks for most investors. Thus, the current IPO and SPAC landscape could be an ideal market for companies looking to go public. For many companies, it is no longer a question of if they should go public, but rather how and when.
Sophisticated clients’ expectations of their M&A deal attorneys have not slackened in the age of remote working and back-to-back Zoom meetings in the wake of the pandemic.
Given that reality, the recent publication of the latest edition of Using Legal Project Management in Merger and Acquisition and Joint Venture Transactions is particularly timely. This unique guidebook contains downloadable and customizable checklists and other tools providing an arsenal of resources for deal lawyers seeking to drive efficiency for and deliver value to their clients. The new edition adds to that arsenal and responds to new developments in the evolving M&A marketplace. It also breaks new ground with an entirely new battery of resources focused on joint venture transactions.
The new edition marks the third iteration of the guidebook to be published in just five years. Several factors have driven the number of editions in this short period.
First, there has been an explosion in the field of legal project management generally as law firms and corporate law departments alike have added legions of project and pricing managers to their ranks. The editors recently participated in a global summit of such managers, something that would have been unthinkable just a few years ago.
Second, corporate law departments and other sophisticated clients are issuing RFPs with increasing frequency that require bidding law firms to include meaningful explanations of how they would use legal project management (LPM) in carrying out their engagement.
Third, the COVID-19 pandemic catalyzed the need for the tools in the field. In a remote work world with lawyers working from various venues, having an organized and coordinated team can be a challenge, but at the same time remains a necessity. The LPM tools found in the guidebook can go a long way to helping distributed legal deal teams stay in sync.
Finally, the 100+ deal lawyers from around the world who comprise the American Bar Association’s M&A Legal Project Management Task Force kept coming up with new and creative ideas as to how LPM might be used in particular types of transactions to respond to new ways of handling deal risks and other matters. As editors of the guidebook, we owe them our thanks for their seasoned perspectives and invaluable input.
As a consequence, the Third Edition includes eight new M&A tools that are particularly relevant to the tumultuous and ever fast-moving world in which deal lawyers find themselves. The following are thumbnail descriptions of the eight new tools:
Cataclysmic Event Due Diligence Questionnaire: This is a list of due diligence and document requests triggered by or related to a cataclysmic or force majeure-like event, incident, occurrence or circumstance such as a pandemic, an Act of God, or anything else that is or has the potential to be, material, major and disruptive.
Limited Auction Checklist: This is a checklist of key items to consider in connection with a limited auction process. Such a process entails a higher degree of complexity than transactions with only one potential buyer, given the need to coordinate and stage the disclosure of information to various interested parties and handle parallel negotiations with multiple bidders.
Deal Cycle Capture Tool: This tool captures and communicate significant matters identified during the deal cycle, particularly during due diligence, where such matter requires later consideration or action, including in connection with the drafting of representations and warranties.
Section 363 Bankruptcy Sale Checklist: This is a checklist of important items to consider in connection with the sale of distressed company pursuant to Section 363 of the U.S. Bankruptcy Code.
M&A Escrow Agreement Checklist: This tool identifies issues to be considered in the negotiation of an escrow arrangement to satisfy a seller’s post-closing obligations, including purchase price adjustments and indemnification claims.
Representation and Warranty Insurance (“RWI”) Tool: This tool provides practical advice and guidance on securing and structuring representation and warranty insurance as a means to make a buyer whole for seller breaches. The tool helps you consider these key questions: What is covered? What is excluded from coverage? What is the process for putting RWI in place?
Post-Closing Reference Checklist: This tool consists of a client alert letter and accompanying list of important post-closing action items and deadlines, including items related to the bringing of indemnification claims.
Post-Acquisition Integration Checklist: While deal making is hard, integration is even harder. Oftentimes, the projected synergies and value to be realized from M&A are lost on integration. One leading contributing factor can be buyer’s failure to consider and plan how the acquired business is to be integrated into its own business after closing. This tool provides a list of questions and action items for a buyer to consider in developing and implementing a post-closing integration plan.
The Third Edition moves beyond M&A by adding four new tools developed by lawyers from around the globe who are members of the International Subcommittee of the M&A Committee of the Business Law Section. Joint ventures are complicated transactions involving sophisticated parties, and raise a number of issues in thorny areas including government, intellectual property, tax, employment law, and regulatory law. As such they are perfect candidates for LPM. The new joint venture tools leverage tools that were developed for M&A transactions, including a task checklist, a scoping tool, a drafting guide and a negotiating tool.
Now more than ever, the Guidebook serves as an indispensable tool not just for driving efficiency and client value, but also for training young lawyers and managing risk.
In a June 14, 2021, Settlement Order[1] (the “Order”), the Securities and Exchange Commission (“SEC”) alleged certain cybersecurity disclosure controls failures at First American Financial Corporation (“FAFC”).
Without admitting or denying the SEC’s findings, FAFC agreed to (1) cease and desist from further violations of SEC Exchange Act Rule 13a-15(a); and (2) pay a $487,616 penalty. Rule 13a-15(a) mandates that every issuer of a security registered pursuant to Section 12 of the Exchange Act must maintain disclosure controls and procedures to ensure that information the issuer must disclose in reports it files or submits pursuant to the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. FAFC provides products and services in connection with residential and commercial real estate transactions, including title insurance and escrow services. In connection with that business, FAFC issues common stock registered with the SEC pursuant to 12(b) of the Exchange Act. Many months before this SEC action arose, FAFC’s IT security personnel had identified a computer system vulnerability that they failed to remedy in accordance with the company’s policies, and about which they failed to inform the company’s senior management.
On May 24, 2019, a cybersecurity journalist notified FAFC that its “EaglePro” application for sharing document images related to title and escrow transactions had a cybersecurity vulnerability. The vulnerability exposed over 800 million title and escrow document images dating back to 2003. These images included Personal Identifiable Information (“PII”) such as social security numbers and financial information. In response to this notification, FAFC issued the following statement to the journalist: “First American has learned of a design defect in an application that made possible unauthorized access to customer data. At First American, security, privacy and confidentiality are of the highest priority and we are committed to protecting our customers’ information. The company took immediate action to address the situation and shut down external access to the application.” The journalist quoted this statement verbatim in his cybersecurity blog report published on the evening of May 24, 2019.[2]
FAFC then furnished a Form 8-K to the SEC on May 28, 2019, attaching an additional press release stating, in part, that there was “[n]o preliminary indication of large-scale unauthorized access to customer information.” The press release also stated: “First American Financial Corporation advises that it shut down external access to a production environment with a reported design defect that created the potential for unauthorized access to customer data.”
The June 2021 SEC Order arose in part because FAFC’s senior executives responsible for the press statement and Form 8-K were not apprised of certain information concerning the company’s information security personnel’s prior knowledge of a vulnerability associated with FAFC’s EaglePro system before making those statements – information that would have been relevant to management’s assessment of the company’s disclosure response to the vulnerability and the magnitude of the resulting risk. In particular, FAFC’s senior executives were not informed that the company’s information security personnel had identified a vulnerability several months earlier in a January 2019 manual penetration test of the EaglePro application (“January 2019 Report”), or that the company had failed to remediate the vulnerability in accordance with its policies. As discussed in the Order, FAFC did not maintain disclosure controls and procedures designed to ensure that senior management had this relevant information about the January 2019 Report prior to issuing the company’s disclosures about the vulnerability.
As evidenced by the FAFC Order, and several additional recent enforcement actions, the SEC is viewing cybersecurity threats to businesses subject to SEC rules as a growing business risk. One such enforcement action concerned Pearson plc, a London-based public company listed on the New York Stock Exchange (with Pearson’s ordinary shares registered under Section 12(b) of the Exchange Act). In August 2021, Pearson agreed to pay $1 million to settle charges that it misled investors about a 2018 data breach involving the theft of millions of student records, including dates of births and email addresses, and lacked adequate disclosure controls and procedures.[3]
Other recent SEC enforcement actions include sanctions against eight firms in three actions filed August 30, 2021, “for failures in their cybersecurity policies and procedures that resulted in email account takeovers exposing the personal information of thousands of customers and clients at each firm.” The eight firms, which have agreed to settle the charges, are: Cetera Advisor Networks LLC, Cetera Investment Services LLC, Cetera Financial Specialists LLC, Cetera Advisors LLC, and Cetera Investment Advisers LLC (collectively, the Cetera Entities) – $300,000 penalty; Cambridge Investment Research Inc. and Cambridge Investment Research Advisors Inc. (collectively, Cambridge) – $250,000 penalty; and KMS Financial Services Inc. – $200,000 penalty. All were Commission-registered as broker dealers, investment advisory firms, or both. Kristina Littman, Chief of the SEC Enforcement Division’s Cyber Unit, is quoted[4] as saying, “Investment advisers and broker dealers must fulfill their obligations concerning the protection of customer information…. It is not enough to write a policy requiring enhanced security measures if those requirements are not implemented or are only partially implemented, especially in the face of known attacks.”
Collectively, these SEC enforcement actions underscore the importance of a business:
Having appropriate privacy and cybersecurity policies;
Educating/training employees about these policies;
Ensuring the business’s contracting practices contain appropriate provisions consistent with these policies; and
Conducting periodic legal audits for compliance to these policies.
The FAFC Order also highlights the importance of executives maintaining an awareness of all material internal and external communications of the privacy and cybersecurity threats facing the business, and providing leadership from the top as to the importance of privacy and cybersecurity issues to the business’s risk management.
Special Purpose Acquisition Companies (SPACs) have become a popular way to raise funds for public mergers and acquisitions in recent years. However, the directors and officers of a SPAC can face unique exposures. These liabilities can include direct risks to personal assets because the funds the SPAC raises through a public offering must be held in a trust. A SPAC’s trust funds cannot be used to cover its defense and settlement costs and its at-risk capital may not be sufficient to cover these kinds of costs.
The right insurance can offer valuable peace of mind, but there is often some confusion about how it all works. This article will review two recent SPAC lawsuits and examine how an insurance policy—a Representations and Warranties (RWI) Policy or a Directors and Officers (D&O) Policy—would respond in each situation.
RWI Insurance and the Immunovant Case
Although SPACs are an exciting way of fundraising and going public, a SPAC is still, at heart, an M&A deal, making RWI insurance useful.
Let’s look at a recent case involving the biopharmaceutical company Immunovant. In Pitman v. Immunovant, Inc.,[1] a company developing a new drug to help with a common and debilitating disease connected with a SPAC looking for such a company. The two merged and went public.
However, when Immunovant announced it had “become aware of a potential problem” and “out of an abundance of caution” was placing a voluntary hold on its ongoing clinical trials, its stock price plunged 42%.
Shareholder Plaintiffs’ attorneys multiplied the 42% stock drop by the number of shares in open circulation and felt that the resulting amount was a large enough “pot of gold” to be worth the trouble of bringing a lawsuit. They united enough shareholders for a securities class action lawsuit with multiple allegations, including:
The SPAC failed to perform adequate due diligence.
The SPAC failed to disclose safety issues associated with the drug.
Because of either of these two factors, the prospects for approval, viability and profitability were diminished.
As a result, the company’s public statements were materially false and misleading.
Let’s first focus on the allegations of inadequate due diligence. These kinds of allegations typically assert that the SPAC team was incentivized to close a deal by a specific deadline and did not take the time or the effort to perform sufficient due diligence. The first implication here is that if the SPAC had made a proper effort to diligence the business and operations of the target company, it would have uncovered the problems being called out by the plaintiffs and would have been able to disclose them. The second implication is that if the SPAC’s diligence had been thorough, but had not uncovered problems, those problems were so well and intentionally hidden by the target company that they amounted to fraud on the part of the target company.
Putting aside the fraud implication for a moment, how does a SPAC refute the first implication of inadequate due diligence? The SPAC is responsible for establishing that it did, in fact, perform adequate diligence. To do so, an RWI policy, similar to the one used in the Immunovant deal, could be of great use. The process the buyer of the RWI policy (in this case, the SPAC) undertakes to secure the policy includes an intensive review by the insurer of the diligence the buyer conducted. The insurer usually engages specialized counsel from big law firms to review the diligence and probe areas that the insurer and its counsel (who see dozens of similar kinds of deals in the same industry on a weekly basis) believe to be particularly risky. In a way, this process serves as a safety net for anything the SPAC’s diligence team could have missed while reviewing the target’s business and operations. The insurer is incentivized to be extremely thorough because it will be the one paying the bills if diligence is patchy.
So in the Immunovant case, if—hypothetically—there were representations given as to the accuracy of Immunovant’s records of previous clinical drug trials, the RWI policy defenses would include:
The assertion that since the company has gone through the process of acquiring an RWI policy, which requires third parties to review the diligence and probe the adequacy of the work done. Thus the Plaintiffs have a much more difficult argument that that diligence was inadequate.
The argument that RWI speaks very clearly to what was known and not known by the SPAC. In essence, RWI provides the Immunovant parties with a third-party paper trail showing how much Defendants knew, how hard they worked to get to the information, and how innocent they were.
Coming back to the second implication of fraud, a RWI policy covers seller’s fraud. So if the diligence efforts fail in the face of fraud by the target company, the RWI policy would step in to cover losses resulting from such fraud. This means that the SPAC could potentially recoup some lost money and return it to the SPAC investors (Plaintiffs), which would diminish their losses and consequently the amount claimed by Plaintiffs’ attorneys in their lawsuit against the SPAC.
The Importance of RWI to SPACs
Representations and warranties insurance can hedge the risk for both the buyer and the seller in SPACs. There’s a common misperception that RWI is not useful in a public company style deal because in a public company deal the seller typical provides very limited or no representations and warranties in the purchase agreement and no indemnification. This reasoning is flawed. When there is lack of indemnification from the seller, the buyer is saddled with all of the risk with no avenue for a recourse. That is exactly the situation where RWI coverage is even more critical. In these kinds of cases, synthetic representations and warranties can be put in place through the use of a RWI policy and at least some of the risk can be transferred to the insurer. The definition of loss in these situations essentially comes from the insurance policy and not from the indemnification section of the agreement, and the buyer is insured against that loss.
D&O Insurance and the Lucid Motors Case
D&O insurance is on everyone’s minds these days because of its rising cost. Naturally, many companies are asking about ways they can save on their D&O premiums by reducing coverage.
Clients often ask if they need D&O coverage at the time of the SPAC’s IPO and whether they can get away with buying the least possible amount. There’s a myth out in the SPAC market that SPACs are not really subject to risk between the time of their IPO and their de-SPAC. Unfortunately, the common belief that all litigation comes after the de-SPAC is just not true and can cause some serious problems for the SPAC and its team of directors and officers. In fact, it is crucial to have coverage between the IPO and the de-SPAC.
Now, let us examine a case study that illustrates the importance of D&O insurance: Churchill Capital Corporation IV SecuritiesLitigation.[2] The Complaint alleges that Rumors spread that Churchill Capital Acquisition Corporation IV was going to acquire Lucid Motors, an electric vehicle company, which caused the price of the SPAC’s shares to jump from $10 to $22 per share. Then, the Lucid Motors CEO spoke to the media and mentioned a plan to deliver 6,000 vehicles in 2021. After several other statements to the media, the SPAC shares climbed to over $57 a share. The merger was finally announced on February 22, 2021, and on the same day the Lucid Motors CEO told the media that, in fact, the production of the vehicles would be delayed.
Documentation filed with merger announcement revealed that only 557 vehicles were planned versus the 6,000 that were previously mentioned and, not surprisingly, the price of the SPAC’s shares tanked. By the time the lawsuit was filed on April 18, 2021, the SPAC’s shares were trading at $18 per share.
What is interesting to note here is that this lawsuit is not your garden variety merger objection suit in which the plaintiffs allege insufficient disclosure and argue for the merger to be halted. These kinds of allegations and demands are typically addressed through additional SEC filings to close any gaps in the disclosure, and the plaintiff usually goes away for a few thousand dollars in mootness fees. These merger objections suits are not looked upon kindly by Delaware courts, which is why they are often filed in New York and have been commonly referred to as an M&A (and now a SPAC) “transaction tax.”
The Lucid Motors case, however, is a full-blown securities class-action lawsuit brought in federal court in Alabama against the SPAC, its CEO and CFO, and the target and its CEO. It alleges that these parties made or were involved in making false statements and omissions that drove the wild price fluctuations, which then resulted in losses for the SPAC’s shareholders. What’s even more interesting is that this lawsuit is being brought in advance of the merger for statements made prior to even the merger announcement.
When lawsuits of this type are brought, defendants’ thoughts automatically turn to insurance. The questions typically are:
Is there an insurance policy in place to protect my SPAC and my directors and officers?
Will the limits of that policy be sufficient to cover litigation defense and settlement costs?
Here we should take a short detour and understand the kinds of policies that a SPAC team will encounter as it proceeds through the life cycle of the SPAC. There are three main types of D&O policies and it is essential to understand which D&O policies are in play before, during, and after the SPAC merger.
The first policy is the one that covers the SPAC and its directors and officers between the SPAC’s IPO and its business combination. This policy binds at the IPO and is funded by the SPAC’s at-risk capital. It typically has a tail component, which is essentially an extended reporting period for claims that come after the merger. Because a SPAC’s at-risk capital is usually very limited and the current SPAC D&O insurance pricing is quite high, these policies, if not planned and budgeted for properly, can cause a lot of aggravation to SPAC teams.
The second policy is the private company policy that covers the target company and its directors and officers until the company mergers with the SPAC. This policy can also have a tail component but is quite different from the public company D&O policy. It is a lot less complex and a lot less expensive than the public company D&O policy placed for a SPAC and for the combined company after the merger. This policy is typically in place ahead of the de-SPAC and is funded out of the target company’s operating capital.
The third policy covers the combined company and its directors and officers after the merger. It binds at the time of the merger and looks and feels very much like any traditional public company D&O policy. It is also considerably more expensive than the SPAC D&O policy and usually renews on an annual basis.
The Importance of Choosing the Right D&O Coverage
The first lesson we can learn from the Lucid Motors case is that serious, expensive lawsuits can and do occur before the de-SPAC and that the period between the SPAC IPO and its business combination is not risk-free. Consequently, the terms and limits of that first policy that covers the SPAC and its directors and officers between the IPO and the de-SPAC should be considered very carefully.
The second lesson is that lower limit of coverage may not be sufficient to cover defense and settlement costs and can put you at risk. Last year, SPAC teams usually considered $20 million in coverage limits for their SPACs because premium pricing was low and affordable. In recent months, however, increases in D&O premium pricing have forced SPAC teams to gravitate towards much lower limits. The majority now purchase between $5 million and $10 million in coverage, and some have even considered limits as low as $2.5 million. While D&O insurance costs are high and at-risk capital is restricted, going for the least expensive policy may not be the right decision for your SPAC and your team.
The importance of risk mitigation is another great lesson to take away from the Lucid Motors case. It is incredibly critical for all SPAC executives and the executives of the target company to pay very close attention to public messaging around deal time. They must be especially careful when making any statements on social or other media because getting sued for even inadvertent misrepresentations can be extremely painful, time consuming, and distracting in the midst of a deal and, without proper insurance coverage, can lead to serious financial losses.
Conclusion
The SPAC market is extremely dynamic and has grown dramatically in size and sophistication over the last few months. SPAC teams and teams aiming to merge with a SPAC must keep on top of the latest developments in the financial, regulatory, and legal aspects of this market.
Allegations and complaints in the lawsuits like the ones discussed above, while novel now, may become standard in the future. Having advisers who can steer you away from traps and anticipate risks and pitfalls, including guiding you through the most efficient and effective use of RWI and D&O policies is a must have for any SPAC team.
[1] Case No. 1:21-cv-00918, U.S. District Court for the Eastern District of New York.
[2] Case No. 21-cv-00539, U.S. District Court for the Northern District of Alabama, Eastern Division. See also, Arico v. Churchill Capital Corporation IV, Case No. 21-cv-12355, U.S. District Court for the District of New Jersey.
Amidst all of the tributes on 9/11, there are two more public servants who deserve America’s thanks. They are not among the first responders, such as firefighters or police officers, who ran towards the burning buildings. They protected America’s financial system on that terrible day and during the days thereafter. They served the public with courage and distinction.
The first is Roger W. Ferguson, Jr., who was Vice Chairman of the Board of Governors of the Federal Reserve System. As the Federal Reserve website notes, “When the terrorist attacks occurred on September 11, 2001, Ferguson was the only member of the Board of Governors in Washington (others were traveling). He quickly moved to assure bankers and investors that the Fed would provide the lending necessary to keep the economy going in the aftermath of the crisis.”
As Mr. Ferguson later explained, the attack “could prompt a chain reaction drying up liquidity, which, unchecked, could lead to real economic activity seizing-up. The shocks to the financial system and the economy that were possible could have been disastrous to the confidence of businesses and households in our country and, to a significant degree, the rest of the world.”[1] It was critical for the Fed to demonstrate leadership in the face of this vicious attack.
First, Mr. Ferguson made sure that the financial system maintained liquidity, the lifeblood of our economy.
Why were we so concerned about maintaining liquidity in the financial system? Liquidity, as you know, serves as the oil lubricating the engine of capitalism to keep it from burning itself out. The efficiency of our financial system at maintaining adequate liquidity is often taken for granted. But on September 11, it could not be taken for granted. The bottlenecks in the pipeline became so severe that the Federal Reserve stepped in to ensure that the financial system remained adequately liquid. In other words, our massive provision of reserves made sure that the engine of finance did not run out of oil and seize up.[2]
Vice Chairman Ferguson and his Fed colleagues made sure that the Fed discount window was open and lending to banks.
On September 12, lending to banks through the discount window totaled about $46 billion, more than two hundred times the daily average for the previous month. The flood of funds released into the banking system reduced the immediate need for banks to rely on payments from other banks to make the payments they themselves owed others.[3]
These and other actions that Mr. Ferguson spearheaded prevented the American economy from going into a tailspin. I don’t know what went on behind the scenes at the Fed. But as the senior Fed governor, Roger acted with focus and determination. He didn’t dither. He demonstrated leadership and patriotism under extraordinary circumstances. If I had an opportunity to whisper in President Biden’s ear, I would urge him to award the Medal of Freedom to Roger Ferguson for his extraordinary service on that day.
A second person who deserves our thanks is Annette L. Nazareth. Ms. Nazareth was the Director of the SEC’s Division of Market Regulation (now known as the Division of Trading & Markets). (President George W. Bush later appointed her to be an SEC Commissioner.) After the attacks, there was enormous political pressure for Wall Street to reopen immediately. Notwithstanding the terrible loss of life and physical damage in lower Manhattan, many in Washington felt it was important to show the nation and the world that Wall Street could keep functioning.
The exchanges and broker-dealers appreciated the need to reopen, but they knew that they were not ready. For those firms whose personnel survived the attack, it was not easy to resume trading. Many firms’ offices were destroyed or were inaccessible. The attack knocked out communications lines and other systems. No one had considered disaster planning for a terrorist attack. Working from home wasn’t a possibility in those days. A premature opening would have resulted in failures and would have done more damage to the public’s confidence, rather than enhancing it.
On 9/11, I was general counsel of the Securities Industry Association (now called SIFMA), the trade group for broker-dealers. My members asked me to deliver one message to Ms. Nazareth at the SEC: don’t force the markets to open before they are ready. Of course, many others offered the same advice to others at the SEC, including Chairman Harvey Pitt.
Fortunately, the SEC took the advice that so many offered. As TheWall Street Journal recently described it, “The stock market stayed closed for four trading days—its longest shutdown since 1933—as crews worked to fix the damage.”[4] The subsequent reopening went reasonably well.
* * * * *
The financial markets are very different today than they were in 2001. Physical trading floors are much less important today than they were twenty years ago. Financial markets face different challenges, such as cyberattacks.[5] Those changes don’t diminish the leadership and heroism of the numerous individuals who worked so hard to restore America’s financial system after the 9/11 attacks.
Both Annette Nazareth and Roger Ferguson deserve our thanks for keeping their heads cool and acting sensibly in the face of a crisis. They prevented a terrible attack from cascading into a financial calamity. And for those of you who don’t know, Roger and Annette are husband and wife.
[1]Remarks by Vice Chairman Roger W. Ferguson, Jr. At Vanderbilt University, Nashville, Tennessee, February 5, 2003.
The folk rock group The Mamas and the Papas’ first hit and Grammy Hall of Fame song, “California Dreamin’,” expressed the hopes and dreams of leaving behind the cold of a winter’s day for the warmth of Los Angeles.[1] Under a recent decision of the California Court of Appeal that reversed the judgment of an L.A. trial court, whether a hit song means that the songwriter realizes the hopes and dreams of the warmth of financially sharing in the song’s success, or bears the cold of a winter’s day in not so sharing,[2] turns on the grant of discretion in the songwriter’s contract with the music publisher.
THE GRANT OF DISCRETION UNDER CALIFORNIA LAW
In Gilkyson v. Disney Enterprises, Inc.,[3] the children of the late songwriter Terry Gilkyson sued Disney Enterprises, Inc. and its music publishing subsidiary, Wonderland Music Company, Inc. (collectively, “Disney”), over royalties for the use of Gilkyson’s songs in the home entertainment releases of the 1967 animated film, The Jungle Book. One of the songs was “The Bare Necessities,” a song that has warmed the hearts of children around the world, whose laughter then warmed the hearts of their parents.
In 1963, Gilkyson entered into a contract with Disney that provided for a royalty equal to 50% of the net amount received by the Disney music publisher on account of licensing or other disposition of the mechanical reproduction right in and to material written by Gilkyson.
In another section of the contract, Disney reserved all revenue and receipts received by and paid to Disney by virtue of the exercise of grand, dramatic, television, and other performance rights, including the use of the material in motion pictures, photoplays, books, merchandising, television, radio, and endeavors of the same or similar nature.
Finally, another section of the contract provided that Gilkyson had no interest in any of the material other than his right to receive the royalties specifically set forth in the contract. In addition, nothing contained in the contract was to be construed as obligating Disney “to publish, release, exploit or otherwise distribute any of the material, and the same shall be always subject to [Disney’s] sole discretion.”
The jury returned a verdict of $350,000 in favor of the Gilkyson children for Disney’s breach of the contract. The trial judge then awarded an additional $699,316.40 as damages for the period after the date of the verdict through the duration of the songs’ copyrights.
Disney appealed the trial court’s judgment. The California Court of Appeal reversed and held that, under the language of the contract, Disney did not have any obligation to pay royalties to the Gilkyson children during the contract’s limitations period. Since the Disney music publisher was not paid for digital downloads of the motion picture or other audiovisual reproductions, it did not receive any amounts for which royalties were due.
Furthermore, nothing in the contract required Disney to exploit the mechanical reproduction rights at all or, if it elected to do so, exploit them in any particular manner. Rather, exploitation of these rights was in Disney’s sole discretion. Accordingly, the Disney music publisher had the right to permit its home entertainment affiliate to use the songs without charging an intercompany license fee and without incurring any liability to Gilkyson. The court keenly observed, “Had the parties intended that Disney would use its best efforts to exploit the mechanical reproduction rights in a manner that generated royalties for Gilkyson, the contracts would not have expressly granted Disney such unfettered discretion.”[4]
Since the trial court had denied the Gilkyson children’s motion for leave to file a second amended complaint that would have added a cause of action for breach of the implied covenant of good faith and fair dealing, and their appeal did not raise this issue, the covenant was not before the Court of Appeal. However, the Court of Appeal rejected the Gilkyson children’s argument that several general provisions of California law required the payment of royalties. Their argument would effectively require the court to rewrite the express language of the contract, which granted Disney the sole discretion on how to exploit the rights it obtained from Gilkyson and limited his right to royalties to Disney’s net receipts. The court was not authorized to engage in such an endeavor.
THE GRANT OF DISCRETION UNDER DELAWARE LAW
The reasoning of the court in Gilkyson is not unique to the jurisprudence of California. Delaware, the venerable bastion of corporate law, has used similar reasoning in its jurisprudence. In Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC,[5] the Delaware Supreme Court’s most recent guidance on the implied covenant of good faith and fair dealing, the court rejected the use of the covenant in the face of a grant of discretion.
In Oxbow Carbon, two minority investors, Crestview Partners, L.P. and Load Line Capital LLC, became members (the “Minority Members”) of Oxbow Carbon LLC (“Oxbow”) in 2007. Oxbow was the leading third-party provider of marketing and logistics services to the global petroleum coke market. Crestview made a $190 million capital contribution in exchange for a 23.48% membership interest, and Load Line made a $75 million capital contribution in exchange for a 9.27% membership interest.
The majority investor, Oxbow Carbon & Minerals Holdings, Inc. (“Oxbow Holdings”), made a $483,038,499.86 capital contribution in exchange for an almost 60% membership interest. Oxbow and Oxbow Holdings were controlled by William I. Koch. Several of Koch’s family members and affiliates also invested in Oxbow, which meant that the Koch group owned a combined 67% of Oxbow’s equity.
The Minority Members bargained for the following exit rights. First, they received a put right that could be exercised after seven years. Second, if Oxbow rejected the put, the party exercising the put could force an exit sale of all of Oxbow’s equity interests. However, a member could not be forced to sell its equity interest unless it received total distributions from operations and the exit sale was equal to or greater than 1.5 times the member’s aggregate capital contribution (the “1.5x requirement”). The LLC agreement provided that all distributions were to be made pro rata in accordance with each member’s percentage interest and that any exit sale must be on equal terms and conditions for all members.
In 2011 and 2012, Oxbow admitted additional minority members, Ingraham Investments LLC and Oxbow Carbon Investment Company LLC (collectively, the “Small Holders”). The Small Holders received a combined 1.4% membership interest. The members of Ingraham were members of Koch’s family, and the members of Oxbow Carbon Investment Company were executives of a large sulfur trading company acquired by Oxbow. Ingraham made a $20 million capital contribution, and Oxbow Carbon Investment Company made a $15 million capital contribution. Oxbow distributed approximately $8.2 million to Crestview and $3.2 million to Load Line from these capital contributions.
The board of directors of Oxbow unanimously approved the admission of the Small Holders, including the directors appointed by Crestview and Load Line, who otherwise had the right to block their admission. Although their admission did not comply with the LLC operating agreement’s preemptive rights provisions and the special approval requirements for related party transactions,[6] and the Small Holders did not deliver signed counterpart signature pages, the Court of Chancery found that in their course of dealing, the parties treated the Small Holders as members.
On September 28, 2015, Crestview exercised its put. When Oxbow rejected the put, on January 20, 2016, Crestview exercised its right to an exit sale. However, at the price offered by the bidder, the sale proceeds were insufficient to distribute to the Small Holders an amount equal to or greater than the 1.5x requirement.
Litigation then ensued. The Court of Chancery held that although the 1.5x requirement prevented an exit sale, under the implied covenant of good faith and fair dealing, the exit sale should go forward. Since the board of directors did not expressly determine the rights, powers, and duties of Small Holders at the time of their admission, in particular whether the Small Holders would have the benefit of the 1.5x requirement, there was a gap in the contractual rights of the Minority Members and Small Holders. According to the Court of Chancery’s summary judgment opinion, had the Minority Members realized that the Small Holders would have the ability to block an exit sale due to the 1.5x requirement, the Minority Members would not have consented to their admission. In addition, had the parties recognized this gap, they most likely would have agreed that the Minority Members could satisfy the 1.5x requirement by making additional payments to the Small Holders from the proceeds the Minority Members received from the sale.
The Delaware Supreme Court reversed and held that there was no gap and the implied covenant of good faith and fair dealing did not apply. Therefore, under the plain language of the LLC operating agreement, the Small Holders had the benefit of the 1.5x requirement and could block the exit sale.
Under the LLC agreement, the terms of admission of new members were left to the discretion of the board of directors.[7] Since the board chose not to specify different rights for the Small Holders, the terms of the LLC agreement applied with equal force to them. The court would not imply new contract terms merely because the contract granted discretion to a board of directors.[8] Conferring discretion on the board was a contractual choice to grant authority to the board and not a gap. Although the grant of discretion did not relieve the board of its obligation to use that discretion consistent with the implied covenant of good faith and fair dealing, the Minority Members did not argue that the board exercised its discretion in bad faith in admitting the Small Holders.
The court found that in light of the absence of a gap, and since the admission of new members and its effect on the exit sale process could have been anticipated, the court would not apply the covenant. The court observed that the parties could have limited the 1.5x requirement to certain members, excluded subsequently admitted members, amended the exit sale right to permit distributions by Oxbow to the Small Holders to satisfy the 1.5x requirement before distributions were made pro rata to the members, or amended the exit sale right to permit the Minority Members to make payments to the Small Holders to satisfy the 1.5x requirement.
The court then described the limited use of the implied covenant of good faith and fair dealing. The covenant was a cautious enterprise best understood as a way of implying terms in a contract, whether employed to analyze unanticipated developments or to fill gaps in the contract. It was not an equitable remedy for rebalancing economic interests after events occurred that could have been anticipated but were not, which later adversely affected a party to the contract. Rather, the covenant was a limited and extraordinary legal remedy.
The covenant did not apply when the contract addressed the conduct at issue, but only when the contract was truly silent concerning the matter at hand. Even when the contract was silent, an interpreting court could not use an implied covenant to rewrite the parties’ agreement and should be most chary about applying a contractual protection when the contract could easily have been drafted to expressly provide for that protection.
Finally, the court pointed out the two situations in which the covenant generally would apply. First, a situation has arisen that was unforeseen by the parties, and the agreement’s express terms do not cover what should happen. Second, a party to the contract is given discretion to act as to a certain subject, and the discretion has been used in a way that is impliedly proscribed by the contract’s express terms.
THE TAKEAWAY
The takeaway from Gilkyson and OxbowCarbon is that in drafting contracts, the grant of discretion usually wins the day. If a party wants to avoid or lessen the risk of another party’s exercise of discretion to deprive it of a benefit, then to the extent that the party has the leverage, it should bargain for the contract to clearly set forth nondiscretionary obligations of the other party or well-defined parameters on the other party’s exercise of discretion. To rely on the implied covenant of good faith and fair dealing is likely no more than a vain hope and dream.
[1] The Mamas and the Papas, “California Dreamin’,” Music and lyrics by John E.A. Phillips and Michelle Gilliam Phillips, on If You Can Believe Your Eyes and Ears (Dunhill 1966).
[2]Cf. Gladys Knight & the Pips, “Midnight Train to Georgia,” Music and lyrics by Jim Weatherly, on Imagination (Buddah 1973) (“L.A. proved too much for the man (too much for the man, he couldn’t make it). So he’s leaving a life he’s come to know, ooh (he said he’s going). He said he’s going back to find (going back to find), ooh, what’s left of his world, the world he left behind not so long ago. . . . He kept dreaming (dreaming), ooh, that someday he’d be a star (a superstar, but he didn’t get far). But he sure found out the hard way that dreams don’t always come true, oh no, uh uh (dreams don’t always come true, uh uh, no, uh uh). So he pawned down his hopes (woo, woo, woo-woo), and even sold his old car (woo, woo, woo-woo). Bought a one way ticket back to the life he once knew, oh yes he did, he said he would.”).
[3] 2021 WL 3075699 (Cal. Ct. App. July 21, 2021).
[5] 202 A.3d 482 (Del. 2019) (en banc) (Valihura, J.).
[6] The LLC operating agreement provided for the admission of new members “on such terms and conditions as the Directors may determine at the time of admission. The terms of admission may provide for the creation of different classes or series of Units having different rights, powers and duties.”
[7]Seealso Kenneth A. Adams, A Manual of Style for Contract Drafting 3.188 (ABA 4th ed. 2017) (“Discretion is primarily conveyed by means of may, which expresses permission or sanction.”).
[8]See also Mohsen Manesh, “Express Contract Terms and the Implied Contractual Covenant of Delaware Law,” 38 Delaware Journal of Corporate Law 1, 35 (2013) (“[W]hen the express terms of a contract unambiguously grant one party unfettered, sole, and absolute discretion, the court will readily construe the express terms to permit the discretion-exercising party to act under any circumstances and for any reason, free of judicial intervention. It is because the Implied Covenant notwithstanding, such language in the contract permits only that reasonable expectation.”) (footnote omitted).
In decisions that may signal things to come for employee plaintiffs in the wake of the Supreme Court’s decision in Alston,[1] two federal courts applying the rule of reason have denied class certification in two pending no-poach antitrust franchise claims for a failure to show the predominance of common questions. On July 28, a Chicago federal judge declined to certify a class action against McDonald’s for violating Section 1 of the Sherman Act.[2] Two days later, a Southern District of Illinois judge also declined to certify a class against Jimmy John’s due to several Rule 23(a) and (b) failures of proof, including the predominance of individual questions.[3]
Both class actions challenged no-poach clauses in the fast food giants’ franchise agreements, which prevented their franchisees from hiring employees of other franchises or company-operated restaurants. Although the courts denied class certification on varied bases, both found that the alleged unlawful restraint — the no-poach provisions — should be evaluated under the rule of reason and not the quick-look analysis sought by the plaintiffs, and the plaintiffs who sought to certify nationwide classes did not present evidence that the relevant geographic market where they offered their labor services was national in scope. The courts suggested instead that the relevant geographic markets for fast-food employees like the plaintiffs could be the hundreds or thousands of markets near where the employees lived and worked, and that they would include all quick-service restaurants in the markets, not just the defendants’ branded restaurants.
Background
Until July 2018, both McDonald’s and Jimmy John’s had provisions in their franchise agreements generally prohibiting their franchisees from employing or seeking to employ individuals who work for other franchisees or restaurants operated by the company. While most of the fast-food giants’ branded restaurants are franchised, they both operate a small portion of the restaurants themselves. The plaintiffs in Deslandes v. McDonald’s and Conrad v. Jimmy John’s Franchise LLC are current or former employees of McDonald’s and Jimmy John’s restaurants, who allege that the no-poach provisions violate Section 1 of the Sherman Act by limiting competition and suppressing their wages.
While the proposed classes — nationwide classes of all persons employed at the defendants’ branded restaurants from roughly 2013 through July 12, 2018 — were sufficiently numerous under Fed. R. Civ. P. 23(a), both courts found, among other things, that common questions did not predominate under Rule 23(b)(3), thus barring certification. Although not discussed in this article, both courts denied class certification on other grounds factually specific to the claims raised in their respective cases.[4]
Rule of Reason v. Quick-Look Analysis
Before assessing whether common questions predominated, both courts decided whether the alleged anticompetitive effects should be analyzed using the rule of reason or a quick-look analysis. Relying on the Supreme Court’s recent decision in Alston, which involved a similar Section 1 Sherman Act claim against the NCAA and 11 Division 1 conferences for allegedly wielding monopsonist power in the market for student athletes, the courts held that a quick-look analysis applies only in rare situations, where the court has “considerable experience with the type of restraint at issue.”[5]
The McDonald’s court did not have enough experience with no-poach provisions in franchise agreements to say with confidence that the practice must always be condemned. Thus, with Alston as precedent, the McDonald’s court applied the rule of reason, as opposed to the quick-look analysis.
The Jimmy John’s court relied on Alston to answer the question it had punted at the motion to dismiss stage and found that the rule of reason applies “in this monopsony case challenging a nationwide franchise’s use of intrabrand restraints that were arguably ‘designed to help [the company] more effectively compete with other brands by ensuring cooperation and collegiality among franchisees, and by encouraging investment in training.’”[6] In addition to following the Supreme Court’s precedent in Alston, the Jimmy John’s court also found that the plaintiffs had failed to present common proof that will show that each franchisee conspired with Jimmy John’s to suppress labor mobility and wages.[7]
The rule of reason applied for several other important reasons. First, Defendant McDonald’s put forth sufficient evidence of the pro-competitive effects of the alleged restraint — preventing free riding and encouraging training — warranting the application of the rule of reason.[8] Second, because Defendant McDonald’s operates far fewer restaurants than its franchisees, franchises do not compete with restaurants McDonald’s operated for employees in many areas of the country, establishing that in many geographic markets, the restraints are vertical not horizontal.[9] Vertical restraints are judged under the rule of reason.[10] Third, Jimmy John’s presented expert opinion that the no-poach provision actually benefited the members of the putative class by encouraging their employers to invest in training, and the relevant labor market was not nationwide in scope and not limited to employment with the Jimmy John’s branded restaurants.[11] Rather, it encompassed employment at all quick-service restaurants within a local relevant market.[12]
Rule of Reason Application Creates Individual Questions Preventing Class Certification
The first question under the rule of reason analysis is whether the challenged restraint of trade has a substantial anticompetitive effect in the relevant market.[13] Both courts rejected the plaintiffs’ characterization of the relevant market as a national service market for McDonald’s or Jimmy John’s restaurant workers. The McDonald’s court said “it defies logic to suppose” that McDonald’s employees sell their labor in a national market.[14] According to the court, employees that compete in national markets are “highly skilled or highly paid” like CEOs — not fast-food employees.[15] This conclusion is buttressed by Defendant McDonald’s evidence: the deposition testimony from lay and expert witnesses demonstrated that McDonald’s restaurants experience local, not national, competition.[16] As such, the court found that proposed class members competed in different relevant geographic markets, making the rule of reason antitrust questions predominantly individual for purposes of Rule 23(b)(3).
Similarly, the Jimmy John’s court found, based on expert testimony, that competition from other quick-service restaurant employers and others would “push the worker’s wages … up to the competitive level associated with the worker’s skills.”[17] As such, individual questions as to whether individual plaintiffs suffered injury because of the alleged restraints existed, given the “varied and dynamic labor markets across the country.”[18]
Because the predominate question of whether the restraint causes an anticompetitive effect in the relevant market is not common to class members, the McDonald’s court did not decide whether the question of antitrust injury or impact is common.[19] But the court did say that it would be “difficult … to imagine that it could be a common question … ” since the question is based on wages, and “[t]he amount each person’s wages are suppressed,” which “will almost certainly vary depending on the amount of labor market power McDonald’s possessed in each relevant market.”[20]
Takeaways
While other courts could disagree,[21] these decisions represent big wins for employers and franchisors after the Alston decision, representing persuasive authority for limiting the use of quick-look analysis in franchise no-poach antitrust claims. Further, to the extent the rule of reason applies, the decisions illustrate the difficulty class plaintiffs and their counsel will face in trying to establish the predominance of common questions under the rule of reason when alleging both horizontal and vertical restraints.
[1]National Collegiate Athletic Association v. Alston, 594 U.S. ___.
[2]Deslandes v. McDonald’s USA LLC, No. 17 C 4857, 2021 WL 3187668 (N.D. Ill. July 28, 2021).
[4] The McDonald’s court found the class was not fairly and adequately represented by counsel due to its litigation tactics, including waiving the right to pursue a rule of reason antitrust claim. The Jimmy John’s court denied class certification for a number of reasons beside predominance, including a failure of typicality and adequacy, and a class was not a superior method of adjudicating the claims.
[5] McDonald’s, 2021 WL 3187668 at *11 (quoting Nat’l Collegiate Athletic Ass’n v. Alston, 141 S. Ct. 2141, 2156 (2021)): Jimmy John’s, 2021 U.S. Dist. 142272, at 25-6 (quoting Nat’l Collegiate Athletic Ass’n v. Alston, 141 S. Ct. 2141, 2156 (2021)).
[8]McDonald’s, 2021 WL 3187668 at *12-16. Even the plaintiffs’ experts echo this point, saying “for the restaurant employees in particular, the crew employees, there may be labor markets of different geographic size and that the key issue there might not even be size, it might be commuting distance.” Id. at 13.
[21]See e.g., Jarvis Arrington, et al v. BKW, et al., No. 20-13561 (11th Cir.). Oral arguments in the appeal of this franchise no-poach agreement case against Burger King have been scheduled for September 22, 2021.
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